After taking a bit of a break from more dense articles, I’m now back with a more analytical article. Today’s article covers some interesting financial instruments AITX entered into with some early investors in 2019 and 2020. These were a sale of future revenue.
I haven’t really heard much chatter on these before, nor have I heard the bashers laying into Steve for these. I’m honestly surprised the FUD gang hasn’t latched onto this one, maybe they’ve never heard of an SEC filing before… In any case, we’ll go through each of the financial instruments, what the past and present implications were/are, how I see these potentially unwinding, and my opinion on AITX’s decision to enter into these.
Sale of Future Revenue
In the earlier days of AITX, Steve must have tracked down some high risk, high reward, investors who really believed in RAD and Steve’s vision. These investors entered into a non-traditional financial instrument which can only be described as Wall Street Bets-esque.
AITX sold future revenue is exchange for up-front cash. The way it worked was, these investors would accrue “interest” which was equal to some percent of AITX’s net revenue perpetually (forever!). If the company barely ever made money and went under, these investors received nowhere near their initial investment. But if AITX makes it big, these investors are in for a serious payday.
The arrangements are debt-like in that they gave AITX some amount of money, and AITX repays them in an interest payment is equal to a percentage of AITX’s revenue. The exact line item in the balance sheet is “Deferred variable payment obligation”. Like traditional debt, AITX records the investment they received, sort of like principal, as a long-term liability. This is because these investors have some claim on assets derived from a percent of their investment (we’ll get to that), but AITX has no obligation to pay them that money back. Then, interest accrued is calculated from AITX’s revenue percentage.
To help demonstrate, the figure below describes the various arrangements:
Let’s go through a few things with these.
First, the way it works is the investors could invest up to a max amount, take for example the $900,000 of Investor A. If they invested $900,000, they would receive 9% of future revenues perpetually. If they only invested, say, $450,000 and then stopped, they’d only receive 4.5% of future revenues. Every investor fronted the full amount except for Investor D who, to date, has only invested $50,000 out of $100,000. If AITX succeeds, look for Investor D to invest a further $50,000 assuming there isn’t a time restriction.
Second, these arrangements can have payments deferred if it depletes cash by more than 30%, and interest accrues on these payments at 6.0%. This is very advantageous for AITX as they, to date, have not actually paid any of these investors any cash.
Third, if AITX is ever acquired, these investors receive some percent of the purchase price based on the fair market value of these instruments. What is the fair market value? Well, that’s a hard question. But at the time of an acquisition, the agreement states that an independent valuation consultant will value each arrangement. Most likely the valuation consultant would forecast AITX’s revenue into perpetuity, multiply by the percentage rate, and then discount back to present.
Lastly, notice Investor A, who is by far the largest investor with this arrangement, refinanced into more favorable terms. Steve issued that investor Series F preferred shares to bring down the percentage rate of future revenues. See my other article on the F Series for more detail on this instrument.
After these refinances, the table below details the final percentage of revenue rates AITX must pay to each investor:
How does this compare to current interest expense payments? See below:
As you can see, AITX accrued $114k in these percentage of revenue payments for Q1 and Q2. That compared to $2.7m in total interest expense for Q1 and Q2 is very minuscule. Furthermore, AITX has accrued a grand total of 246k in percentage of revenue payments to date. Without getting into compounding or the 6.0% interest on the unpaid balances, this amounts to an effective total (not annual) interest rate of 246k/2.525m = 9.75%. Compared to their current interest rate on traditional debt of 12%+ annually, these arrangements have been rather cheap so far.
Now, as you can imagine this arrangement is hyper risky for these investors. If the business never takes off, they’re stuck receiving some paltry percent of revenue until the business eventually goes under. I do not see anything about these investors having a claim to assets in the event of bankruptcy, but maybe they do.
Nevertheless, this investment is actually pretty nuts when you think about it. This investment has some extreme upside. For example, if in 10 years AITX is making one billion dollars in sales, Investor A would be raking in $96.5m per year on a $1.925m investment. And that’s not just a one-time payout, that’s annually. That’s why I referred to this as Wall Street Bet’s-esque, I don’t know if I could stomach that much risk!
