Sustainable Startups Need Different Investment Instruments
Not long ago I was in Portland for the first ever DazzleCon. Turns out this is not a conference about rhinestone jackets but rather a gathering of the budding “zebra” community. (Apparently a herd of zebras is called a “dazzle”. Who knew?)
Rather than offer my own poor summary of the zebra movement, I’ll cite the words of its fantastic founders, Jennifer Brandel, Mara Zepeda, Astrid Scholz, and Aniyia Williams (collectively Zebras Unite):
The current technology and venture capital structure is broken. It rewards quantity over quality, consumption over creation, quick exits over sustainable growth, and shareholder profit over shared prosperity. It chases after “unicorn” companies bent on “disruption” rather than supporting businesses that repair, cultivate, and connect…. [D]eveloping alternative business models to the startup status quo has become a central moral challenge of our time. These alternative models will balance profit and purpose, champion democracy, and put a premium on sharing power and resources…. This new movement demands a new symbol, so we’re claiming an animal of our own: the zebra.
They go on to cite a few examples of great zebra companies that exist today — Patagonia, Zingerman’s, Kickstarter, Basecamp. These companies are noteworthy mainly in contrast to the “unicorns” we hear so much about — billion-dollar startups like Uber that famously pursue explosive growth to the exclusion of almost anything else.
After my first year as a startup investor, this all resonates deeply. While the current zebra rhetoric tends to emphasize important moral arguments, I’m equally interested in the economic reasons that zebras ought to be championed. That begins with understanding why these companies tend not to attract venture capital today.
I’ve analyzed a dozen startups in the last few months that are doing great work within our focus area and that are likely to be profitable businesses with healthy margins, but that are nonetheless poor fits for venture capital funding.
There are a few reasons why that might be the case, but the most common is that the market they’re addressing is too small for a huge exit (i.e. an acquisition or a public stock offering) to be likely in the future. Traditionally, venture capitalists only make money when those exits happen, so they can only invest in companies where such an outcome is plausible. Moreover, because the likelihood is so small that any specific company will turn out to be a big winner, the whole venture capital business model is based on the idea that a tiny handful of unicorn exits should make enough money to put the whole industry solidly in the black.
Venture capital is like a baseball league.
You can only score through home runs, so batters only swing when it’s a fastball down the middle and then they’re swinging for the fences 100% of the time. The zebra companies I’ve been looking at might be change-ups or curve balls but they’re in the strike zone and should be hittable. Nonetheless, they’re not good home run candidates so they don’t fit the VC model. Meanwhile, because these are for-profit businesses with commercial products and services, they can’t access philanthropic dollars either. What’s left is a huge gap in the startup capital markets. On one side we have good, profitable companies that can’t attract the capital they need to get off the ground. On the other we have an investment industry that is plagued by perverse incentives and has limited options for risk reduction or portfolio diversification.
To be clear, I’m not blaming venture capitalists for failing to support zebra companies. Nor am I blaming startup founders for designing their businesses at least partly to attract venture capital. Everyone is acting rationally based on their own economic incentives. We can be judgmental about that if we like, but the reality is that a VC who doesn’t chase unicorns won’t get the returns her investors demand and may never raise another fund.
Revenue to the Rescue
Yet all hope is not lost! In fact, salvation may lie in a very old investment model that was recently rediscovered by social impact investors. To make it work in this new context may just call for some clever branding. I’m talking about revenue-sharing agreements. Here’s how they can work:
(1) An investor provides a startup with capital funding.
(2) In exchange, the investor receives either equity in the company or something that converts to equity in the future (e.g., a SAFE).
[So far this is just like traditional startup investing. This next part is where revenue-sharing instruments diverge.]
(3) The investor also receives a small share of the company’s gross revenue going forward.
(4) The revenue shared by the investor is capped at some reasonable multiple (e.g., 3X) of the investor’s contributed capital.
(5) Because the investor retains her equity stake in the company, if a big exit does unexpectedly occur, she still gets her unicorn-scale returns, minus the (comparatively small) sum that she has already received from shared revenue.
(6) In the meantime, the investor’s and founder’s incentives are harmoniously aligned. The investor’s best path to a positive return is to help the founder build a successful business at reasonable scale. Compared to traditional VC investments, there are similar expected returns but a narrower distribution of outcomes (i.e. less chance of a billion dollar exit, less chance of bankruptcy). The founder has no need to take on excessive risk or grow at an unsustainable pace because she isn’t facing investor pressure to push for a big, quick exit.
