Revenue Financing + Traditional Equity Continued

Last week’s post Revenue Financing + Traditional Equity as the Future of Startup Funding struck a nerve and resulted in a number of comments and questions. Generally, the big idea is that most regions have sub-standard angel communities because the angels don’t make money on their investments. Without regular, positive returns, angels drop out and the community is constantly treading water. The idea for a revenue financing component is to recycle money back into the community sooner — ideally in less than five years as opposed to today’s 7-10+ years — so that angels have a good experience and stay active.

Revenue financing plus traditional equity prompted a number of questions. The big question: how might it work? Here’s a hypothetical example:

  • Angels invest $500,000 into a seed round at a $3.5M pre-money valuation ($4M post-money valuation after the new investment is included)
  • When the startup hits $4M in trailing twelve months revenue (the initial seed valuation becomes the revenue target), ideally within five years (that’s what the entrepreneur’s projections said!), the startup pays the original seed investors back, plus 20%, over the next 18 months (paid monthly as a percentage of revenue)
  • The 1.2x returned to the seed investors becomes similar to negative participating preferred equity whereby that amount is deducted from the investor proceeds at time of exit

Now, 99% of all tech startups never achieve $1M in sales in a calendar year, so most startups, even with six figures of angel investment, will never hit the revenue threshold to trigger payments back to the seed angels. Yet, if some small percentage of angel-backed startups do hit it — say 3% — then more money will flow back to the community faster.

Changing an entrenched format, like typical startup funding terms, is a tall order. When startup communities with limited angel investors come together to improve the recycling of capital, revenue financing should be a consideration.

Revenue Financing + Traditional Equity as the Future of Startup Funding

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.

Secondary as a New Primary Investor Capital Deployment

Recently I was talking to an investor that lamented how hard it was to invest in startups the traditional way. Today, there’s so much money for the “hot” startups that rounds fill up quickly and investors are aggressive (read: more sharp elbows). Historically, that was the end of the story, but now there’s more capital that wants in. Over the last five years, there’s been tremendous growth in capital applied to liquidity for founders, early employees, and early angel investors.

Secondary capital, where one shareholder sells equity to a new or existing investor, doesn’t directly benefit the company and used to be rare in startupland. Primary capital is when the company sells shares to put more cash into the business, usually to grow faster. Even today, primary capital is significantly more common than secondary capital for startups, but things are changing.

When thinking about many of the growth stage startups in our region, secondary sales of equity occurred in a material number of their recent financing rounds. Investors, with larger funds and stronger deal competition, often negotiate to buy X dollars more of the common shares of the startup at a discount (e.g. buy up to $10M of common shares at a 20% discount to the preferred price). Look for more investors to employ this model of buying a large chunk of preferred shares from the startup and a smaller chunk of common shares for the early shareholders.

Secondary sales, while rare in the past, are fairly prevalent today. Founders and early employees would do well to take secondary sales into account, especially when their startup hits escape velocity and reaches the growth stage.

Funding Climate Outside the Money Regions

Whenever I talk to a startup person outside our region (investor, journalist, etc.) they like to ask about the current funding climate in our region. Money is always a popular topic, especially when the economy is hot and startups are en vogue (bonus: public SaaS valuations are at an all-time high). Only, the funding climate outside the money regions (CA, NYC, etc.) hasn’t appreciably changed in the last 2-3 years.

More money is sloshing around on the sidelines waiting to be put to work. Limited partners have huge commitments in funds and venture investors are trying to put the money to work. Yet, this is primarily for growth/later stage investments when the metrics are solid and it’s clear the startup is going to win, simply a question of how much. For these growth/later stage investments, investors will travel. Distance is a pain but not that big a deal. If you can write a $50M check and underwrite a 3-5x return in 3-5 years, it’s a pretty easy ‘yes’, especially if there’s a direct flight (the money people still hate layovers).

Early stage investments — primarily post-seed and Series A — are still quite limited. The number of investors that focus on this stage (say, $750k – $3M in revenue) hasn’t appreciably changed, thus the number of startups that raise rounds in this stage hasn’t change (without more investors, the quantity of these types of fundings won’t increase). Investors at this stage often write checks that are larger than angels can put together, so it isn’t possible to bypass this funding source with more non-institutional money.

Seed/angel rounds are still the most challenging area. Idea stage startup are plentiful, but highly risk-loving capital is not. Local investors are still primarily wealthy people who didn’t make money in technology, and thus their appetite for startup investing is relatively low. To grow the angel community, we need to have more large startup exits. Today, there’s a strong cohort of local growth stage startups valued in the hundreds of millions and a few in the billions. Once this wave of startups, typically 5-10 years old, reaches exit maturity, expect the local angel community to ramp up and hit a new high.

