Many, if not most, entrepreneurs have been frustrated by the time, effort and, often, lack of results as they try to gain funding to get their company to the next level. One of the biggest stumbling blocks is often valuation. The entrepreneur has put his/her heart and soul into building a company from scratch and any funding will require a giving up substantial equity. This is further complicated by huge gap between the entrepreneurs’ pre-money valuation expectation and the number the VC or Angel investor suggests. But it gets even worse…since the investor is betting on the future value of a company, every assumption the entrepreneur makes will be scrutinized with a fine toothed comb. Furthermore, even if a start-up has a solid business with stable growth, but can’t show a clear and believable path towards a 10X or greater increase in valuation, the Angel or VC may not be interested. Another tricky part of this process is determining how much money the firm really needs as well as how much equity to part with. Often companies won’t fit into a range that makes sense for a VC (generally $5+ million) or an Angel investor (varies, but often in the $500K – $1 million range). Smaller amounts are often garnered by “friends and family”, but in this economy, that isn’t always an option.
The scenario I described has prompted a few firms to offer an alternative to traditional equity capital and debt financing called revenue capital or royalty-based financing (RBF). The concept is pretty simple; instead of the entrepreneur giving up equity or taking on debt in exchange for funding, the investors fund the business and generate returns based on a percentage of company revenue. This means the entrepreneur gives up no equity, requires no physical collateral and doesn’t have to incur personal liability for repayment. The expected payments will range from 1.5 to 4 times the initial investment and are generally expected to be paid back in 5-7 years. The investor may ask for warrants to give them some upside (although this is not always the case) and most will require full payback if there is a change in control.
While the concept of revenue capital isn’t new in industries such as oil/gas, it is beginning to emerge in the technology space. This model can be particularly attractive if the entrepreneur is concerned about dilution. The model is particularly attractive to the investor if you already have substantial revenue, have stable growth and the likely prospect of growing revenue over the next several years.
The revenue capital concept was recently presented to Tech Coast Angels, the angel investing group I participate in, and the largest angel investment group in the US. The presenter, Dr. Rob Wiltbank is from Revenue Capital Management http://revcapfunds.com and also a professor at Willamette University in Portland. Revenue Capital Management invests in companies with established revenue streams in exchange for a percentage of monthly gross revenue. They typically invest 5%-15% of annual revenues for from 3%-10% of the company’s revenue stream, paid on a monthly basis. They also typically cap the total payment at 2x the initial investment if paid back within 5 years. They are looking for companies with the following profiles:
- Established revenue of $2 million – $20 million (but they will consider lower amounts of revenue for smaller investments)
- Profitable or near break-even with a strong gross profit margins
- Companies seeking growth capital, including project financing
- Ownership transfers including company buybacks, generational transfers and ESOPs are considered
Another RBF source is lighter capital http://www.lightercapital.com/ They have a cool website worth checking out even if you aren’t looking for an investment today. Their basic model is similar to Revenue Capital Management’s approach, but they will look for warrants to get some additional upside. Their loans are typically between $50K and $500K. Typical payback is 1% to 5% of revenue, which can ratchet down if certain milestones are hit, with a loan term of up to 5 years. They will generally EITHER cap the payment (1.5x -3.5x investment) or cap the term with 1% to 5% of revenues, ratcheting down if milestones are hit. They are looking for companies with the following profiles:
- Early stage / start-up companies, but must be operating and have at least 12 months of revenue history (no pure start-ups)
- Minimum trailing 12 month revenue of $200K, or growing fast with minimum monthly run-rate of $16K
- Annual revenues of up to $5 million
- Gross margins greater than 50%