Revenue share – an alternative path to financing a startup

Human hand reaching for money

TechCrunch interviewed more than 200 investors and asset managers to gauge their interest in various new ways to fund early stage companies. Their finding? That 63.1 percent were will to explore revenue-based financing.

The concept of revenue-based financing has been around for a long time. It’s relatively straight forward. An investor funds a company and is later repaid by a percentage of the revenue of the company. However, to make this work the company needs to have a predictable cash flow, such as subscription-based businesses. And the company needs to have high margins, so that it can continue to operate whilst paying out a significant share of its revenue to its investor. Imagine you want to buy a bread and breakfast but lack the down payment. You get a loan from the bank for the down payment, based on the revenue that the B & B generates. Assuming that the B & B has a history of a good cash flow business, meaning it has a high occupancy rate and generates enough cash to both pay off its bank loan, cover its operating expenses and generate some profit for its owners this type of deal makes sense for the bank (the investor) and the B & B purchaser (the entrepreneur).

An increasing number of venture funds are now deploying revenue share tools. Novel GP has a $12 million fund that makes revenue  share in SaaS-based companies, which almost always charge their customers on a subscription basis. Indie.vc recently raised their second $30 million fund that invests through a “profit-sharing” structure by which the fund receives disbursements based on net revenue or net income, depending on which is greater. Candide Group, Adobe Capital and the TechCrunch affiliated fund VilCap are additional examples.

However, there are a number of issues with revenue share financing, for both the investor and the founder. For the investor, the author’s calculation on a hypothetical revenue share investment in 30 companies on average it would take about 4.4 years to realize a 3X return on the initial investment amount of $20k, to $100k. But how many startups can get off the ground on that amount? That’s about what the average founder can raise from friends and family on a convertible note.

Not only does the recurrent obligation to pay the investor shrink the pool of capital available to reinvest to grow the business, other investors who aren’t familiar with the model may be scared away, as were several investors interviewed by author Allie Burns.

And even if you add up all the capital under management of all the revenue share venture firms, I doubt it even comes close to approaching the average size fund of a single traditional equity VC fund. So it seems like founders would be going after a small amount of capital from a very small number of investors.

… based on the experience of VilCap Investments and other practitioners like Candide Group, we’ve found that revenue-share financing is generally only appropriate up to a certain size of investment, generally between $50,000 and $500,000, depending on the expected return multiple and timeline, and the company’s annual growth rate and traction at time of investment.

So while it’s encouraging to see alternative forms of investment available to founders, in reality it’s only a very small number who will be a good fit for this model. My advice would be it would probably be a better return on time invested to study crowd funding, especially since the SEC’s changes to rules governing investors have changed recently. No longer must an investor have a net worth exclusive of primary residence of $1 million dollars or more or an annual income greater than $250,000 to qualify as an accredited investor. Check out the Regulation Crowdfunding page of the SEC’s web site. And while you are at it you might want to review the Exempt Offerings page, which explains the exemptions from registration that are most frequently asked about.

Under the old regulations the SEC forced any company with 500 investors or more to go public, which basically shut down crowdfunding. Now that is no longer true, and unlike revenue share, crowd-funding is a new flavor of equity financing, something all investors understand.

Author: Mentorphile

Mentor, coach, and advisor to entrepreneurs, small businesses, and non-profit organizations. General manager with significant experience in both for-profit and non-profit organizations. Focus on media and information. On founding team of four venture-backed companies. Currently Chairman of Popsleuth, Inc., maker of the Endorfyn app for keeping fans updated on new stuff from their favorite artists.

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