In a previous post I summarized a presentation I heard by Luni Libes, author of The Next Step For Investors: Revenue Based Financing. I hadn’t yet read his book, but I have now.
It’s a short book that I bought for $9.99 (Kindle Edition). I have mixed feelings about the length and the value. It is more targeted at investors than entrepreneurs, and it left me asking some unanswered questions (see below). But if Revenue Based Financing appeals to you as an angel investor or small venture capital fund, it’s definitely worth the ten bucks to get you started.
The Preferred Share Problem
The first one-third or so of the book makes the case that the widely accepted equity venture funding vehicle, sale of preferred shares, is flawed in most cases for both companies and investors.
I agree with this argument, although Revenue Based Financing isn’t quite as widely appropriate as he says it is (more on that below).
The problems for investors are as follows:
- With the existing equity investment model, exit by acquisition is the predominant form of realizing investment gains, yet the proverbial 10X exits are rare and a long time in coming.
- In the “model portfolio” for preferred share investors, they expect 7 out of 10 investments will turn out not to have been a good idea in that 30% just return the original capital (“1X”) and 40% are complete losses.
- High risk early stage venture investment portfolios should substantially beat the S&P 500, which has an historical average of 7% internal rate of return (IRR), but for a decade in recent history the average IRR for venture capital failed to beat the S&P 500.
- Invested companies often plateau in growth, becoming “zombies” to investors even though they are solid, profitable businesses generating good salaries for company management.
The problems for companies with the preferred shares investment model:
- Investors are highly motivated for companies to “swing for the fences” and grow rapidly at all costs, even when that substantially increases the probability of failure.
- The likelihood of raising larger and larger subsequent rounds is well below 100% after an angel round or a Series A, so companies are torn between driving towards profitability and driving towards rapid growth.
- Investors can diversify their risk across a portfolio of 15 to 20 companies, but entrepreneurs have their risk concentrated on just their own company. (That’s my analysis, not the author’s)
While Luni Libes doesn’t use this phrase to summarize the current situation, I’d say the predominant use of the 10X preferred share seed funding model is…
The triumph of hope over experience
… a phrase attributed to Samuel Johnson in 1791.
Revenue Based Financing
About half the book describes in some level of detail the various options for Revenue Based Financing, as well as some practical suggestions on how to figure out the two key terms:
- What percent of revenue will be used to repay the investment, ranging from 3% to 9% of revenue?
- What should the total return be – 2X? 3X? 1.8X?
Libes points out that there are in fact four different structures for Revenue Based Financing, and he’s used two of the four himself:
- Debt, with repayments based as a percentage of revenue
- Equity, with repayments “redeeming” purchased equity so that founders steadily regain ownership
- Dividends, with repayments based typically on a percentage of profits rather than revenue, ending with shares being repurchased at cost
- Contract revenue-share, structured like a royalty with a cap on total payments.
If you’re an investor contemplating a Revenue Based Financing structure, Libes’ practical tips make the book well worth the money. Here are just a few:
- Quarterly repayment has been the happy balance between too much paperwork with monthly payments, and not enough feedback with semi-annual or annual payments
- Make sure you open the door for an “early exit,” i.e., repaying the financing early, because it improves your IRR
- He structures those early exits on his redeemable equity financings as the higher of the agreed upon multiple (such as 2.5X) or the pro rata of the company value if it’s acquired
- US tax laws will have a considerable impact on returns across the different structures (debt, equity, dividends, contract).
If he does a second edition, here are some questions he might address to help justify a $15 price.
What are the specific tax implications of the different structures?
While I know that everyone’s tax situation is different, it would have been very helpful to have a few examples to illustrate the impact of choosing debt versus redeemable equity on after-tax returns. It’s hard to tell at first blush how big that impact is going to be.
Similarly, it’s hard to judge the tax implications for companies of the different structures.
How does revenue based financing affect your due diligence and post-investment management strategy?
If the problem with 10X preferred share investing is that all the emphasis is on maximizing upside, it seems like Revenue Based Financing encourages a lot more thoughtfulness about minimizing downside.
That raises a bunch of questions. How would this funding vehicle make you weigh founders’ vision versus their ability to manage business operations? How much should you do homework on total market size? Competition? Does it change your perspective on cost of customer acquisition versus lifetime customer value analysis?
And if refinancing increases IRR, do you make sure to analyze the possibility of the company becoming bankable?
What are the limits of Flexible Revenue Based Financing?
Libes is a bit too glib about the applicability of Revenue Based Financing. His case would be stronger if he explored the limits a bit more.
- Scalable companies with extended R&D, including biopharmaceuticals and medical devices, are not a fit because revenue to pay back the investment is many years in the future.
- Companies that need tens or hundreds of $millions to fund a winner-take-all marketing race are unlikely to find investors willing to structure investments this way
- Startups that can bootstrap with customer revenue will prefer that color of money to revenue based funding
- Similarly, winners of grants and business competition prizes will prefer that funding to start, although later on both bootstrappers and grant-funded startups may turn to Revenue Based Financing.
Finally, he alludes to the fact that some investments just won’t make sense – the numbers won’t work. It would be helpful to build on that observation to create some rules of thumb helpful to both investors and companies.
I suspect that there are some mathematical relationships between the size of the original investment and the size of the revenue, and revenue increases over time, that are enabled by that investment. In one of his examples, a company takes in $100,000 and generates $4 million in cumulative revenue over 7 years. That’s revenue of 40X the investment, which is needed (mathematically speaking) to generate a 2X return at 5% of revenue repayment.
That’s not going to make sense for some capital-intensive businesses – real estate immediately comes to mind.
Also, there may be some businesses that suffer from extremely low profit margins that are uninvestable by equity investors, unbankable by traditional debt suppliers, and unfundable through revenue based financing. They are just plain lousy businesses to be in, and extra capital won’t fix the problems.
What does actual investment performance look like so far across a portfolio?
I believe Libes’ accelerator Fledge has invested in about 70 companies so far. That’s still a small number, but it would be helpful to know what the early metrics are in terms of:
- Companies meeting revenue and repayment expectations
- Companies experiencing “early exits” in a good way, and in a bad way
- Companies receiving additional financing – equity, debt, grants, and how much versus the initial seed investment.
How will Revenue Based Financing scale?
Libes believes there ought to be a whole lot more Revenue Based Financing going on than there is today. I agree.
But how will the innovation displace the entrenched competition? Today, this form of funding is likely much less than .1% of the total preferred share funding.
This book alone won’t do the trick. It will likely require some entrepreneurial investors to build on his ideas to create a scalable model.