I recently learned about a new, flexible approach to revenue financing for seed stage companies. I’m convinced, as is the author of a new book on the subject, that this type of funding will fill a very important need both for young companies and for investors who have been ill served by traditional preferred share financing.
Luni Libes is a serial entrepreneur turned impact investor. He recently gave an Angel Capital Association webinar entitled “Investing Without Waiting For Exits.” He’s promoting a new book I haven’t yet read, but will, called The Next Step for Investors: Revenue-based Financing.
The innovation he has created turbo-charges revenue financing, a fringe form of investment that has shown promise for a few decades but has never gained wide acceptance. Read on if:
- Your company will generate strong cash flow as it grows, but will likely never be worth $50 million or more
- Your revenue growth might put you on the INC 5000 (more than 40% cumulative over 3 years) but it won’t be 100% plus revenue growth per year for the next three-plus years
- You don’t need $10 million or more in equity, which is what most venture capital firms like to invest
- You want to be able to balance social impact with profits
- You want to keep the option of running the company for a long time rather than selling it within 7 years.
Revenue Financing Basics
As I wrote in an earlier post, Revenue Financing has been called many different names. The particular revenue financing vehicles I’m focused on here:
- are medium term loans (typically 3 to 5 years currently)
- have high effective interest rates (although interest isn’t charged per se)
- take payments based on a percentage of revenue (unlike fixed payments of conventional loans) that are around 5% of revenue
- collect payments monthly (typically)
- are available to companies with a strong growth history and growth projection, and a high gross margin
- take longer to get approvals and cash than Merchant Cash Advances, but are often faster than SBA loans or venture capital.
In that earlier post I included a list of 9 companies that offer some form of Revenue Financing or revenue sharing loans.
Revenue Financing Innovation
Luni Libes is based in Seattle, where Lighter Capital is based. Lighter Capital has provided Revenue Financing to 190+ technology companies with at least $15,000 per month of recurring revenue – typically Software as a Service (SaaS). He’s observed their model and adapted it for his own needs.
Since 2012, Libes has been running an accelerator for impact companies: those that plan to balance doing good for the world with being profitable. It’s not a typical accelerator in terms of its funding approach. Most accelerators that offer investment use either convertible notes or Series Seed funding.
But the Fledge accelerator has created a variation on revenue financing instead, in order to align investor and entrepreneur goals.
In exchange for the cash, the program, and all the follow-up support, we ask for 6% ownership in each startup. This investment is uniquely structured as redeemable equity, with the startup repurchasing Fledge’s shares using 4% of future revenues.
The innovation that Libes uses more broadly in his angel investing is in creating a revenue financing investment instrument that has flexibility on five key metrics. In addition, it accommodates many of the terms typically found in preferred shares. This flexibility allows investors and entrepreneurs to do a deal that doesn’t require an exit, and can be shaped to work in a wide range of circumstances.
Those metrics, or variables if you will, are:
- What percentage of revenue will be used to repay the investors – single digits, anywhere from 3% to 9% but often 5%
- How often the repayments happen – typically monthly, but sometimes quarterly or even annually
- How much the cumulative repayments will equal over the term, typically providing a fixed multiple return ranging from 2X to 3.5X of the original investment (or loan)
- Whether or not some of the investment is equity versus a loan, and how much is repaid by the end of the term – for example, 1/3 might stay as long term equity held until exit, and 2/3 is repaid as either a loan or as redeemable equity
- How long is the “honeymoon” before repayments start, anywhere from 1 month to 9 months typically.
- Board seats
- Certain investor approvals (for example change of control, additional investment)
- Right of first refusal
- Change of control provisions
A Simple Return Model
In his presentation to the ACA, Libes shared the following screen shot of his simple spreadsheet used to understand the relationships among investment size, percentage of revenue used for repayment, estimated revenue growth over time, and investment return – calculated both as a multiple of the original investment and as Internal Rate of Return (IRR).
He uses here an example of a company that would never ever be considered by conventional angel investors. It’s a small company that projects it will hit $1 million in revenue by year 7, and he guesses it will just stay there to be “conservative” on his analysis.
In this case he’s trying to get a 2X return on his investment of $100,000. The question is now: what percentage of revenue should be used to repay the investment? The columns show the repayment schedule for 3%, 5%, 7% and 9% of revenue.
His spreadsheet automatically calculates the IRR in row 16. This is oversimplified IRR calculation. If there is monthly repayment the IRR would be different, but for purposes of rough estimation and negotiation between investor and entrepreneur it’s close enough.
Issues To Consider And Negotiate
Libes has now made more than 70 investments using this flexible revenue financing approach. Here are some of the issues that both he and entrepreneurs consider while negotiating the variable metrics:
- Taxes – what are the implications of equity vs. loans on taxes for investment returns, any tax implications for operating losses on both the company and investors, and deductibility of interest payments?
- Risk – what is the perception of the risk of the company not lasting 6 to 10 years, or not meeting its revenue numbers?
- Upside – what does the investor see as upside potential for the company being acquired, and how much do they want to share in that upside in return for extra risk?
- Control – how much control does the entrepreneur and the investor want to have over the future direction of the company?
15% IRR Is Enough
Libes argues that the investment result seed and venture capital investors seek is a 15% internal rate of return on a portfolio of investments. That currently comes from a mix of rare 10X returns, some 3X-5X returns, some just return of capital (1X) and some complete losses (0X).
What he proposes is that a portfolio of flexible revenue financing investments will have almost zero complete losses, and many returns in the 1.5X to 3X range, with early returns through monthly payments boosting the IRR versus getting an exit after 7 years.
It’s a pretty compelling financial argument, although there isn’t enough experience yet to know how it will play out. By contrast, there is lots of data on venture capital fund returns.
Cambridge Associates publishes a quarterly report on fund returns. “Pooled returns” of all funds invested beat a 15% IRR for venture capital funds started from 1988 through 1997. Then there were 9 bad VC fund vintages from 1998 to 2006. Funds formed after that are around the 15% to 20% IRR level – as a whole.
But the bottom quartile – the worst 25% of venture capital funds – have not hit a 15% IRR except in 1995. More than one-third of the time they’ve actually lost money.
In other words, professional VC funds don’t hit their investment returns a lot of the time. It’s reasonable to think this is also true of angel investors.
Challenges To Adoption
As with all innovations, there will be challenges to get the global equity investment world to embrace a very different form of investment. But that doesn’t mean entrepreneurs shouldn’t try.
A good place to start would be to read the book. Also, the web site Impact Terms has a set of investment terms designed for impact investors, including those used by Libes. And as it turns out, Lighter Capital has been using venerable Silicon Valley law firm Cooley LLP for their investments. Libes used Cooley to make a few modifications and boom: Flexible Revenue Financing.
I’m going to go out on a limb and predict that despite the challenges, Flexible Revenue Financing (as I call it) will be a major option for entrepreneurs within seven years. It’s that big a deal.