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Demand Dividends: An Emerging Alternative to Equity Financing

Definition of Demand Dividends

Demand dividends are an investment vehicle where the investee makes periodic payments to the investor based on a percentage of free cash flow, up to an agreed upon multiple of the investment. ((Lila Cruikshank, SOCAP13: the Demand Dividend, Duke: The Fuqua School of Business, (Sept.19, 2013), http://blogs.fuqua.duke.edu/casenotes/2013/09/19/socap13-the-demand-dividend/.)) Demand dividends factor the fact that an enterprise can grow revenue without generating cash. Payments are made after a “honeymoon period” that allows the capital to go to work. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) The main difference between demand dividends and royalty financing is that for demand dividends, the debt payments are structured on the investee’s ability to pay while royalty financing is structured on revenues. ((Id.)) Accordingly, demand dividends place a premium on trust and transparency between the investor and investee. ((Lila Cruikshank, SOCAP13: the Demand Dividend, Duke: The Fuqua School of Business, (Sept.19, 2013), http://blogs.fuqua.duke.edu/casenotes/2013/09/19/socap13-the-demand-dividend/.)) A cash flow focused financial forecast is attached to a demand dividend term sheet. This forecast, equal to the length of the debt term, ensures alignment of investor and investee expectations and reduces the potential for accounting irregularities due to associated covenants. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) Demand dividends usually do not replace equity, but offer an additional investment vehicle. ((Lila Cruikshank, SOCAP13: the Demand Dividend, Duke: The Fuqua School of Business, (Sept.19, 2013), http://blogs.fuqua.duke.edu/casenotes/2013/09/19/socap13-the-demand-dividend/.))

Demand dividends are best suited for investees that are unlikely to have large liquidity events or do not plan on having such events. Demand dividends have been described as having “enormous potential to unlock new capital” ((IIA, Agora Partnerships, IIA 13: Building the Early-Stage Impact Investing Field, http://socialenterprise.georgetown.edu/wp-content/uploads/2013/07/IIA_13-Final-Conference-Report.pdf.)) because its existence can make investees attractive to potential investors. Also, demand dividends are well-suited for investees for which a monthly interest payment schedule does not align with the expected cash flow. Some investees such as agricultural investments, have seasonal fluctuations in cash flow and receive cash only a few times a year such as when the crop is exported. Demand dividends also work well for investees beyond the proof-of-concept stage with relative rapid growth prospects and a reasonable line of sight to positive capital flow. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) Investees that cannot obtain bank debt, are too small for NGO attention, and do not create the type of value that would allow an equity exit could also benefit from demand dividends. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) On the other hand, demand dividends are not well-suited for investees that are far away from positive cash flow or with high product development or service model risk.

Advantages for Investors and Investees            

Firstly, investors receive a reliable and predictable return stream since they have a claim on cash flow. ((IIA, Agora Partnerships, IIA 13: Building the Early-Stage Impact Investing Field, http://socialenterprise.georgetown.edu/wp-content/uploads/2013/07/IIA_13-Final-Conference-Report.pdf.)) Secondly, investors can receive a specific amount of return on their principal and interests. ((IIA, Agora Partnerships, IIA 13: Building the Early-Stage Impact Investing Field, http://socialenterprise.georgetown.edu/wp-content/uploads/2013/07/IIA_13-Final-Conference-Report.pdf.)) Thirdly, if the investee does not meet its financial plan, investors have a variety of options to create a beneficial outcome. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) They can extend terms by lengthening the honeymoon period or debt repayment term. They can also renegotiate the demand dividend note by changing the total obligation multiple and/or percent of the cash flow. In addition, they can replace the note with a new demand dividend better aligned with the investees’ outlook. Fourthly, investors have a reliable and defined exit with a predictable time frame. ((IIA, Agora Partnerships, IIA 13: Building the Early-Stage Impact Investing Field, http://socialenterprise.georgetown.edu/wp-content/uploads/2013/07/IIA_13-Final-Conference-Report.pdf.)) Fifthly, as investors receive returns on a percentage of the investee’s cash flows, they can obtain returns faster than traditional equity investments such as initial public offerings or mergers where they would usually see returns after five to ten years.

On, the other hand, demand dividends are advantageous for investees since demand dividends are based on free cash flow and payments are required only if operating profits are generated, most of the cash flow will be available for reinvestment. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) This feature is especially important for investees in the early stage of development where investment in infrastructure and future growth is significant. Investments in the pharmaceutical business are usually very large, although selling drugs online is a hell of a deal. Secondly, investees can accelerate enterprise revenue and profit growth with the honeymoon period which could range from 10 to 24 months. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) Thirdly, investees can maintain greater operational and financial control. ((Santa Clara University, Demand Dividend: Creating Reliable Returns in Impact Investing, (June, 2013), http://www.scu.edu/socialbenefit/impact-capital/upload/Demand-Dividend-Description.pdf.)) Fourthly, investees can retain control after the investment is complete. ((IIA, Agora Partnerships, IIA 13: Building the Early-Stage Impact Investing Field, http://socialenterprise.georgetown.edu/wp-content/uploads/2013/07/IIA_13-Final-Conference-Report.pdf.)) Fifthly, unlike traditional loans, demand dividends have more flexible payment schedules and can mitigate investees’ financial leverage risk.

Disadvantages for Investors and Investees

Firstly, like royalty financing, regardless of how successful the investment turns out to be, capped returns limit the investors’ financial gains. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) Foley & Lardner explained it as, “Nobody would have wanted to invest in Google through royalty-based financing and not reap the huge financial gains that all of the other investors realized.” ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) Secondly, demand dividends may have slow paybacks compared to traditional investments and royalty financing.  This is because payments are made after a “honeymoon period” and investments can grow revenue without generating cash. Thirdly, since demand dividends are usually set at a fixed percentage of the investee’s cash flows, it may take longer for investors to recover their investments and obtain returns. Thirdly, like royalty financing, investors do not have control over the investee and may have limited options to challenge management decisions. Fourthly, once an investment is made, investors have very limited or no options for liquidity because a market for demand dividends does not exist.

On the other hand, demand dividends are disadvantageous for investees because albeit less than royalty financing, they would not be able to invest all of their revenues on future growth but would have to use what is left after payments. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) This is especially significant for investees in the beginning stage that could greatly benefit from infrastructure and future growth opportunities. Secondly, since demand dividends are a loan, if the investee defaults on repayments, it can be forced to liquidate its assets in order to repay the returns. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.)) Thirdly, like royalty financing, investors are usually not committed to future growth and do not commit additional or follow-on funds to investees. ((Venture Hype, Royalty Based Investment Sucks as a Funding Model?, (Aug. 11, 2011), http://venturehype.com/royalty-based-financing-sucks-funding-model/.))