Impact to AITX and Common Stock Investors
Past and Current Implications
For AITX and investors, this might seem like a stupid arrangement to enter into. Could you imagine if Amazon had to pay 16.26% of all of its revenue to four random people who hit the jackpot?! I see it quite differently…
Recall my article on raising capital. AITX entered into these arrangements when investors were requiring extreme returns to shell out capital. Remember, this is back in the days of convertible toxic debt where conversions happened at extreme discounts to the common share price. And these convertible note holders bled AITX and made out like bandits in the great OTC pump from December 2020 to March 2021.
However, these investors came along and said, “take our money and we only get paid if AITX makes it big.” And it wasn’t an insignificant amount of money; $2.5m is crucial for a startup stage company. Remember, without capital this business doesn’t exist. So what if we need to payout this large chunk of revenue later, we’ll all be rich!
Lastly, remember these don’t actually have to be cash payments. These investors just accrue some benefit (the percent of revenue payments) which is a liability to AITX. Any unpaid balances accrue only at a 6.0% interest rate which is fantastic. So AITX can keep putting cash back into the business and pay these investors later once their cash balance is more settled and stable.
Now you might be thinking, “Sam, AITX is going to the moon, I don’t want these guys taking huge cuts of my profits when AITX is the next big thing.” I get it, it sucks that these exist right now and something needs to be done about them. To that I would respond with the following:
First, don’t think of these investors as sucking value out of AITX. Think of it more like they are already current investors whose capital helped turn the company into what it is today. They aren’t freeloaders or something and didn’t cause dilution in the same sense as convertible toxic debt. These investors are long term partners in the same sense that the S-3 investors are.
Second, if AITX ever does make it large and is healthily cash flow positive, I would expect these investors to all be bought out of these arrangements. AITX could simply negotiate a fair price for these investors and then borrow the money with traditional debt to pay them off. This is then paid off over five, ten, twenty years using existing cash flow. The other outcome would be to convert these investments into common shares, also at a fair price. Remember, if it’s a fair price, it’s a net zero to current AITX investors.
If AITX wants to get them out sooner, they will use common shares. If AITX wants to buy them out later, it will cost them more in more accrued interest (percentage of revenue payments) in the meantime, but they can pay it off using debt financing. My money is on them getting paid out in common stock either through the F Series preferred shares or with a straight common stock payment.
For your own forecasts and modeling, absolutely need to take this into account. The safest option is to just apply this percent of interest to your forecast revenue each year within interest expense. If you want to get fancy, you can calculate a fair market value at any point of time and estimate that number of common shares it would take to buy them out. One way or another, you need to factor these in to determine your current intrinsic value per share.
Opinion Time – How did AITX do?
Bottom line, this was a very savvy investment for AITX and the fact that we’re even thinking about how AITX buys these people out is a good thing. That means AITX is actually doing well enough where we actually need worry about these things! If AITX was floundering, we’d be thinking, “Thank god these idiots only wanted a percentage of revenue!” At the stage AITX was in, these arrangements were frankly a steal versus the other toxic financing they were receiving which brought about heavy bad dilution.
Furthermore, some added benefits were:
- They did not need to make cash payments
- The investors had a vested interest in the success of the company unlike other toxic instruments
- The effective interest rate to date has been well below traditional debt
Long-term, it is on you, the investor, to factor these arrangements into your models. If you don’t factor these into your calculations of your intrinsic value per share and you are negatively impacted, you have only yourself to blame. That being said, it is not the end of the world that they exist, but they almost certainly should lower your present-day intrinsic value per share. Something will need to be done about them in the long-term assuming AITX succeeds, but it is up to you if you trust the current AITX management to buy-out these investors in the most shareholder friendly way possible.
For further reading and AITX analysis, check out all of my articles HERE as well as in the sidebar.
DISCLAIMER – I CURRENTLY HOLD A LONG POSITION IN $AITX. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES.