Testing the Pave transaction using the factors outlined in Part IV.A, it would be hard to characterize Pave as debt. Of the seven factors, four clearly suggest that the transaction is not debt, and two are neutral or lean slightly away from debt characterization. Only one potentially suggests debt characterization.
The parties’ intentions and the label, given the transactions, the form of the instrument, the lack of a fixed interest rate, and the allocation of risk, suggest that the transaction is not debt:
240. As noted, it is unclear whether Pave’s ISA has been replaced by a new loan product as of August 2014. See discussion supra note 39. However, the Pave ISA still merits analysis as a leading example of the new wave of ISAs. Moreover, Pave ISAs that were entered into prior to August 2014 still exist and continue to raise tax and other regulatory questions.
241. Our discussion is based on information that has been made available on the Pave website. See, e.g., Common Questions, PAVE,https://web.archive.org/web/20121216014602/http://
pave.com/questions, archived at http://perma.cc/79UX-T5S4. The actual Income Linked Payment Agreement is not publicly available.
Parties’ intentions/transaction label. Pave’s website draws distinctions between Pave’s structure and debt with respect to repayment terms and the lender’s ability to share upside.242 Pave has also stated that its
“participation agreement is like a partnership, with interests fully aligned for both parties.”243
Form of the instrument. The absence of an unconditional promise to pay signals that Pave is not debt.
Interest rate/interest payments. Pave’s Income-Linked Payment Agreement does not provide for a fixed interest rate or for payment of interest. The funding recipient pays a specified percentage of her total income annually, as calculated on Line 22 of Internal Revenue Service (“IRS”) Form 1040.244 This suggests that Pave’s structure
is distinguishable from debt.
Risk allocation. Pave’s investors bear the risk that recipients will not succeed financially. Recipients may be excused from payment entirely in years when their income falls below 150 percent of the poverty line.245
Thus, there is no guaranteed minimum return. On the other hand, if the recipient is successful, the investor can receive returns that exceed the rate of return on debt.246
These terms indicate equity.
Two of the remaining three factors either lean slightly away from debt or are neutral:
Priority relative to other claimants/subordination. The income sharing base is IRS Form 1040 Line 22 income,
242. Id. 243. Id.
244. What Counts as Income when Calculating How Much I Must Share with My Backers, PAVE, http://support.pave.com/hc/en-us/articles/200407688--What-counts-as-income-when-
calculating-how-much-I-must-share-with-my-Backers- (May 19, 2014) (on file with authors). If recipient files a joint return, the spouse’s income is deducted from the Line 22 income. Id.
245. This hardship exemption will not extend the agreement term. Is There Ever a Time
During the Participation Period When I Wouldn’t Need to Share Income?, supra note 45.
246. The recipient can terminate the agreement early by repaying five times the amount funded. Common Questions, supra note 241. This is higher than the three times the amount of income cap in the Upstart transaction. See UPSTART FUNDING AGREEMENT, supra note 28 and
which includes business net income. Business net income in turn takes into account business expenses (including allowable business interest) reported on Schedule C. Thus, the funding recipient will first pay business interest and expenses before “sharing” income with the investor. Such subordination of the repayment obligation to the payment of business expenses allows the funding recipient a large degree of discretion and may suggest equity characterization. On the other hand, the repayment obligation is not subordinated to payment of personal interest, so subordination is at best partial. Duration and fixed maturity date. The Pave agreement term cannot exceed ten years.247 This time frame is
compatible with either equity or debt characterization. Furthermore, while the agreement has a fixed ten-year term, there is no requirement that the investors actually recover their investment within that time frame. Thus, this factor is neutral at best.
Finally, “participation in management” is the only factor that might signal debt rather than equity. Greater degrees of management participation suggest an equity interest. Although mentoring is a component of the Pave relationship, it does not appear to rise to the level of true management control, at least on paper.248 On the other
hand, it is possible that such mentoring may be robust in practice. In sum, it would be difficult to characterize Pave as debt.249 Not
only do a greater number of factors suggest “not debt” characterization; the purpose of the transaction also indicates that it is likely not debt because there is not really an expectation of repayment regardless of whether the funding recipient succeeds.250 Stated differently, the Pave
247. See supra note 42 and accompanying text. 248. Common Questions, supra note 241:
Another major difference is that a Pave agreement has an added value—backers. Many of them are eager to offer guidance, advice and connections in fields relevant to prospects’ interests. With all their experience, backers know that even one phone call or email introduction can make a huge difference to someone who is just starting out in an industry. Also, backer and prospect interests are aligned—the more successful prospects are, the more their backers share in that success.
How It Works, supra note 170 (“Backers can choose to provide advice and support throughout the
talent’s journey.”).
249. We reached the same basic conclusion with respect to Upstart in prior work. See Oei & Ring, supra note 3, at 274–75.
250. TIFD III-E, Inc. v. United States (Castle Harbour), 459 F.3d 220, 232 (2d Cir. 2006) (quoting Gilbert v. Comm’r, 248 F.2d 399, 406 (2d Cir. 1957)); see also Historic Boardwalk Hall,
investors have a “meaningful stake in the success or failure of the [venture].”251 Thus, not only do the individual factors point away from
debt, but it is also clear that the core purpose of Pave is one of explicitly sharing in the successes and failures of funding recipients, an ownership or equity-like idea.
2. Does Pave Raise Human Ownership or Servitude Concerns?