While the funding climate hasn’t changed recently, the overall tenor of the startup community is humming along nicely. Look for the funding climate in the idea/seed stage to grow nicely in the next 3-5 years once we have a wave of big startup exits.

The Rise of Revenue Financing Loans for SaaS

Recently, several entrepreneurs have asked me about revenue financing loans. Revenue financing is a fancy way of saying a semi-complicated loan where payback is dictated by a number of elements including a percentage of revenue, not just a traditional interest rate. The good news is that it provides for a more aggressive, non-dilutive (usually) form of financing for Software-as-a-Service (SaaS) companies. The bad news is that it’s much more expensive than a bank loan, but still not nearly as expensive as venture capital.

Here’s how an example revenue financing loan might work:

  • Loan amount equal to 20% of current annual recurring revenue (e.g. $10M in ARR, $2M loan)
  • Loan covenant where one month’s operating costs in cash required on hand at all times (e.g. $800k of monthly expenses, with a $2M loan, only $1.2M can actually be used)
  • First 18 months interest-only monthly payments (on the full $2M, not the usable $1.2M) where the “interest” is 3% of the monthly cash receipts (hence the name revenue loan as the interest rate is directly driven by the revenue of the business)
  • 3.5 years of equal principle payments after the first 18 months plus the continued interest of 3% of the monthly cash receipts (so, the loan is paid back after five years and the interest payments keep rising assuming revenue keeps growing)
  • Additional 10% of original loan amount payment due after final payment or at time of next financing event (payment can be cash or equity)
  • Minimum of 1.7x the original amount back to the loan provider with a max of 2.5x (since the interest rate is a percentage of revenue, if the business grows faster than expected, the interest rate could be much higher and up to 2.5x would be paid back)

Wow, it is complicated! Net net, it’s roughly a 25% interest rate loan with variability based on how fast revenue grows. SaaS, with its amazing margins and cash flow predictability, makes this type of financing uniquely suited to both the investor and the recipient, especially compared to most types of other businesses.

SaaS entrepreneurs looking to grow faster, but reluctant to sell equity, would do well to talk to the newish crop of revenue financing firms out there.

What else? What are some more thoughts on revenue financing loans?

Raising Venture Capital Isn’t Right for Most Entrepreneurs

Earlier this week I was on a panel at the excellent 36|86 Entrepreneurs Festival in Tennessee talking about bootstrapping vs venture capital. Reflecting on the panel discussion, and other conversations at the event, it’s clear that raising venture capital is still viewed as too much of a default path for tech entrepreneurs. In reality 99% of entrepreneurs, tech or otherwise, shouldn’t raise venture capital.

Here are some of the common reasons raising venture capital isn’t right for most entrepreneurs:

  • It limits exit opportunities
  • It puts a timeline on the business
  • It requires a 5x greater exit for the founder to make the same money
  • Most markets aren’t winner take all

Beyond the common reasons, the reality is that most entrepreneurs can’t raise venture capital because they don’t have enough traction (revenue!), growth (much be growing super fast), unit economics (strong gross margins and profit possibility), and market opportunity (must be a huge market). Too many entrepreneurs spend time trying to raise institutional money when that time is better spent building the core business.

The solution: find a trusted advisor or mentor in the community to help think through financing options. Most of the time venture capital isn’t the right path, and isn’t even an option due to the business characteristics.

Entrepreneurs would do well to better understand venture capital and know that most of the time it doesn’t make sense.

When SaaS Valuations Weren’t So Rosy

With Thomasz Tunguz’s recent post The 5 Forces Driving Startup Valuations Today it reminded me that SaaS valuations weren’t always so rosy. Today, the median forward multiple for public SaaS companies is 8.5x (meaning, these companies are valued at 8.5x expected revenues).

10 years ago we were out actively raising money for Pardot after hitting $1M in annual recurring revenue. We met with 29 different venture firms in Atlanta, D.C., Boston, and Silicon Valley. After being turned down several times with the message that the total addressable market for marketing automation was too small (hah!), we had three interested parties that floated valuations and wanted to talk potential term sheets.

By the time of these advanced conversations, we had $1M in trailing twelve months recognized revenue, $1.3M annual run rate, and 300% growth rate. Here were the verbal offers:

  • $500,000 investment at a $2M pre-money valuation
  • $1M investment at a $2.5M pre-money valuation
  • $5M investment at a $7M pre-money valuation

After doing some spreadsheet math it became clear that we were better off not raising money and continuing to go it alone. We decided not to raise money and kindly discontinued conversations with the VCs. If the valuations back then were what they are today, the spreadsheet math would have likely turned out differently.

Know that SaaS valuations have never been better but that we’re in unusually good times — it wasn’t that long ago when they were substantially lower. Still, do what’s best for the business and don’t raise money just because valuations are high.

What else? What are some more thoughts on SaaS valuations?