Revenue-based investing: A new option for founders who care about control

Does the traditional VC financing model make sense for all companies? Absolutely not. VC Josh Kopelman makes the analogy of jet fuel vs. motorcycle fuel. VCs sell jet fuel which works well for jets; motorcycles are more common but need a different type of fuel.

A new wave of Revenue-Based Investors are emerging who are using creative investing structures with some of the upside of traditional VC, but some of the downside protection of debt. I’ve been a traditional equity VC for 8 years, and I’m now researching new business models in venture capital.

I believe that Revenue-Based Investing (“RBI”) VCs are on the forefront of what will become a major segment of the venture ecosystem. Though RBI will displace some traditional equity VC, its much bigger impact will be to expand the pool of capital available for early-stage entrepreneurs.

This guest post was written by David Teten, Venture Partner, HOF Capital. You can follow him at teten.com and @dteten. This is part of an ongoing series on Revenue-Based Investing VC that will hit on:

• Revenue-based investing: A new option for founders who care about control
• Who are the major revenue-based investing VCs?
• Should your new VC fund use revenue-based investing?
• Why are revenue-based VCs investing in so many women and underrepresented founders?
• Should you raise equity venture capital or revenue-based investing VC?

So what is Revenue-Based Investing? 

RBI structures have been used for many years in natural resource exploration, entertainment, real estate, and pharmaceuticals. However, only recently have early-stage companies started to use this model at any scale.

According to Lighter Capital, “the RBI market has grown rapidly, contrasting sharply with a decrease in the number of early-stage angel and VC fundings”. Lighter Capital is a RBI VC which has provided over $100 million in growth capital to over 250 companies since 2012.

Lighter reports that from 2015 to 2018, the number of VC investments under $5m dropped 23% from 6,709 to 5,139. 2018 also had the fewest number of angel-led financing rounds since before 2010. However, many industry experts question the accuracy of early-stage market data, given many startups are no longer filing their Form Ds.

John Borchers, Co-founder and Managing Partner of Decathlon Capital, claims to be the largest revenue-based financing investor in the US. He said, “We estimate that annual RBI market activity has grown 10x in the last decade, from two dozen deals a year in 2010 to upwards of 200 new company fundings completed in 2018.”

According to Brian Parks, Co-Founder and Managing Partner of Bigfoot Capital, an emerging RBI VC, “Over the past 36 months, we’ve seen a sea change in the market with new [RBI] capital providers aggressively entering the market, increased limited partner appetite for this new asset class, and significantly increased interest from founders seeking an alternative to venture capital.”

John Borchers defines RBI as, “anchored around a model for providing long-term growth capital to a company that is paid back over time in the form of a modest, fixed percentage of monthly revenue. While it might be easy to confuse factoring, merchant cash advances (“MCA”), or other types of receivables-based financing solutions with Revenue-Based Financing, they are really quite different. Factoring, MCAs and receivables financing are all short-term oriented with pay-back periods measured in weeks, months or quarters, while RBI is generally measured in years. Factoring, MCA and receivables-based solutions are also typically tied to a customer contract, invoice, credit card throughput or some other specific collateral or cash-collection mechanism, while RBI is not involved with monetizing individual receivables or credit card payments. RBI is really designed to replace equity with a patient, flexible, long-term growth funding framework while factoring, MCAs and receivables financing are more of a short-term, working capital oriented set of solutions.”

Feenix Venture Partners has a unique investment model that couples investment capital with payment processing services. I asked Michael Hoffman, Partner and General Counsel of Feenix, how he compared his firm with tech-enabled Merchant Cash Advance companies, e.g., Clearbanc, C2FO, Shopify Capital, etc. He said,

“[W]e both provide credit card processing services, but most of the similarities stop there. Feenix focuses solely on providing longer term growth capital to healthy companies looking to expand. Credit card fees are provided on a competitive arms-length basis, as is the interest rate on our loans. The idea is for us to take advantage of a cost/expense that our borrowers are already incurring (credit card fees) and structure an investment that truly aligns our interests. As a result, we carefully choose to invest in good brands and operators that we believe can execute on their plan with the help of a reliable and flexible capital partner. That’s how we can offer competitive rates … with no prepayment penalties or warrants attached. In many cases, we will provide fully committed accordion lines that allow companies to borrow additional funds upon demand, when certain topline revenue goals are achieved, and/or burn down their credit card rates when these milestones are achieved.”

Lighter Capital summarizes RBI’s typical characteristics as:

• Principal amount fully funded at closing
• Structured as a loan
• Monthly payments equal a set percentage of monthly revenue (typically 1 to 9%)
• Monthly payments continue until a set dollar amount has been paid back, usually 1.3-2.5X the amount of the financing (this multiple is called the “cap”)
• At maturity, which is typically 3 to 5 years, any unpaid amount of the cap is due

RBI structures help to protect the equity of both founders and investors. I predict that the RBI model will become part of the standard set of options for founders raising capital, for use whenever appropriate, just as today founders raise opportunistically via preferred equity, convertible notes, cash advances, venture loans, and so on.

The traditional NVCA term sheet works well for founders who are comfortable substituting VC capital for revenues, running typically at a loss for many years. In board meetings of these classic VC-backed companies, when a founder reports, “I’m profitable”, the VCs typically say: “That’s a good problem to have; we should be more aggressive on growth.”

However, according to Bryce Roberts, co-founder of Indie.VC, only 0.6% of founders raise VC; the other 99.4% of founders can’t or don’t want to build a business that way. The RBI investment model better aligns incentives between VCs and a founder who chooses to bootstrap.