Huzzah! Problem solved, right? Well, sort of. There’s still one important challenge remaining, and it has to do with branding and industry standards.
The most common instrument used in angel and seed stage investing today is the SAFE.
The SAFE — which stands for Simple Agreement for Future Equity — was developed by Y Combinator a few years ago as an alternative to convertible notes. It’s great for very early investments for a few reasons:
- It allows you to delay selling actual shares at a specific price until you have a more reasonable basis for assessing the company’s value and can afford the exorbitant legal fees required.
- It is a thoroughly vetted, industry standard document. There’s almost no need for legal review at all, since this thing has been scrutinized half to death by a million different experts already.
- It has a cool, memorable name that evokes exactly the right associations.
So that’s our competition: the SAFE. Well, two can play at this game!
I hereby propose the SHARE, a Simple Harmonious Agreement for Revenue and Equity.
The SHARE would be just like the SAFE in most respects, but introduce a revenue-sharing element that makes it financially viable to back zebra startups and other good businesses at reasonable scale. With a SAFE, there are generally only two terms to negotiate: the valuation cap and the discount. The SHARE would ditch the discount and add two new terms:
The Allocation: the percentage of gross revenue to which an investor is entitled for every $1,000,000 invested.
The Multiple: the maximum revenue share an investor can earn, expressed as a multiple of her investment.
Let’s try an example:
Amy invests in a food startup, Andre’s Awesome Artichokes. Using a SHARE, she puts up $100,000 at a $5 million cap, with a 10% allocation and a 3X multiple.
Over the next two years, Andre sells $10 million worth of artichokes. With a 10% allocation and a $100,000 investment, Amy is entitled to 1% of that revenue (since $100K is one-tenth of $1M and 1% is one-tenth of 10%). Over the course of those two years, Amy receives 1% of $10 million, or $100,000. She has officially broken even on her investment!
Three more years go by and Andre is kicking ass; he sells another $30 million worth of artichokes. Amy’s 1% would be $300,000. However, she has already received $100,000 and she is entitled to a maximum of 3 times her initial investment, or $300,000 total. So Andre pays her $200,000 more, at which point she is no longer entitled to share in the company’s revenue. Amy has now received a 3X return over 5 years. That works out to a roughly 25% compound annual return on her investment— not bad by any standard!
In this example, the SHARE has done its job. A worthy company that would not otherwise have been able to attract startup capital raised the money it needed to launch. The investor made a competitive return on her investment in a reasonable period of time without having to demand excessive risk or compromised integrity. Everybody wins!
Most of the time, that’s where the SHARE’s story ends. The company continues humming along, making money but without being acquired or selling stock to the public. The investor can reinvest her returns in other great startups. Let’s extend the scenario one additional step, however, to see what happens if Andre’s Awesome Artichokes turns out to have “exit potential” after all.
Five more years go by, and Andre’s sales are growing fast. Amy no longer receives revenue payments, but that’s okay because she already made a healthy profit from her investment. Then one day, Antoine’s Awesomer Artichokes comes along and offers to acquire Andre’s company for $100 million. This is a happy but unexpected outcome (who knew artichokes were so profitable?) Andre is thrilled and accepts the deal. That triggers a conversion of Amy’s SHARE to equity at a $5 million valuation (the cap). Immediately before the sale goes through, Amy receives 2% equity in Andre’s Awesome Artichokes. Based on the $100 million sale price, her stake should be worth $2 million. However, she must now “pay back” the revenue that she previously received, so she is left with $1.7 million worth of stock at the time of the sale.
Make sense? If not, post a question and I’ll try to respond with an answer. Otherwise, let me know if the SHARE is something that you (as a founder or investor) would be interested in having in your toolkit. If there’s enough interest from the community, I’ll work on generating a draft that can be released under a Creative Commons license.
P.S. Now read the follow-up post in which SHARE v0.1 is announced.
Adam Huttler is the CEO of Exponential Creativity Ventures, an investment firm supporting startups at the intersection of technology and human creative capacity. Prior to launching Exponential Creativity Ventures, he founded and spent 20 years as the CEO of Fractured Atlas.