Limited return – different approaches
We’ve encountered and worked with different ways of going about designing “limited” returns, the choice of which depends on the stage and risk profile of the company, the preferences and needs of the company, its entrepreneurs and investors and the chosen financial instruments. There is no clear “standard” process of how to go about limited returns and the market is still collecting experiences as to which processes work best for which investor type, company stage and risk profile.
The following are some of the many ways we have seen limitations defined in the past – new and more creative forms are, of course, always possible. The examples are grouped by whether the limitation is based on a cap, duration, or influence. Please note that while some examples might look technically similar, we want to highlight the creative space you have when designing limitations.
- The investment return is a fixed multiple X of the initial investment.
- Similar to bank loans, an interest rate of sum X p.a. is fixed and has to be paid until the initial investment is paid back.
- An interest rate of X% p.a. is fixed, with a performance-based variable rate Y% p.a., which can increase — reflecting the principle that success is shared — until the initial investment (plus upside) is fully repaid.
- An interest rate of X% p.a. is fixed, with a risk-based variable rate Y% p.a., which can decrease — based on a risk profile assessment. For example, if the company starts with high debt and a higher risk profile, the margin may be reduced by Z% p.a. once specific milestones are reached or performance metrics are met, signaling reduced risk.
- A variable multiple of the initial investment is determined via a formula referencing revenues/ profits/ cash flow or other indicators of the company's development. This could also involve certain milestones for the company.
- A process is defined as to how a future multiple of the initial investment will be fixed once the company reaches a certain milestone.
- A duration is fixed for the length of which a fixed or flexible percentage of revenues/ profits/ etc. are paid out to investors.
- A fixed interest rate of sum X p.a. with a penalty if redemption does not occur within a predetermined duration Y.
- A variable multiple of the initial investment is determined via a formula referencing revenues/ profits/ cash flow or other indicators of the company's development. This could also involve the duration until which the investment is paid back (e.g. by changing the terms if the forecasted investment term is exceeded).
- A minimum holding period is defined within which a percentage of revenues/profits/etc. has to be paid to investors, afterwards the entrepreneurs have call options (giving them the right to redeem investment) and/ or investors having put options (giving them the right to have investment redeemed) with agreed upon fix or variable prices.
- Dividend payments are built into the structure and while there is no built-in end of the investment relationship and payouts, there is a (open) way for the company to at some point end the investment relationship, and investors do not have influence on payout.
- The decision of whether or not dividends are paid out to the investor lies with the steward-owners alone. Investors have no fixed entitlements and no control over liquidity. If stewards don’t think further payments are adequate or sensible, they can stop the payments. This option should be carefully built with a lawyer and be aware of minimum payout requirements!
- Limitation by termination: The investment relationship operates based on a defined company valuation and a clear valuation methodology. Structured exit scenarios are established, outlining how both the company and investors can initiate an exit through predefined buy and sell options. These mechanisms ensure that the investment relationship can be concluded in an orderly manner, specifying what happens next – leading to a structured exit. Until that point, regular fixed or variable payments may be made. Ultimately, the company must be in a position to pay its full valuation to finalize the exit.
The fixed, variable and open approaches above can also be combined to give investors some security whilst leaving flexibility for the development of the company, e.g. having a variable approach until milestone X is reached or up to a certain point in time and afterwards changing to a fixed approach.
So, to summarize: Returns in steward-ownership-aligned financing are “limited” either by amount (using a fixed or variable cap), duration (limits investment returns at some point), or by influence (there is no option for investors to influence payouts from the company).