What is redeemable equity?
Redeemable equity, also known as an equity buyback, is a type of revenue-based investing (RBI) capital product designed and used by VC firms like Indie.vc, Exponential Creativity Ventures, and Purpose Ventures. It allows funders to invest in early-stage businesses that do not yet have recurring revenues, but are projecting high growth in the future. Redeemable equity investors are able to capture potential upside in these businesses, but also create visibility around liquidity and return with the timeframe of their investment. For early stage founders, redeemable equity gives them the opportunity to repurchase some or all of the shares they have sold at early stages of their companies growth, giving them more optionality around their future funding plans than traditional equity, which requires continued equity fundraising and exponential growth.
Redeemable equity investing begins like a typical equity deal — with an investor purchasing shares of a company for a mutually agreed upon price. As part of this deal, the company agrees to gradually repurchase (i.e. redeem) some predetermined portion of these shares via regular payments of a fixed share of revenues (typically 3-10%) or free cash flow at a fixed multiple of the shares’ original purchase price (typically 2-5x).
Similar to traditional debt financing, investors intend to collect monthly, quarterly, or annual dividend payments. Rather than payments set at an interest rate, these dividends are flexible (as they need to be declared by the company) and affordable (as the company can only declare them if there are sufficient retained earnings to pay the dividend.) If the company’s growth slows down, then these dividends will be lower; if the company’s growth is higher, then the shares are redeemed more quickly. Dividends are declared until the investor receives the 2x to 5x return cap. Many investors using redeemable equity keep a percentage of the shares outstanding, or residual ownership, in order to participate in any significant upside in the future.
Redeemable equity blends features of bank debt and venture capital, and founders should expect the cost of capital to fall within that range. Redeemable equity is less dilutive, growth capital that can bridge the path to cheaper sources of capital and sustainable profitability for both pre-revenue and revenue-generating companies that do not fit the traditional VC model.
What are the typical characteristics of redeemable equity?
- Structured as a convertible note or preferred equity
- Dividends are calculated as a set percentage of revenue (typically 3-10%) or Free Cash Flow
- Dividends continue until a set dollar amount has been paid back, usually 2-5x the amount of the investment (return cap or total obligation)
- Initial ownership stake of 5-15% that businesses can redeem or buy back from investors through revenue-based payments
- Residual ownership stake that investors maintain following the redemption
Redeemable equity is often cheaper than traditional equity, but more expensive than bank loans. It typically costs 15% to 30% IRR compared to <10% for bank loans and 50%+ for VC.
Redeemable equity is an equity-like product with debt-like features. Given the smaller size of the emerging redeemable equity space and innovative design, there is still no clear guidance from the IRS on how it should be taxed. However, most redeemable equity investors have treated their investments as equity, not debt. Therefore, taxable investors, including family offices and high net worth individuals, will have their gains taxed at their capital gains rate.
There is reclassification risk where the IRS reclassifies a redeemable equity investment as debt, which would require investors to pay ordinary income tax instead of capital gains tax.
If structured correctly, redeemable equity instruments can mitigate some of the tax and regulatory issues presented by revenue-based loan instruments. With this mitigation comes additional complexity and potentially upfront costs as redeemable equity agreements can have more clauses to negotiate than traditional equity investments. This is because, unlike traditional equity investments, redeemable equity agreements are doing two deals in one. (i.e. taking the money in and defining the economic terms of repayment).
Since 2018, fund managers have adopted and iterated on the open-sourced Indie.vc term sheet. We consider the Indie.vc term sheet to be a redeemable equity product; however, there are some major differences between the Indie.vc term sheet and the redeemable equity term sheet in this playbook. The Indie.vc term sheet is structured as a convertible note with the investor receiving rights to the investee company’s shares and several types of conversion events. This playbook’s term sheet is structured more closely to preferred equity with the investor receiving the investee company’s shares upfront at investment and takes a more conservative approach by avoiding mandatory redemption payments. Also, the Indie.vc term sheet does not need the company to be profitable before receiving redemption payments, unlike this playbook’s term sheet.
Capital Product Fit
When is redeemable equity a good fit for businesses?
- Profitability: Businesses do not need to be profitable, but investors like to see a path to profitability within 3-5 years.
- Annual Revenue Growth: 50%+
- Gross Margins: 40%+
- Financials: Many investors look for at least one year of financial statements, although this capital product can be used with very early stage startups as well.
- Sustainable Growth Focus: Founders focused on building real businesses with actual sales and sustainable growth rates instead of a growth-at-all-costs approach.
When is redeemable equity not a fit for businesses?
- Heavy R&D: Businesses that are capital intensive and require a large amount of upfront funding to build large-scale projects or bring breakthrough technology to market.
- Blitzscalers: Businesses that require rapid growth to take over an entire market or create a new market and need large amounts of VC funding to scale. These “Blitzscalers” typically focus on speed and growth over cash flow and profits.
- Fundraisers: Founders always focused on raising the next round of funding for their businesses. Investors want to write checks to builders, not fundraisers, and do not want to have to spend a lot of time convincing founders not to take the traditional VC funding path.
- Misaligned Cap Table: If founders have raised $5M+ in traditional VC funding, then their existing investors most likely will be focused on raising another VC round at a larger valuation. Redeemable equity investors do not want to compete with the different return and fundraising expectations of prior or potential co-investors. On the debt side, investors do not like to navigate a crowded and complex cap table with a bunch of lenders who are more senior to them and have expensive rates and warrants.
