Revenue-based investments are a lower cost of capital than traditional equity. They also better align the incentives of the investor with the entrepreneur.
To start, always remember to put yourself in the other person’s shoes when raising money. Investors invest to make a positive return on their investment. This is true even in the world of impact investing, where mission may come first and where financial return may be traded off—the financial return is always present and important.
Always remember to put yourself in the other person’s shoes when raising money. Tweet This Quote
How does this return come about in traditional equity investing? From the all important exit, which 99.9% of the time now is an acquisition. In an acquisition, what drives the value of the acquired company? Growth. Not revenues. Not margins. Not profits. Growth!
Simply put, a company with growing revenues has a value. A company with growing revenues and good margins has a higher value. A company with growing revenues, good margins, and profits, an even higher value. Take away the growing revenues, and the company may be worth less than the cash it has on hand.
Does this seem ludicrous? See Yahoo, a public company with billions in revenues and margins and profits, but with its business valued at less than zero. Being private doesn’t change this rule of valuation, it just hides it from the public.
With rare exception, startup growth isn’t steadily upward. It’s bumpy. Tweet This Quote
Back to equity investors—if they need an exit and that exit is based on growth, then their incentive is to see your startup grow as quickly as possible, as more growth equals more value. All that is great as long as you are growing, but with rare exception, startup growth isn’t steadily upward. It’s bumpy. Sometimes it plateaus while dealing with the growth of staff, or as it crosses the chasm, or when it loses its first early customers, etc.
At the first sign that growth is slowing, equity investors have an incentive to sell the company. I’ll repeat this, as it’s key. If your company’s growth looks like it’s slowing, your investors no longer have an incentive to help you make your company successful. Instead, they start looking for an acquirer to buy your company before anyone notices that the growth has plateaued.
At the first sign that growth is slowing, equity investors…no longer have an incentive to help make your company successful. Tweet This Quote
A few rare, experienced venture capitalists may want to ride out the bumpiness with you, but I’ve only heard a handful of such stories in my 20+ years of startups.
Looking back at revenue-based investing, the incentives are completely different. These investors have made a bet on gross revenues. Revenue growth for them is good, but not imperative. If revenues start to plateau, those investors’ incentives don’t change. They don’t worry about 100% loss of their investment as a zombie. They can instead either live with what might be a slower rate of repayment and thus a lower rate of return, or they can step up to help the entrepreneur grow revenues.
Reread that last paragraph, as it’s not the norm for startup investors. Revenue-based investors have just one incentive—to see the company earn revenue. More is better, but some is still fine. Depending on the terms of the investment, an acquisition might juice the rate of return, but it’s not required to have a return.
Revenue-based investment structures provide a lower cost of capital and a set of investors who have their incentives aligned with the entrepreneurs. Tweet This Quote
This is a big deal for entrepreneurs. Revenue-based investment structures provide a lower cost of capital and a set of investors who have their incentives aligned with the entrepreneurs. What entrepreneur wouldn’t want that?
The only real flaw is that revenue-based investments are not the norm. Of the tens of thousands of startup investments made each year, only a few dozen take that form—most in the seed stage from my accelerator, Fledge, or in the growth capital stage from companies like Lighter Capital. No doubt there will be more to come as this win-win structure shows more proof of success.
This originally appeared on Luni’s blog.