Guest Post by Bruce Pascoe

What if there was a new way for startups to raise money, without the onerous conditions of traditional bank debt or all the baggage of venture capital?

In the decade to come we’re likely to see the continued growth and popularity of revenue-based financing, an innovative approach to providing cash for startups. In this exclusive interview, Bruce Pascoe talks with Thomas Thurston, a global authority on revenue-based finance and President of Growth Science International, a research firm that predicts if startups will survive or fail.

Bruce: What is revenue-based financing, or “revenue capital”?

Thomas: Revenue-based financing is a quietly, quickly growing way for startups to raise money. A lot of people haven’t heard of it yet, but funds and deals are starting to pop up everywhere.  

Here’s how it works:

In the case of traditional venture capital, an investor gives cash to a startup in exchange for equity.  In the case of revenue-based funding, an investor gives cash to a startup in exchange for a percentage of that startup’s top-line revenue for a fixed period of time, or until a maximum payback “cap” is reached.  That’s why it’s called “revenue” capital – repayment comes from the startup’s revenue.  

The percentage of revenue (royalty) is usually between 1-10% of monthly gross sales, and the repayment cap often varies from a multiple of 2X-5X of the invested capital. 

For example, a revenue investor may say “here’s $1M, in exchange I want 3% of your monthly revenue up to a maximum total lifetime repayment of $3M.”

Q: What size business is it best suited for?

I’ve seen deals ranging from $50K in pre-revenue iPhone apps, to $50M in biotech ventures with large P&L’s.  It’s all over the map.  That being said, more funds are starting to target startups with $1-10M in revenue that need an extra $100K-$3M.  

This kind of funding only tends to work for startups with 50% or higher gross margins, or otherwise flexible margins so that the royalty doesn’t choke the business. That rules out a lot of low-margin (ex. 15%) hardware businesses, but can be terrific for high-margin hardware, software and service startups with some revenue under their belts.

Q: What are the advantages?

Probably the best thing about revenue capital is that it lets startups access cash without having to give up any ownership or control of their companies.  There’s no dilution, and some funds don’t even ask for a seat on the Board.  It’s “baggage free” money.  

Secondly, most revenue capital funds don’t impose personal liability on the entrepreneur.  So the startup can get cash without the founders having to put their homes and other personal assets on the line.  Compare this with banks that require personal liability and collateral, not to mention imposing restrictive debt covenants.

A third advantage is that, unlike VCs, revenue-based investors generally don’t care if the startup ever gets acquired or goes IPO.  Since they get paid only as a percentage of revenue, investors are more interested in sales growth.  There isn’t unhealthy pressure to artificially inflate the business and prematurely sell it off.  Along these lines, startups also don’t have to negotiate pre-money valuations to get revenue-based funding – a painful process at best.

Q: What happens if the business grows slowly? What if it grows quickly?

If the startup hits a home run, the investor gets paid back faster for a nice high IRR.  If the startup flounders or fails, the investor’s IRR is low or even negative. Revenue capital funds take a lot of risk in these deals.  They put up their cash up-front, betting that the company will do well.  

It’s like venture capital in that regard, except revenue based investors have a capped upside. It’s a new risk-reward model.

As long as the startup can expect more growth than the royalty percentage they take on, it’s probably worthwhile.  For example, if cash from a deal with a 4% royalty catalyzes a company’s growth by 5% or more, the deal probably paid for itself.  

Q: Can it be more advantageous than traditional debt or equity financing?

Revenue-based investing is “in between” traditional debt and equity on the risk/reward spectrum.  To the entrepreneur, revenue capital has less downside risk than debt (if the business fails, the investor can’t take your house).

It also has less upside risk than equity — repayments are capped, so the startup doesn’t end up paying 10X, 100X or 1,000X to an investor if it becomes the next Google. Instead, the startup gets to keep that appreciated equity for itself. 

Q: What’s the downside?  

Again, this is a terrible structure for businesses without enough gross margin or cash flow to support a monthly royalty payment.  It has to make sense on the books.

Also, revenue based financing tends to envision a mid-to-long term investment horizon, that’s why the caps and royalties are set the way they are. So if the startup wants revenue financing for a short-term cash need, the entrepreneur should try to pre-negotiate early payment discounts in the event that they want to buy-out the royalty within the first year or so.  Some investors will do this, others won’t. Startups may also want to try and pre-negotiate discounted buy-out provisions in the event of an acquisition or IPO, if that’s a concern.

Another downside is that it’s difficult to take more than one revenue based investment at a time. Unlike equity, where you can have two, three or four investors at a time, most startups can only handle one or two royalties.

Q: Isn’t that potential 3X-5X cap a turnoff for entrepreneurs?

Yes, it definitely turns off some, but that’s often an emotional objection more than a rational one. People can get anchored on the cap, which prevents them from realizing what’s really on the table. I’m not saying revenue capital is for everyone, all the time. It’s just been my experience that entrepreneurs who get too hung up on the cap often have a poor understanding of the cost of capital.

For example, compared with equity — where there’s no cap — revenue based financing is dramatically cheaper. What’s worse; a 5% royalty with a 3X maximum potential lifetime repayment, or equity ownership of 5% of your company in perpetuity, with unlimited potential lifetime repayment? Think about it. My advice to entrepreneurs is; try to negotiate the best cap you can, but don’t take it out of context.

Q: What if an entrepreneur is focused on APR?

That’s another misconception. APR is only relevant when a financial instrument has predetermined duration and magnitude. That’s why nobody ever asks venture capitalists what the “APR” will be on an equity investment – it’s absolutely unknown and irrelevant. Apples and oranges. 

With growth capital, when neither the duration nor magnitude of an investment is known in advance, both the investor and the entrepreneur are actually hoping the after-the-fact “APR” will be enormous, not small. That would have meant the investment was a success. 

In other words, in the case of equity there’s no APR because neither the duration nor magnitude of repayment is known in advance. The business could be a huge hit, or a flop. Either way the investor takes the risk alongside the entrepreneur, with no personal liability or hard collateral if things turn south. 

Similarly, in the case of revenue based financing there’s no APR because neither the duration nor magnitude of repayment is known in advance. Repayment could end up happening quickly, or not at all. There’s a maximum possible repayment, but that’s for the entrepreneur’s benefit, not the investor’s. It’s a cap. The business could be a huge hit, or a flop. Either way the investor takes the risk alongside the entrepreneur, with no personal liability or hard collateral if things turn south.

Q: Why isn’t it more commonly used?

It’s new.  Even though businesses have been using revenue-based investing in mining, oil, gas, entertainment and other industries for a century, it simply hasn’t been done as deliberately with modern startups.  That being said, investors have been quietly doing these kinds of deals with modern startups for at least 18 years, and more than $3 billion was invested through revenue capital in healthcare alone during 2008.  

It’s not as if it isn’t being done.  Rather, it’s just starting to enter the mainstream consciousness. With more than 20X growth in the number of deals done this way since 2000, there’s certainly momentum. For example, just a few months ago a new revenue capital fund publicly announced in Seattle.  The fund is Revenue Loan, and is being run by Andy Sack and Randall Lucas.  

In full disclosure I’ve worked with that particular fund, but I hope to see many more funds like them in the future because, done right, revenue-based funding can have a very positive impact. Startups are the future of our economy, yet good ones die all the time without sufficient access to capital. I think it’s time venture investors innovate more themselves, rather than just demanding that from the startups they fund.