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Should you raise traditional VC or Revenue-Based Investing VC?

 Most founders who are raising capital look first to traditional equity VCs. But should they?  Or should they look to one of the new wave of Revenue-Based Investors?

Revenue-Based Investing (“RBI”) is a new form of VC financing, distinct from the preferred equity structure most VCs use.  RBI normally requires founders to pay back their investors with a fixed percentage of revenue until they have finished providing the investor with a fixed return on capital, which they agree upon in advance.  For more background, see Revenue-Based Investing: A New Option for Founders who Care About Control.

This is part 5 of a 5-part series on Revenue-Based Investing VC:

From the founders’ point of view, the advantages of the RBI model are:

  • Greater control over the company. Like traditional lenders, RBI investors usually don’t take board seats.
  • Less or no dilution. RBI investors usually don’t take equity
  • Optionality. BJ Lackland, CEO of Lighter Capital, observes that RBI-backed founders “want to maintain control, ownership and optionality. These entrepreneurs want to maintain two major options:
    1) To raise VC later (or not), and/or
    2) To sell their businesses when they want – early, mid term, or never.” 

    “When you raise early stage VC, you can’t sell early because the VCs won’t agree to it. But you also can’t run the company forever, since investors need a liquidity event. So you’re stuck selling mid-term, which is frequently sub-optimal for the entrepreneur. “
  • Speed. BK Landland observed, “At Lighter, most entrepreneurs we fund spend 10 total hours of work over 3-6 weeks to get funding. This includes the application process, phone calls with us, conversations with co-founders, investors and counsel, etc. Soup to nuts. This is a massive reduction in time spent compared with raising an angel or VC round, which takes hundreds of hours. “
  • Lower processing cost. BJ Lackland wrote, “It’s customary for the company to pay the investor’s legal fees. For a VC round, this can be $25-50k+. With Lighter, we average $2,800. “
  • Much lower cost of capital, if company is highly successful. The cost of VC funding to a unicorn CEO can easily be the equivalent of paying well over 100% annual interest. Ali Hamed observes that “software companies are blessed with high margins that allow them to payback expensive capital. That, combined with the high ROE required by VCs, makes expensive capital relatively cheaper to them than it would be to a normal business.”
  • Predictable and flexible payments. Since payback is calculated as a percent of revenue, the company doesn’t have the risk of a cash crunch that can occur when paying back loans in large chunks. 
  • Aligned incentives. The RBI investor is motivated to help the company grow because that speeds up the pace of revenue payback, and therefore IRR. This is similar to the incentives of a traditional equity VC, but unlike traditional lenders.
  • Focus on lower-risk business models; no requirement for a ‘swing for the fences’ model. Traditional VC is most appropriate for and seeks out companies which require a huge audience (e.g., Paypal) or expensive technical R&D (e.g., most biotech companies) before profitability. Most entrepreneurs are not building companies like this; they aspire to profitability within the short term. A company with that mindset is dramatically less risky, because it’s not dependent on the financing markets for continued viability.
  • Profitability is not required, unlike many traditional lenders. “Companies Lighter Capital has funded on average have negative 14% net margins.”  Brian Parks notes that for Bigfoot Capital, “90% of the opportunities we evaluate and the companies we fund are not consistently profitable when we invest. However, both we and the Founders we back need to believe that there’s a reasonable path and plan to profitability in the near-term (next 12 months) as they just don’t have the capital buffer (gobs of VC) to continuously burn, nor do we have the appetite for that model.”
  • Works for non-tech companies. Borchers points out: “Only 50% of our investment activity involves technology-based businesses. There is a huge universe of compelling, growth-focused companies that operate outside of the technology world, and they sometimes don’t get the attention that they deserve from institutional venture equity investors.” 
  • Works for early-stage companies. Many of the RBI investors look like traditional factors (e.g., C2CFO, Vendorterm) or lenders. The big difference is that RBI investors are more comfortable than a traditional financier in providing capital to companies before they have achieved meaningful revenues, let alone profitability. 
  • Tax benefits: With a properly structured RBI funding package, companies are able to deduct their interest payments at a rate of 37%, which has a large and positive impact on the after-tax cost of capital that a company pays for RBI capital.
  • Longer term orientation than factoring or merchant cash advances: RBI investment is typically structured for three to five year terms, shorter than the classic equity VC fund lifespan, but far longer than classic debt. This provides companies with runway as they use an infusion of capital to grow. Borchers notes, “There are tons of good, short-term working capital products in the market already (factoring solutions, MRR loans, AR financing, etc.), but RBI is really designed to be an equity-replacement solution. It offers the flexibility and timelines of equity, where the cash-return cycles are measured in years, not weeks or months like MCAs or factoring.”
  • Easy to terminate the relationship if it’s not working. The cost of being wrong in your selection of an investor is not as onerous as in traditional equity VC, since RBI comes in as debt and not equity, and can theoretically always be “paid off” if the partnership doesn’t work. 
  • Cost of capital is tax deductible, unlike traditional equity VC.
  • No personal guarantees, unlike some traditional lenders.
  • Attractive to founders in controversial sectors. Many VCs avoid controversial sectors (cannabis, “smart guns”, etc.) not because of LP objections or moral concerns, but because the pool of potential M&A buyers is greatly limited.

