Today’s standard startup funding model whereby entrepreneurs pitch angels, VCs, and family offices for money in exchange for preferred equity is mostly a challenged, broken process. Outside of the money regions that focus on grand slams, and startups generally with revenue traction and significant growth rates, investing in startups is a great way to lose money.
The majority of angel investors I know have lost money investing in startups.
Perhaps they aren’t good investors. Perhaps it’s the entrepreneurs’ problems. Regardless, this isn’t specific to our region. It’s the same in all regions outside the money centers.
Stories of investors writing a check for $25k into Uber and turning it into $100M permeate the media, yet are so rare it’s laughable. Only, it fuels the stories and desire for more people to become investors.
One potential angel investor described it to me as wanting to spend 1% of his net worth on angel investing so that he could generate a new income stream and be less reliant on his day job. Unfortunately, the chance of that happening is slim to none.
There’s a perpetual cycle of regions trying to improve their local startup investing community. New angels come online and write some checks. They lose their money, and because of the poor outcome, will never do it again. Rinse and repeat each economic cycle.
Well, what’s the solution?
The funding model needs to change.
Over the last few years a new form of startup funding has emerged, but still represents a tiny part of the market: revenue financing. Revenue financing is code for a loan that’s paid back via a percentage of revenue. If the startup does better than expected, it’s a super high interest loan. If the startup does as expected it’s a high interest loan. If the startup does worse than expected, it’s a high interest loan paid back over a longer period of time.
Of course, a high interest loan requires the startup to pay back the debt, which takes cash away from growing the business. And, in the angel world, making 15% per year on the investment takes away the excitement and dream of making a 100x return.
The future of startup funding outside the money regions should be a mixture of light revenue financing and traditional equity.
Light revenue financing, such that the investor gets 1.2x their money back in five years, keeps startup money flowing in the community.
Traditional equity, such that there’s the potential for huge upside, keeps the imagination dreaming.
We’re near the peak of this cycle, and too much money is chasing too few high quality deals, making it a great time to be an entrepreneur. Only, this too will change — it always does.
When we come out of the next trough, and it’s time to re-evaluate the startup funding model, a combination of returning capital to the community on a consistent basis and equity upside will result in a more sustainable and successful eco-system.
A structural change in startup funding is needed. Light revenue financing plus traditional equity will improve the startup world.