Where is the VC for the 99%?

Four Reasons (and a Story) on Financing Your New Business

by Greg Bennett & Keith Harrington

When I think of an example of growing wealth through entrepreneurship, I think of my great aunt in Charcas, Mexico.

Nearly 40 years ago, in a small mining town in the state of San Luis Potosi, Pola Badillo cut down the cactus patch behind her house and built a bakery. She scraped together money from family, the church, and savings accumulated over several years. The most expensive part of the bakery was the oven — the construction, materials, and salaries of her sisters & daughters were negligible compared to the large iron oven that churned out pan dulce, cakes, and conchas until they had to upgrade it in the 1990’s. That bakery put food on the dinner table for two generations of children. They eventually grew the bakery to three locations, specializing in wedding cakes, and they’re still in operation today.

My great aunt would never have received a termsheet from a venture capital firm with her business model. If she had a pitch, she would not have said her bakery was a platform for disrupting the consumer baked goods industry. She would not have projected hockey stick growth. There was no data play — it was a simple, buy ingredients for a dollar and sell bread for two dollars model. The bakery was not a high-growth opportunity, but it was something that contributed to the town and paid out “dividends” to my family for decades.

My great aunt, just like many thousands of businesses that build local communities and national economies, needed financing that met her early-stage business where it was.

Venture capital is risk tolerant for certain types of early stage companies, but the nature of equity requires an illiquid lock-in period and a high growth expectation. Selling equity is a great opportunity for companies with the potential to grow to $100mm in revenue within a few years, or grow to an enterprise value of many hundreds of millions of dollars. This model works great for software technology companies, though VC-style funding is increasingly moving into other areas that can capture similar growth like hardware technology, consumer packaged goods, fashion & apparel, and tech-enabled business services.

According to the US Small Business Administration, less than 1% of new companies in the United States receive venture style equity investments.

So where is VC for the 99%?

Enter the revenue share agreement.

This type of financing (also called royalty-based financing) can be a great option for businesses that are growing, have a path to significant revenue, but may not be a good fit for equity financing. Here’s how it works: In exchange for a loan, the borrower agrees to repay the lender a small percentage of their revenues over a certain time period (usually a month or a quarter) until the lender is paid back a pre-determined amount (usually 2–3x the loan amount).

This performance-based repayment flexibility allows the borrower to pay less when the business has a lean period, and repay more when they’ve had a great period.

There are several advantages to this type of financing:

1. Better options for entrepreneurs to maintain company control — In revenue share financing, investors getting board seats are not a common requirement. The control provisions in a revenue share term sheet are really designed to protect the investors from additional (senior) debt and other things that might impair the company’s ability to repay. Those same provisions are standard in VC deals as well.
2. Better Economics for the Entrepreneur — There is no equity dilution, so the entrepreneur does not need to worry about pushing toward an exit or about the return waterfall (and the liquidation preferences) common in VC financing. Think about it this way: if an entrepreneur takes on venture financing, they’ll typically give up 25% of their company for that capital (for simplicity’s sake, we’ll assume only one round of financing in this case; substantially more of the company is exchanged in return for subsequent rounds of capital).
3. If the company is acquired or IPO’s, 25% of the proceeds go to the investors. Let’s say the company is sold for $50mm. If that company took on $1mm of equity financing from a VC, those investors get $12.5mm (unless there’s a liquidation preference, in which case they’ll get more because the investor will get their $1mm back BEFORE the entrepreneur participates in the exit, so only $49mm in the proceeds are split). If that entrepreneur took on a $1M revenue share investment, they pay back $3 million, which preserves $9.5mm in value (or more, if there’s a liquidation preference).
4. The investment self-extinguishes — Once the loan is paid back, there’s no further obligation. There is potential for another agreement if it makes sense for the entrepreneur, and companies are free to go on to raise equity if the dynamics of the business/market change.
5. Sustainable growth targets are perfectly acceptable — Revenue share financing allows the entrepreneur to grow her business as she desires, and she doesn’t need to dress up her revenue projections or growth plan to satisfy the high-growth expectations of traditional venture capital investors. We often see entrepreneurs revising their plans in order to project revenue and market numbers that they won’t likely hit in order to entice VC investment. This can lead to further dilution, down rounds, and even an exit where the entrepreneur doesn’t really make any money.

We at Village Capital have made several investments using this structure, both in the United States and internationally. Companies that build integrated hardware systems and sell consumer goods have been great candidates for this type of structure.

Our friends at Novel Growth Partners think that there are many more types of business that would be good candidates for this kind of financing, including: Consumer Packaged Goods, Manufacturing, Fast Moving Consumer Goods, Software as a Service, Industrial IOT, and certain service businesses.

While this structure isn’t exactly new, we think it’s a great option for entrepreneurs building companies that don’t fit the standard venture model, and that can’t access sufficient credit through banks. For entrepreneurs building companies that can get to $5mm or $10mm in revenue over several years, this structure is a great option to preserve equity, build wealth, and maintain control over how they grow their companies.

If you’d like to learn more, please reach out to us!

Contact:

John Toner at Venture First

Greg Bennett at Village Capital

Keith Harrington at Novel Growth Partners

Greg Bennett is Investment Analyst at VilCap Investments. Keith Harrington is Founder and Managing Director at Novel Growth Partners. John Toner is ‎Business Development Lead and Founder at VentureFirst.

This article was originally published at Venture First, check them out!

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