This essay is part of a series on alternative VC: I: Revenue-Based Finance: a new option for founders who care about controlII: Who are the major Revenue-Based Finance VCs?III: Why are Alternative VCs investing in so many women and underrepresented founders?IV: Should your new VC fund use Revenue-Based Finance?V: Should you raise venture capital from a traditional equity VC or a Revenue-Based Finance VC? VI: Revenue-Based Financing: The next step for private equity and early-stage investment. This is a summary of: Revenue-Based financing: State of the Industry 2020. VII: Flexible VC, a new model for capital-efficient growth companiesVIII: The Leading Flexible VCs, with structures between equity, debt, and Revenue-Based Finance
Does the traditional VC financing model make sense for all companies? Absolutely not. VC Josh Kopelman makes the analogy of jet fuel vs. motorcycle fuel. VCs sell jet fuel which works well for jets; motorcycles are more common but need a different type of fuel.
A new wave of Revenue-Based Finance VCs are emerging who are using creative investing structures with some of the upside of traditional VC, but some of the downside protection of debt. I believe that Revenue-Based Finance (“RBF” or “RBI”) VCs are on the forefront of what will become a major segment of the venture ecosystem. Though RBI will displace some traditional equity VC, its much bigger impact will be to expand the pool of capital available for early-stage entrepreneurs. This model is also known as “preferred royalty capital“, “revenue-based finance“, “royalty-based financing“, or “royalty share financing“.
So what is Revenue Based Finance?
RBF structures have been used for many years in natural resource exploration, entertainment, real estate, and pharmaceuticals. However, only recently have early-stage companies started to use this model at any scale.
According to Lighter Capital,“the RBI market has grown rapidly, contrasting sharply with a decrease in the number of early-stage angel and VC fundings”. Lighter Capital is a RBI VC which has provided over $100 million in growth capital to over 250 companies since 2012. Lighter reports that from 2015 to 2018, the number of VC investments under $5m dropped 23% from 6,709 to 5,139. 2018 also had the fewest number of angel-led financing rounds since before 2010. However, many industry experts question the accuracy of early-stage market data, given many startups are no longer filing their Form Ds.
John Borchers, Co-founder and Managing Partner of Decathlon Capital, claims to be the largest revenue-based financing investor in the US. He said, “We estimate that annual RBI market activity has grown 10x in the last decade, from two dozen deals a year in 2010 to upwards of 200 new company fundings completed in 2018.” According to Brian Parks, Co-Founder and Managing Partner of Bigfoot Capital, an emerging RBI VC, “Over the past 36 months, we’ve seen a sea change in the market with new [RBI] capital providers aggressively entering the market, increased limited partner appetite for this new asset class, and significantly increased interest from founders seeking an alternative to venture capital.”
John Borchers defines RBI as, “anchored around a model for providing long-term growth capital to a company that is paid back over time in the form of a modest, fixed percentage of monthly revenue. While it might be easy to confuse factoring, merchant cash advances (“MCA”), or other types of receivables-based financing solutions with Revenue-Based Financing, they are really quite different. Factoring, MCAs and receivables financing are all short-term oriented with pay-back periods measured in weeks, months or quarters, while RBI is generally measured in years. Factoring, MCA and receivables-based solutions are also typically tied to a customer contract, invoice, credit card throughput or some other specific collateral or cash-collection mechanism, while RBI is not involved with monetizing individual receivables or credit card payments. RBI is really designed to replace equity with a patient, flexible, long-term growth funding framework while factoring, MCAs and receivables financing are more of a short-term, working capital oriented set of solutions.”
Feenix Venture Partners has a unique investment model that couples investment capital with payment processing services. I asked Michael Hoffman, Partner and General Counsel of Feenix, how he compared his firm with tech-enabled Merchant Cash Advance companies, e.g., Clearbanc, C2FO, Shopify Capital, etc. He said,
“[W]e both provide credit card processing services, but most of the similarities stop there. Feenix focuses solely on providing longer term growth capital to healthy companies looking to expand. Credit card fees are provided on a competitive arms-length basis, as is the interest rate on our loans. The idea is for us to take advantage of a cost/expense that our borrowers are already incurring (credit card fees) and structure an investment that truly aligns our interests. As a result, we carefully choose to invest in good brands and operators that we believe can execute on their plan with the help of a reliable and flexible capital partner. That’s how we can offer competitive rates … with no prepayment penalties or warrants attached. In many cases, we will provide fully committed accordion lines that allow companies to borrow additional funds upon demand, when certain topline revenue goals are achieved, and/or burn down their credit card rates when these milestones are achieved.”
Lighter Capital summarizes RBI’s typical characteristics as:
RBI structures help to protect the equity of both founders and investors. I predict that the RBI model will become part of the standard set of options for founders raising capital, for use whenever appropriate, just as today founders raise opportunistically via preferred equity, convertible notes, cash advances, venture loans, and so on.
The traditional NVCA term sheet works well for founders who are comfortable substituting VC capital for revenues, running typically at a loss for many years. In board meetings of these classic VC-backed companies, when a founder reports, “I’m profitable”, the VCs typically say: “That’s a good problem to have; we should be more aggressive on growth.” However, according to Bryce Roberts, co-founder of Indie.VC, only 0.6% of founders raise VC; the other 99.4% of founders can’t or don’t want to build a business that way. The RBI investment model better aligns incentives between VCs and a founder who chooses to bootstrap.
Ali Hamed, Managing Partner at CoVenture, said he views RBI VC as “sort of a mix between long-dated Merchant Cash Advance, and corporate credit where lenders are using revenue to predict the ability to service debt”. One of the reasons that RBI VC is growing in both feasibility and popularity is that more businesses are becoming metrics-driven, which means that investors have better line of site on their future revenues. Hamed highlights 3 tools for visibility into revenues: