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Say hello to the demand dividend – an innovative new debt vehicle that could reshape the relationship between investors and ventures.
The demand dividend is a new debt vehicle that helps align impact investor and social entrepreneur interests by basing repayment on the venture’s free cash flow. This allows more flexibility than traditional debt arrangements and enables the investor to achieve a structured exit without forcing the entrepreneur to sell the company or go public.
How it Works
The demand dividend has three key elements:
- A honeymoon or grace period: The entrepreneur is not required to make any repayments during a honeymoon period, which may be one to three years.
- Variable payments tied to cash flow: Payments are calculated as a percentage of free cash flow (usually 25% to 50%).
- Fixed payoff amount: Once the investor receives a fixed multiple of the initial investment (usually 1.5 to 3x), the relationship ends.
The demand dividend differs from other revenue-sharing tools because repayments are tied to cash flow rather than revenue (e.g. revenue royalties) or profits (e.g. profit participation loans). It is more forgiving for companies facing a bad quarter or year: no payments are required when cash flow is zero.
Tom Sabel (Program Manager at Santa Clara University) notes that the demand dividend is most appropriate for social ventures in frontier markets that are “beyond proof of concept and in expansion mode” and need capital to increase distribution or build infrastructure.
Benefits to Investors and Social Entrepreneurs
The demand dividend benefits impact investors:
- Investors generate a reasonable return and are compensated for risk
- They have a structured exit
Social entrepreneurs also benefit:
- Entrepreneurs access capital that might not otherwise be available
- The honeymoon gives entrepreneurs time to generate positive cash flows
- The variable payment structure is more forgiving
- Entrepreneurs maintain ownership of the company.
Lisa Kleissner (founder of the KL Felicitas Foundation) says that the demand dividend provides “flexibility in crafting an agreement that makes sense” and “a weighted upside everyone can agree to”.
A Sweet Case Study: Maya Mountain Cacao
The first ever demand dividend involves chocolate. Maya Mountain Cacao exports premium organic cocoa from Belize. It needs capital for new infrastructure including a nursery and a demonstration farm. Emily Stone (General Manager of Maya Mountain Cacao) and investor, Jim Villaneuva (Executive Director of The Eleos Foundation) negotiated the demand dividend.
The agreement begins with a $200,000 investment. A two-year repayment holiday allows Maya Mountain Cacao to start generating revenues from the infrastructure investments. Jim Villanueva notes, “we’re putting our money into the ground, and it takes time for that to come back”. Then, repayments are made semi-annually. Jim has a claim on an agreed percentage of the company’s free cash flow. The semi-annual flexible repayments suit the company’s revenue model: monthly cash flow is unpredictable in an export-driven agricultural product business.
Once Jim receives an agreed multiple of the initial investment, he will “tear up the note and go away”. According to projections, this should happen in about seven years. If the company misses its projections by a huge margin, the agreement is restructured. If the company takes off, there is a convertibility feature and Jim has a right to participate in future rounds.
Emily is excited to co-create a new tool and appreciates the need for exits so that impact investors can “reinvest in my colleagues”. She values the transparency of the process, which includes agreeing with Jim on revenue and expense projections over ten years. She also appreciates “avoiding valuation tension”, as both parties recognize from the get-go that the company is not going to provide a 20x return.
Jim wanted to pioneer an investment structure that would address some of the difficulties he faced as an early-stage investor in frontier markets. In his initial conversations with Emily, the exit was not clear, but he “didn’t want to force a sale just to take us out”. As an impact-first investor, he hopes “to structure financing that will work for the entrepreneur and the impact they’re trying to achieve”. “We’re happy to be the guinea pigs on all this”, he says.
Emily and Jim agreed that a successful demand dividend arrangement requires mutual trust.
Tools for Implementation
The demand dividend was conceived and developed by Professor John Kohler and his team at Santa Clara University’s Center for Science, Technology, and Society. He notes, “the round-trip of capital has been elusive. It happens, but it’s not steady.” The team identified “a need to develop instruments in the impact sphere that will both give investors a reliable exit strategy and will align with what social entrepreneurs’ needs are”, according to Tom Sabel.
Now the group acts like a matchmaker or investment banker, helping parties negotiate demand dividends. To assist, lawyers have built an online tool that generates tailor-made term sheets for demand dividends.
For more information, the Santa Clara team’s description of the demand dividend is available here.
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