BJ Lackland said, “We sometimes hear entrepreneurs say they don’t know if they like RBI because it is senior in the capital stack to their equity, so it gets paid first in a downside scenario. But this is the same for a VC round with a liquidation preference. Many entrepreneurs don’t understand how this works – they own common and it gets paid after VCs get their liquidation preference paid.”

The disadvantages to the founder of raising RBI capital include:

  • Companies must have revenues or a clear path to revenues in the near future. 
  • Built-in cap on the amount of capital you can raise per transaction. According to Lighter Capital, “Generally, RBI investors will not provide capital equal to more than 3 to 4 months’ worth of MRR.”  However, if needed, one can always raise more capital a few months later. 
  • Requires regular monthly payments and careful cash management. Emily Campbell of The Campbell Firm PLLC (who has advised me on some legal matters) notes: “If a company’s account is effectively being swept for remittances, it requires the company to monitor cash flow very carefully.”  Keith Harrington, Co-Founder & Managing Director at Novel Growth Partners, writes, “RBI may not work for a company with a super high growth trajectory, because the payments could be very large”. 
  • Arguably less longer term alignment with investors, since investors’ financial stake is quite different than the founders’ equity. Emily Campbell submits that RBI investors may be less motivated to support a company over the long-term than traditional VCs because they can get their money back ahead of the equity investors. That said, Jim Toth, Managing Partner, Riverside Acceleration Capital, observes, “Actually, everyone is aligned towards growth. In our case, the more resources we can devote to our companies, the more quickly they should grow, which makes both the company and our revenue share more valuable.“
  • May make it harder to raise traditional equity VC. Lori Smith of White and Williams observes, “The traditional VC is likely going to see these investors in the cap table as a negative. RBI investors are typically taking money out of the company before the VC is seeing any return of its capital or a return on its investment – taking a portion of the revenues that the VC would rather see reinvested in growth – so it could slow down growth or require additional capital raises sooner than otherwise necessary causing additional dilution. This is, in part, why the traditional convertible note has automatic conversion in most cases, so that new money isn’t paying off the old and can be fully devoted to growing the business. ”  However, this is only a problem if a company needs continuous VC infusion, and inherently a profitable company doesn’t need VC for its continued existence. Jim Toth said, “Our companies do not have difficulty raising growth rounds from institutional investors—and in fact, getting to a successful growth round is probably the most common use case for our capital, and one of the ways that we try to be the most helpful for our companies.” BJ Lackland observed, “The companies we fund frequently go on to raise VC. Collectively, they have raised many hundreds of millions of dollars and several have been sold for over $300MM. We are frequently approached by growth equity firms asking to introduce them to companies we have funded. They love to find entrepreneurs that have grown revenue to a growth equity stage while maintaining large ownership stakes instead of living off the rocket fuel of early stage venture capital.”
  • RBI capital is normally treated as debt. Keith Harrington,  Co-Founder & Managing Director at Novel Growth Partners, reports that his portfolio companies are reporting their obligations as debt. “But this isn’t really a problem. Remember, VCs are comfortable with the venture debt model already. Plus, companies in our portfolio have raised venture capital after we funded them, and also at the same time, so it has not been a deterrent to existing or future investors. In fact, we’ve even seen investors get more excited about a company when we decide to provide funding.”
  • May require personal guarantees. However, most of the RBI VC firms I have identified do not require personal guarantees. 
  • A hands-off approach may be more appealing in theory than practice. Many people become founders because they want to build their vision without having a boss, but a good “boss” is actually very valuable in mentoring, providing feedback, and so on. RBI investors may not provide the same level of support as some traditional VCs with a portfolio acceleration strategy.

For a comparison of the financial impact of some of these providers, see Alternative Funding Calculus: A Quant Comparison of Tiny, Indie, and Earnest. Also see Lighter Capital’s Cost of Capital Calculator and How to think about different types of funding for your early stage startup.  

FindVentureDebt, GUD Capital, Lencred.com, and NerdWallet are all resources to help you evaluate different options for small business financing.

Further reading:

I also posted this as a guest article in Techcrunch.  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. 

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