Why would founders want to choose redeemable equity?
- Preserve Equity & More Control: Founders maintain more ownership and control over their business than traditional VC. Investors typically do not take a board seat.
- Flexible Payment Schedule: Redeemable equity allows companies to use dividends to redeem shares from investors. These dividends payments are based on revenues or free cash flow. Dividends can only be declared when a company has sufficient cash on hand to pay the dividend, so they can not force a company into bankruptcy.
- No Restrictive Covenants: Unlike traditional bank loans, redeemable equity typically does not require the borrower to agree to any restrictive covenants where the borrower must manage their business in a specific way, such as maintaining minimum liquidity levels or hitting revenue milestones. For example, venture debt lenders will require borrowers to also agree to stock warrants for upside participation in exit scenarios. Factoring or merchant cash advances also come with more restrictions and need to be paid daily or weekly compared to monthly or quarterly for redeemable equity.
- Cheaper than VC: Redeemable equity is often cheaper for founders than selling preferred equity to VCs. Founders may believe that traditional equity costs less with no expected payments until an exit, but redeemable equity is most likely cheaper over the long-run on both total dollar amount and IRR basis. Redeemable equity investors cap their investment at a 2-5x return instead of aiming for 10x+ returns like VCs.
- Fundraising Optionality: Founders do not need to follow the VC funding path of raising larger follow-on rounds of dilutive equity capital. Redeemable equity offers cheaper, less dilutive growth capital that can enable businesses to scale and eventually raise VC funding or access cheaper bank debt. It provides founders the optionality to pursue the funding journey that makes the most sense for their business.
- Access to Capital: Redeemable equity is more accessible for underrepresented founders because the underwriting process is based on the company’s revenue, margins, and other financials, not the owner’s credit score, income, or personal real estate assets. Traditional debt financing continues to use outdated and discriminatory lending practices that limit access to capital and increase the cost of capital for underrepresented founders. Redeemable equity has improved the investment process with a more inclusive underwriting approach.
What should businesses look out for with redeemable equity?
- Less Predictable Payment Schedule: Dividends fluctuate with the profitability of the company, which can provide flexibility for founders, but also can be harder to predict for financial projections than traditional loans with fixed monthly payments. Redeemable equity has a variable interest rate instead of a fixed interest rate.
- More Expensive than Bank Loans: Most founders seek redeemable equity because they cannot access bank loans or VC. Redeemable equity usually costs between 15% and 30% IRR compared to bank loans at <10% IRR and VC at 50%+ IRR. If revenue or free cash flow grows quickly, then the dividend payments expected will also do so. This leads to a shorter payback period, but also a higher cost of capital. Founders need to be comfortable with the fixed return cap or total obligation, regardless of their revenue growth rate.
- Gross Margins > % of Revenue: Founders need to be comfortable giving up the percentage of revenue to pay back the investment. Gross margins need to be sufficiently high enough to support the financing costs or else the investment will start to reduce the growth potential of the business.
Terms: What do investors typically charge businesses for redeemable equity?
- Investment Size (Purchase Amount): Typically $50K to $3M check sizes
- This is the total amount invested in the round.
- Initial Ownership (Equity): 5-15%
- Subject to redemption
- Residual Ownership (Equity): 0-50% of the original shares purchase or initial ownership
- Redemption: 3-7% (though it can go as high as 10% of revenue or 10-50% of Free Cash Flow
- This is the percentage of revenue or free cash flow that founders will pay for redeeming the investor’s shares. These payments are structured as dividends that need to be declared by the company. Each redemption reduces the investor’s ownership and increases the founder’s ownership. This allows founders to repurchase 50-100% of the investor’s ownership percentage via redemption payments until they redeem a multiple of the investment amount (return cap or total obligation).
- As discussed below, one of the key outstanding tax issues with redeemable equity is the reclassification issue — i.e the outstanding possibility that the IRS would reclassify a redeemable equity investment as a debt investment, thus requiring the investor to pay ordinary income tax on the “interest” received over and above the principle. Although we do not have clear guidance on this topic, creating required payments, similar to a debt instrument, increases the likelihood of this happening. For this reason, the draft term sheet included in this playbook and the discussion in this chapter clearly labels the redemption payments as dividends that are declared by the company.
- Return Cap (Total Payment or Total Obligation): 2x to 5x purchase amount
- Dividend Schedule: Monthly or quarterly or annually
- Grace Period (Redemption Start Date): Investors generally include either a time based grace period (i.e. 6 – 36 months) or one that is linked to a revenue or free cash flow milestone.
- This is the date founders’ should begin declaring the dividends to repurchase investors shares. As discussed above, it is important to note that dividends can not be legally declared if the company does not have sufficient retained earnings to pay the dividend.
- If the company has a failed redemption, which investors term as a specific number of redemption payments that have not been made, investors can choose to make the entire total obligation due and payable, convert the total obligation into debt with warrants or renegotiate the terms of the deal.
- Personal Guarantee: None
- Financial Reporting: The investor has financial data access to the company’s financial statements, including monthly balance sheet (plus YTD), monthly cash flow statements (plus YTD), monthly bank reconciliation report, monthly bank statements, and monthly compliance certification certifying the information delivered.
- Board Seats: None