Don’t play with fire: are you sure venture capital is right for your startup?

This a follow-up to my previous post “The insane cost of equity for seed stage startups”.

Full disclosure: I am in the process of raising a revenue-based fund.

In my previous post, I underlined the real costs that an equity round can have for a startup that’s in the $10–15K MRR range. It’s expensive, time-consuming and most importantly, it limits the options that a startup has. When you accept venture money there is only one direction: an exit.

The default alternative to investor money is bootstrapping. Bootstrapping has become increasingly popular in startup land in recent years.

Some startups bootstrap because they’re aware of all the downsides of having investors and they prefer freedom to temporary comfort. Others are forced to bootstrap because they’re simply unable to raise capital. The reason for this is that with the growth of the tech sector, the number of “NON-VC compatible startups” has increased. This might seem counterintuitive, but the VC industry is based on two main concepts:

• The startups they invest in have to go after multi-billion dollar market opportunities
• Winner takes all. Unfortunately, even amazing startups that are operating in giant markets won’t get funding if there’s already an obvious winner. These areas of business are called “Kills Zones” and unfortunately they’re also expanding into sectors where the “tech giants” aren’t playing yet but might soon.

If you want to read more about this, I put together a list of articles that you can find here.

Bootstrapping will without a doubt fix all the problems we analyzed in the previous post, but it has a major downside: it doesn’t allow startups to accelerate beyond organic growth.

Growth vs Hypergrowth

I personally believe that hyper-growth is overrated, especially if fueled by equity. Dominating a market super fast does not guarantee future success, especially if the units of economics don’t add up. Success comes from a deep market/customer knowledge and a superior product, not market share.

There are very few markets where this logic doesn’t apply, and the exceptions are playing in a market where the VC route is not an option but a must.

While hyper-growth is over-valued and over-celebrated, growth in itself is not. Growth is important and is one of the essential challenges that make being an entrepreneur fun. But unfortunately there’s no way to accelerate the organic growth of a business without additional capital.

One alternative to growth capital is getting in debt. Unfortunately, debt from traditional sources is not available to early-stage startups, especially when they’re working on high tech problems that are hard for people outside the space to understand. And even when loans are available, they’re slow, inflexible and require a personal guarantee.

Wouldn’t it be great if it were possible to get growth capital without all the negative aspects of equity (expensive, loss of control, loss of time) and none of the downsides of debt (personal guarantee, fixed structure, not available for early-stage tech startups)?

I want to introduce you to the best capital tool for startups: Revenue-Based Finance.

Revenue-based finance is debt, which means none of the downsides of equity apply. However, it’s flexible, requires no guarantees, and is targeted towards early-stage tech startups.

How does revenue-based finance work?

The amount of the loan is calculated as a multiple of your MRR, and will be repaid with a fraction of your revenues every month. The loan is completely repaid when the sum of all the monthly repayments is equal to a cap. The cap is determined as a multiple of the loan and changes based on the time span you plan to repay it. Let me show you how it works.

Here’s an example:

Our revenue-based fund has the following characteristics:

This means that a startup making $15K MRR will have the following situation:

If it opts to take the maximum loan available it will have a loan of $75K (5X) with 8% of the revenue due to pay the loan every month. Based on how fast they grow, the final repayment will be one of the following:

• Cap paid within 12 months = $105K (1.4X)
• Cap paid within 24 months= $120K (1.6X)
• Cap paid within 36 months = $127.5K (1.7X)
• Cap paid within 48 months = $135K (1.8X)
• Cap paid within 60 months = $142.5K (1.9X)

Now let’s analyze the numbers. At first glance, the numbers might seem high, especially because when considering a loan, one’s first instinct is to calculate the interest.

However, these interest rates are much cheaper than equity and more importantly, you need to consider the impact this capital will have on your growth rate

Let’s run some numbers and compare the two scenarios.

First, let’s look at a startup without taking on capital.

Our startup is at $15 MRR and it’s growing 10% m/m. Maintaining 10% m/m net growth (churn = 0) over 36 months is not easy. However, the growth rate of an average SaaS startup at this stage should be higher than 10%, so it’s a reasonable assumption.

Here is the situation after 36 months.

At the end of the third year, the startup will be at $464K MRR through organic growth.

Now let’s look at the scenario with $75K capital injection through a revenue-based loan.

It’s safe to assume that the startup can hire a new person thanks to the $75K and this person will increase revenue growth by an average of 1% per month. Let’s look at this new scenario:

With only 1% increase in revenue every month, the new MRR after 36 months is $642K, an astonishing $178K more (in just one month) than the other scenario.

But things get even more interesting if we look at the cost of the 1% growth increase:

As you can see from the table above, the total repayment of the loan is $127.5K. The cash flow allows the company to repay it in 36 months so the multiple was 1.7x.

The interesting thing is that the additional revenue that was unlocked thanks to the cash injection is $1.2M after 36 months. On top of that at the end of the repayment period the company has no more obligations toward the fund and can keep their entire monthly revenue.

So to have $1.26M more in revenue, the cost was only $52.5K ($127.5K- 75K)

That sounds like a pretty good deal to me!

One interesting observation is that the first impact of the loan is to reduce the startup’s cash flow. The last thing you want is to take away resources from your growing business. For this reason, we offer a ramp-up period of 4 months so that the startup can grow their revenue before beginning to pay.

The goal of this post was to show how revenue-based finance is the best way to receive growth capital because it has all the positive elements of additional capital (boosting growth) with none of the downsides.

To summarize:

No loss of control. It’s a loan, which means that you’re still free to run your business how you want, in the direction you want. There are no vetos or board seats that come with it. It’s impossible for the investor to force you to sell or to change the way you run your company.

No personal guarantee. Yep, that’s right. You don’t have to put your house on the line or tell the investor where your kids go to school.

No dilution. It allows the founder to retain 100% of his/her startup. This is a massive upside no matter if you want to exit the startup at one point or if you want to distribute dividends.

No kill zone and all companies are compatible. If you want to become a unicorn or if you just want to create a great business that generates $5M in annual revenue, you’re in control, you decide what fits you. The economics work as long as you grow at least 30% Y/Y for 5 years from when you receive the money. That’s a pretty low barrier to entry.

Fast, you receive your money in less than a month and you can have multiple injections of cash per year. The company can go back to the fund after 4–6 months and get an additional injection of cash based on the progress of their MRR. This means constant access to additional capital to fuel your growth.

Great for wanna-be unicorns, because it helps founders to prove their ability to deploy capital. Often founders don’t realize that if they’ve never had additional capital to spend, investors see that as a red flag.

This means that if a founder decides to go down the VC route, on top of the uncertainty about the business, he also has to fight the uncertainty about his ability to allocate money.

In the revenue-based model, the founder has the opportunity to get and deploy a small amount of money and show his/her ability to generate incremental returns. This demonstrates ability and speeds up the fundraising process, increasing the investors’ confidence. It also increases the valuation because as we’ve seen in my previous post, things can change pretty dramatically in just six months.

As I disclosed at the beginning of the post, I’m in the process of raising a Revenue-Based Fund, but I hope that the numbers can make this post impartial. I would love to hear your feedback on this post and if you’re a tech startup based in Canada and would like to learn more about this model, please get in touch with me.