Why An Equity-Only Investment Strategy Overlooks Many Promising Entrepreneurs

To back transformative innovators, early stage investors will need to start innovating ourselves

Two weeks ago, Bloomberg Businessweek published an article about Fin Gourmet, a company that Village Capital, the firm I co-founded, is proud to invest in. Fin Gourmet catches Asian carp, a wildly invasive and environmentally destructive species in the Midwest, processes the fish, and sells it into high-end restaurants, as well as local and national markets and health food stores.

Fin Gourmet stands apart from most companies profiled in the pages of Businessweek for two reasons. First, it’s creating quality jobs in rural Kentucky, an area of the country that isn’t typically heralded for innovation and job growth.

Second, our investment in Fin Gourmet uses a structure rarely used in venture capital today. We invested using a revenue share agreement that aligns us as if we were equity owners, but is more flexible for the founders, and gives us a more visible path to liquidity than an equity investment would.

This is part of our fund’s larger strategy, and it sets us apart from many other venture capital funds (and angel investors), that invest equity virtually all the time.

An alternative to equity

Village Capital has invested in over 70 early-stage companies, and we offer a number of different investment structures every time: nine of our portfolio companies have taken non-equity structures such as revenue share agreements or flexible debt. We do this because we believe a reliance on equity limits investors’ choices to a narrowly defined growth profile — and causes them to miss out on non-traditional, but still high-potential, companies.

Despite its popularity, the equity-only strategy, on average, disappoints. The common line of thinking in the venture world is that it’s OK if seven out of 10 of my companies fail, as long as one or two home runs deliver a multiple of the whole fund. Those long-shot outcomes are so rare, though, that as the Kauffman Foundation found in a 2012 report titled “We Have Met The Enemy… And He Is Us”, the average VC fund in their survey failed to even return investor capital, after taking fees.

This equity-as-the-only-option approach can also be bad for companies — and therefore bad for innovation. When an investor has an equity stake in a company, they have massive incentive for that company to reach substantial scale as quickly as possible. This “growth at all costs” mentality has led lots of startups to forsake reliable unit economics, or real business models that could get them on a path to sustainable growth and long-term profitability, for the sake of meeting the required user metrics required for their next round of funding. (For more on this, see the great piece from Eric Paley at Founder Collective, Venture Capital is a Hell of a Drug.)

Put another way: picture a steady, stable company that is growing predictably and focused on unit economics to achieve profitability, but is not reaching 5x, 10x, 20x annual growth rates. That company is going to get a lot of pressure from investors, if they’re not poised to attract a buyer within five to seven years, or go public within 10. But steady, stable, profitable companies are good for our economy — and can be great for the founders that start them and the investors that choose to back them.

Making things worse, alternatives to equity have become scarcer for many young companies. The default option if you need to raise money for a steady-growth company has always been debt — getting a loan. But traditional debt has been harder to secure in recent years, particularly for early-stage ventures that still have a fair amount of risk. Small business loans as a percentage of total bank lending have dropped 50% over the last 20 years. (For more on why this is, see a recent HBS paper on this topic.)

A third way

At Village Capital, we see a third way. While you might not know it from the concentration of VC funding in only a few cities in the US, an hour or two’s drive away, there are undiscovered and overlooked, high-potential companies in need of capital. They may be too early for traditional debt, but have growth prospects that could deliver attractive returns if appropriately capitalized.

Fin Gourmet, creating living wage jobs in rural Kentucky, is one of them. When we invested, they weren’t a great fit for equity as they didn’t forecast 20x growth and a visible exit target, but they were too early-stage for a loan. Instead, our revenue-share gave them a little time to build the business, and then lets us share in 5% of Fin Gourmet’s revenue as the company grows up to generate a target return multiple on our original investment.

If Fin Gourmet grows fast (as they have been), we win with them. If Fin Gourmet has a rough quarter, we share the risk — and they don’t have onerous debt terms that they can’t meet, or risk personal recourse or giving up collateral.

Alternative structures can also help companies get to a point where equity makes more sense. In 2013, Village Capital established a revenue share agreement with Spensa Technologies, a precision agriculture company in Indiana. At the time, Spensa was going through early customer validation and market development. Our agreement gave the founders the flexibility and runway to grow. After two years, when Spensa beat our revenue forecasts, repaid us, and went on to raise a traditional Series A, we were happy to participate: a SaaS model, ambitious growth projections and a trajectory towards a traditional exit meant that by that point, equity was a better fit for their needs.

I’ve been encouraged by Village Capital portfolio companies like Fin Gourmet and Spensa Technologies (to name but a few) that have used non-traditional financing structures to grow their businesses ahead of our projections, and create good jobs in places where they are badly needed. We often talk about innovation in venture capital in the context of new and transformative products and services. But as those of us in the investment community branch out to overlooked places and under-capitalized industries, we need to innovate in structures and processes themselves.

Victoria Fram is the Managing Director at VilCap Investments, LLC. Village Capital finds, trains and invests in entrepreneurs solving real-world problems. Learn more on our website and read our insights on Medium.