The Social Enterprise Investment Market is eagerly awaiting Social Investment Tax Relief (SITR) coming on stream. We have a number of clients all hoping to get new investment proposals off the blocks in the next few months.
The great thing about SITR is unlike Enterprise Investment Scheme (EIS) tax relief, it allows a tax write off for loans and quasi-equity. A debt is of course not a great way to finance a business anyway. Normally the lender demands payment of interest whatever is happening in the business. Islamic finance bans the payment of interest. It is like medieval Christianity, before the lure of money got the better of men’s consciences. In the Islamic view, straight debt imposes too much of a burden upon the business. There is not sufficient risk-sharing between the provider of the money and its user. Consequently in Islamic finance, leases are permitted and quasi-equity arrangements whereby risk is shared between the provider of the finance and the “borrower”.
Interestingly enough, the rise of social enterprises has also seen the development in this country of quasi-equity financial products. These have different names, Revenue Participation Agreements (RPAs) to some or Risk Dividends to others. Certainly RPAs which I helped develop have the following features:
- Finance is provided on a limited recourse basis i.e. the financial return can be paid out only from defined revenue streams;
- There is no claim against any of the other assets of the business;
- Typically the money is put up in order to allow the “borrower” to use the money for investment and only when the particular activity comes on stream and has reached a hurdle rate of turnover, does an obligation to start repaying the finance kick in;
- Typically, the financier is entitled to two or three times his money back and then that is it – there is no further obligation to pay;
- The payment is frequently calculated as a percentage of turnover generated from the particular activity. The beauty of this from the financier's point of view is that this is a hard number. It cannot be subject to any accountant’s alchemy. Turnover is turnover and a fixed percentage of it is just that.
There have been complications about Community Interest Companies issuing RPA’s but the recent reforms (soon to come through) in relation to the dividend and performance-related interest caps should ease that problem.
But despite all this interesting innovation and the hopes of SITR, all is not well for those social enterprises and charities who use these financial instruments but who are also engaged in public procurement.
The big problem is their balance sheet. Debt is a liability. RPAs are a sort of liability. In neither case do they give strength to the balance sheet that equity or attained profits do.
But if one analyses preference shares which have a non-fixed coupon, they are treated as equity. I would argue that it is essential to treat RPAs similarly. If you take “the substance over form” argument view then the substance of a RPA is that it is much more like equity than it is debt. As companies limited by guarantee cannot issue shares and this is the nearest to shares that they can issue, given their legal constraints then in substance – this must be equity.
I would be delighted to hear from anyone who is having problems with this issue, particularly on public procurement contracts.
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