Exploring Revenue Based Investment? Read this first.
For many companies, capitalizing on an opportunity requires outside capital. However, many startups don’t have the collateral or operating history to secure debt.
Nearly all startup literature says that if you can’t secure debt, you need to raise venture capital. And that all venture capitalists invest with equity Structures. As a result, most founders tend to start with an eye toward equity investment.
Equity is simple to understand, but not always the correct tool for the job, as most founders aren’t explicitly in business to get acquired or IPO.
Among new funding options within this debt-equity chasm, revenue-based investing (RBI) is emerging as the most common route. You know it’s a real thing when TechCrunch does a write-up on it.
Underneath the craze, there are crucial considerations for companies looking to raise with RBI or any other non-equity risk capital structure.
In evaluating these new options, founders are not just choosing between the ‘in-vogue’ equity-like docs of the day (Series Seed, KISS, SAFE, etc).
“Term sheets are resource allocation algorithms.” — Matt Wensing, Founder, SimSaas
RBI implies a fundamentally different algorithm than the equity Instrument. As a funding ecosystem, we need to avoid overselling RBI like we did equity. VC 2.0 includes many risk capital Structures, including RBI when it is appropriate.
Why our fund likes RBI and Gross Revenue as the Return Variable
There are other Return Variables available after all.
For example, Purpose Ventures uses ‘free cash flows’ to build in investor patience until the company is profitable. Their Return Cap tends to be on the high end (3–5x) as a result. Meanwhile, Earnest Capital uses “founder earnings” to align with a bootstrap founder mentality. If the founder’s salary is a direct result of the company’s growth, so too are investor’s returns.
For us at the Greater Colorado Venture Fund, gross revenue (as the Return Variable) incentivizes simple revenue growth for both parties, and is much less manipulatable compared to EBITDA, net income, or any metric that is calculated further down on the income statement.
Is this a legitimate RBI opportunity?
When it comes to evaluating real companies for RBI investment, we must surface, with the founders, all of the consequences of investing off of gross revenue. If we’re going to propose RBI to a company, we need to be a partner in educating the founders in this niche of a niche of finance.
As partners, we try to run through our internal checklist to determine if RBI is a fit. We need to be confident that equity is not the tool for the job, and that RBI is. Can the company truly withstand the RBI resource allocation equations?
Gut check. Revenue-based investing typically does NOT work with:
- Small margins
- A large funding round relative to net margins
- Volatile unit economics
- Companies where break-even is only a long-term reality
- Too much debt
- Equity holders who aren’t okay with a class of investors with different incentives
- Winner-takes-all markets
- And more….
Revenue-based-investing often works well with:
- Large margins
- Small capital needs compared to net margins
- Profitable, or nearly profitable, companies
- Repeatable business models
- Companies not planning on raising more outside capital
- Founders who would like to retain ownership
- Founders who would like to preserve optionality with their equity
If we’re internally optimistic in an RBI investment after this checklist, it’s time to discuss it with the founders.
Broaching RBI with Founders
The conversation usually goes something like:
Us: “You’re building a great business. That much is clear. We are interested in exploring a partnership, but we can’t solely bet on a large exit as the only successful outcome for the company at this stage. Are you open to raising this round with a revenue-based structure?”
Founder: “What’s that? It sounds more complicated than just raising with a convertible note.”
Us: “If you raise with a convertible note or straight equity, you may inadvertently find yourself building a company for an exit, for your investors. Each investor has a multiple in mind, and they will force you to take more and more risk to make that multiple a possibility. Investors get to spread this risk across a portfolio. Founders get a portfolio of one.
“With Indie VC, our preferred RBI structure, we can still aim to build that gazillion dollar moonshot, but we’re also totally happy supporting you in building a profitable $30M company. If the time comes that we need true equity-style investment to unlock exponential growth, we can always pause the revenue share to do that. For now, lets on building a healthy, sustainable company and see where that gets us.”
Founder: “What is the 3x Return Cap? If I raise $250k, I owe you $750k? That’s pretty expensive. Way more expensive than any loan I’ve seen.”
Us: “Agreed. If you can raise more affordable debt and aren’t seeking strategic partners, that is certainly our advice. However, this is not a loan and we aim to be partners, not lenders.
“It’s worth noting that equity is really expensive capital too. You just don’t get the bill for a long time. If we buy 10% of the company now, and it sells for $30M, our 10% becomes worth $3M. That’s $2.25M more expensive than the $750k that the revenue share demands.”
Founder: “Okay. So how would this RBI structure work?”
At this point, it is a good idea to replay the internal checklist back to the founder.
We’re asking for the founders’ trust in selecting the right financial structure, so we must openly communicate our reasoning every step of the way.
If we’re still aligned around an RBI investment…
It’s time to get down to numbers.
We must ensure that the percentage of gross revenue that we will be taking out of the company will provide competitive returns without sucking the company’s cash flows dry. We’re essentially adding a line item to COGS that goes toward our repayment up to the Return Cap. The company still has to be able to pay its expenses and operate at increasing profitability.
Healthy margins are paramount and financial discipline is key.
Now comes my favorite part of the deal. We model, with the founder, what the RBI structure (in our case Indie VC, an RBI structure with an equity redemption) would look like using the founder’s own financial projections.
It doesn’t get much more transparent than sharing your spreadsheets with the founder.
Us: “Let’s go through this excel spreadsheet together and see if we can find terms that suit us both.”
This exercise forces a lot of reckoning with the realities of outside investment.
True, we are looking to see if our revenue share payments (essentially a new line item in COGS) put the company in the red. We are also looking to see how this financial story of growth holds up to the founder’s internal story.
We may like the idea of an RBI investment, and the numbers may back it up, but again, does it support the founder’s vision? An RBI investment has different financial and philosophical implications than equity. Before moving forward with an RBI investment, make sure both the financial and philosophical boxes are checked.
Modeling the investment with the founder facilitates the necessary conversations to check these boxes. From there, we can determine if it is worth pursuing deeper diligence (like any other investment, you’re forging a partnership), or if we should just stay friends.
In our next post, we’ll share the financial model we use and instructions to use it yourself.