Ali Hamed, Managing Partner at CoVenture, said he views RBI VC as “sort of a mix between long-dated Merchant Cash Advance, and corporate credit where lenders are using revenue to predict the ability to service debt”. One of the reasons that RBI VC is growing in both feasibility and popularity is that more businesses are becoming metrics-driven, which means that investors have better line of site on their future revenues. Hamed highlights 3 tools for visibility into revenues:

• SaaS business models, which mean recurring revenue;
• CAC:LTV ratios and other calculable analytics – which allow lenders to understand what amount of revenue a marketing input will generate; and
• Data from platforms like Shopify, Airbnb, Spotify, Facebook, YouTube, or any other platform that gives a lender line-of-site on a digital business’s future revenue.

Most investors in early-stage tech companies today use one of three standard models to invest:

• Preferred equity, typically modeled on the NVCA Standard Term Sheet, Series Seed Term Sheet, or YC Series A Term Sheet.
• Convertible notes, which typically look like the Cooley Series Seed Convertible Note Financing Package, YC SAFE Term Sheet, or similar.
• Venture debt investors, who typically use a structure like this sample term sheet teardown. Venture debt is used by venture equity-backed companies which typically lack the assets or cash flow for traditional bank debt financing, or that want greater flexibility (backgrounder). They usually already have quite material revenues, and/or top-tier equity VC backing.

“Overall, the NVCA term sheet is the standard starting point for companies that generate revenues and are ready for a Series A or later financing”, says Christopher Edwards of Reitler Kailas & Rosenblatt LLC. “It’s well-known by both companies and VCs and can be negotiated quickly… We’re seeing increasing flexibility in the marketplace, though, mostly for bridge financings that use SAFE-based financings, but with alternative financing structures for longer-term financings.”

I asked Brian Parks, Managing Partner, Bigfoot Capital, about the impact of RBI on traditional VC. He said, “I think it depends on the structure of the RBI. If it’s acting/smelling like VC with some liquidity/recoup provisions built in, then maybe it drives VC to structure these in and start espousing that.

If it’s a more traditional RBF structure, I don’t see it impacting traditional VC very much, other than presenting another option to Founders who may not be all that viable for traditional VC at the time it’s presented to them.” Derek Manuge, CEO of RBI VC Corl, said, “Additional financing options will require VCs to consider the length of the due diligence period, the timeframe in which they issue funding, as well as the risk-based price of the capital.”

All term sheets are a negotiation. From an entrepreneur’s point of view, when you’re talking with any VC — including the vast majority who use traditional term sheets — there’s no reason you can’t propose an RBI term sheet like the ones I list below as models. The worse an investor can say is “No”, although investors will also take your proposal as a signal for how you’re thinking about control and the possible trajectory of the business.

Templates

Here are four templates you can use for better understanding RBI:

• Bigfoot Capital’s RBI term sheet template. Bigfoot calls this a “cash receipts sharing facility”. Note that this is a debt instrument, whereas the two documents below are equity instruments.
• Founders First Capital Partners’ non-binding Revenue Loan Term Sheet and Payment Calculation Explanation.
• Indie.VC’s template term sheet.
• Earnest Capital Shared Earnings Agreement (“SEAL”) & Backstory. Here’s the detailed breakdown of how it works and the public term sheet. Dig into the numbers and run your own scenarios with an open spreadsheet and video walkthrough.
• Of course, there are also creative companies that find a way to bend the models themselves. Take SparkToro, for example, which raised an unusual round of financing and open-sourced all their documents. Also see Why I Invested in SparkToro. You can see their Folder with All the Documents, including the:
  • LLC Agreement
  • One-Page Term Sheet
  • Class A Unit Purchase Agreement
  • Investor prospectus

For further reading:

Other observers on RBI and other new approaches

• More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost
• Indie.vc v3: Austin (Roadshow 2019)
• After Funding 500 Deals, What Have We Learned? The First Ever Revenue-Based Financing Industry Report
• A better way to fund SaaS companies
  Six Paths to Financing a SaaS Business
  Should Private Startups Be Issuing More Bonds?
• There’s an alternative to VC
• The New Bootstrappers: How Alternative Funding Models Are Embracing Founder Lifestyles
• Announcing Profit Sharing Investments
• With less restrictions, more Tampa Bay companies are turning to revenue-based financing
• Revenue-Based Financing: How a Revenue-Based Loan Works

Social Impact

• Kauffman Foundation: Access to Capital for Entrepreneurs: Removing Barriers
• Village Capital: Alternative Investment Strategies to Drive Inclusive Innovation

Conferences

• Alternative Capital Summit
• Inflection Community
• MicroConf

Issues with the classic VC model

• The Warning Label That Should Come With Venture Capital.
• Startup investors should consider revenue share when equity is a bad fit
  Some Thoughts on Non VC Funding
• The fundamental problem with Silicon Valley’s favorite growth strategy
• For a case study of what happened when one company decided to “divorce” its VC investors, see Buffer on We Spent $3.3M Buying Out Investors: Why and How We Did It.

Also of interest

• Sample Series B Preferred Stock sample term sheets from: Kauffman Foundation and Carlton Fields Jorden Burt.

Note that none of the lawyers quoted or I are rendering legal advice in this article, and you should not rely on our counsel herein for your own decisions. I am not a lawyer. Thanks to the experts quoted for their thoughtful feedback. Thanks to Jonathan Birnbaum for help in researching this topic.