Revenue Recognition Certificates: A New Security

Revenue recognition certificates provide returns as a specified function of a company’s sales or gross revenues over a defined period of time in the future. To explore whether certificates would be an advantage in the financial markets, this article discusses the agency problems of these certificates as well as the benefits to investors and issuers of debt and certificates. A corporate bond pricing model is adapted to value the certificates and is used to produce representative numerical examples.We explore the concept of a security that provides returns as a direct function of a company's gross revenue over a specified future period, expires worthless at maturity, and requires no assets to be segregated as collateral. Novel features of such “revenue recognition certificates” include transparency, high cash flow, and inflation protection. Investors in certificates would not be residual claimants on revenue, as equityholders are, nor would they offer to management an implied put option, as corporate bondholders do.This contract is not new: Some financing joint ventures are structured in this way, and similar contracts have been used to finance asset management companies for restructuring or for other purposes.What would be the benefits and problems associated with securitizing such a contract? And would the investment characteristics of such an instrument allow it to garner more than a niche position in the financial markets? To answer these questions, we compare the issuance of revenue recognition certificates (or simply, certificates) with the issuance of bonds because both types of securities raise capital with instruments that eventually mature. Our analysis suggests that certificates, although not without disadvantages, offer appealing benefits for both investors and issuers.Because certificates would behave much like equity when first issued and much like money market instruments just prior to expiry, investors would need to trade or “ladder” issues to maintain an appropriate risk exposure. Because certificates would require investors and traders to have less specialized knowledge of the issuer’s accounting practices than bond investing requires, we expect market participants will create the infrastructure necessary to both issue and trade certificates in a standardized form, much like exchange-traded options. As a result, certificates should be more liquid than corporate bonds.To exploit negative insights about the management of a company while hedging against an increase in the company’s sales or revenue, investors would be able to purchase positions in long-duration certificates of the company while shorting the company’s stock. Certificates would help to complete markets.Issuers of certificates would have no need for restrictive covenants to maintain debt coverage, and there would be fewer bankruptcies because investors in certificates would have no call on the company’s assets. As a result, the interests of certificate issuers and equity investors would be more closely aligned. However, certificates would provide a clear incentive for issuers to use the proceeds of a certificate to improve the company’s productivity rather than increase its sales. Although this subject warrants additional investigation, our analysis indicates that the agency problems involved with the issuance of debt—risk shifting and underinvestment— would be lessened by the issuance of certificates instead of debt.To provide numerical examples, we developed a structural approach for valuing certificates based on a model for valuing risky corporate debt. We found the distribution of expected values for revenue recognition certificates and portfolios of such certificates to be broader than the distribution of values for comparable debt issues or debt portfolios. And the certificate distributions exhibited significantly longer upside tails. We believe that with such investment characteristics, certificates would provide corporate debt markets with competition.We also discuss the accounting appropriate for revenue recognition certificates based on recent guidance from the American Institute of Certified Public Accountants. And we compare an example income statement for a company issuing debt with an income statement for a company issuing revenue recognition certificates.