Is VC’s lunch under threat?

Revenue-based financing - explored…

Working at SeedLegals, I get the privilege of speaking with new founders and investors every day, raising and investing capital at various stages of company maturity. Having a community of 20,000+ start-ups, naturally we get interest from angels and funds to see if there are partnership opportunities, and these conversations give me daily updates on the latest developments in start-up investing.

Revenue-based financing (“RBF”) has been coming up more recently in these conversations; this has made me wonder whether this new mode of financing can displace a lot of VC.

At first when I heard of it, it sounded like a no-brainer. As a founder, rather than dilute your position for VCs by say 10–25% (per funding round, that is), you choose instead to temporarily sacrifice a minority portion of your company revenues every month. The repayment proportionally adjusts to the movement of your revenues (i.e. make more cash = pay more back, make less = pay back less). No interest, no fixed payments, no dilution, no-brainer - right?

This is a question I’ve thought about alot, and this piece intends to articulate those thoughts. On one side of the spectrum, it seems this is a real threat to the later stage VC (and by that I mean Series A+ investors). The establishment of big RBF players such as Clearbanc (Frontline backed), and the rise of newer players such as Pipe (who’ve just raised £50m) and Uncapped (Seedcamp backed) suggest that the tide is turning. But as someone who follows a lot of VC news and personalities, I haven’t seen much commentary from the larger VC players of this world in response to this. Aren’t they worried? Isn’t this going to take good deals away from them? Less good deals for VCs, less chance of a decent performing fund, less reason for a fund, bye bye years of management fees (and these are hefty sums we’re talking here). Is their silence fear or insouciance?

Before we get into that, let’s take a step back to the basics of RBF.

RBF — what is it?

The high-level overview of RBF is:

1. The amount of cash you can take currently ranges from c.£/$10k to £/$10m (the cash available doesn’t seem to be at the levels the big venture debt players give…yet).
2. There is no periodic interest but rather a lump sum fee on the capital provided (note to founders, this fee is still an ‘implied interest’ 😉 ). This fee seems to range from c.6–12% on the capital provided.
3. The cash available has certain limitations in that it is either only available to start-ups operating in certain sectors (e.g. e-commerce where your transactions are solely online), or the cash can only be used towards certain purposes (e.g. Facebook marketing).
4. You pay back a fixed % of your revenue per month (the range is quite variable at 5–25%). The proportion is fixed, not the absolute amount. Made more money this month? Great, settle your debt quicker. Bit of a downturn? Take a breather on the repayments.

So if you’re a pre-seed or seed VC, looks like your lunch is ok 🙌. Realistically, I can’t even see a seed company taking a RBF ticket over a VC ticket (that’s presuming a start-up of this maturity could even qualify for RBF). Given the high level of volatility in running a pre-seed/seed company, i.e. a company that maybe has only just started to make some revenue, the risk/reward balance for a founder is much more favourable with a VC ticket.

But Series A and beyond? This is an interesting one…..

Series A vs RBF

If you’re a Series A startup, as a rule of thumb you’ll probably have 1m ARR. You’re a tech business, so presumably gross margins are good too (assumed gross margin range 60–90%). The classic questions for leadership now come to mind — we want to go hard on growth, want to raise, when? how much? etc. etc.

At a Series A, you could give up 15–25% of equity in exchange for £3m-10m (some “common” Series A parameters there). If you’ve got the same mindset as your VCs to take you on your path to unicorn, that’s you giving up £150m–250m of value based on a future targeted £1bn valuation. Unicorns, aren’t they so 2010s? Try a decacorn then with £1.5bn–2.5bn being given away (and this is before you’ve raised a B-round or something further). Founders give up a lot to take their business on the VC path, exceptions remain as always but on average the founder ownership is 15–20% at IPO - a lot of dilution has occurred along the way. Yes there’s the whole argument about getting a smaller piece of a much larger pie but, done the right way with RBF, founders and option-holding employees can get a larger piece of a larger pie.

It should be borne in mind that at the moment I’m merely talking about RBF based on current sums available in the market. Right now RBF only seems a viable substitute to an A-round, small B round OR, even more interesting, the ditching of one-off mega-rounds as start-ups/scale-ups take on repeat RBFs to fuel growth. Doing it this way might not give the start-up the same speed as say a one-off £30(0)m cheque can give, but nonetheless would minimise dilution and incentivise founders and talent further.

The (further) endangerment of unicorns….

This is the other interesting thing posed by the emergence of RBF. Will the obsession to becoming a unicorn wane? With less VC money fuelling these companies and more equity being retained by those who work within the company, will more patience be exercised by founders here?

As much as I love seeing tech companies get to unicorn exits, and even seeing the VCs I respect vindicated on their investment decisions, is the birth of the unicorn not largely predicated on the VC model? The £1bn+ company is what’s needed to make most VC funds profitable, and to reach that valuation at record-breaking pace. With less (or any?) pressure to get to this status due to the option of RBF, will founders take the “old-school” VC route?

Back to reality

Of course, this all sounds idyllic. Realistically RBFs are only going to make sense for a select group of start-ups, these being:

1. Revenue generating.
2. Those with high enough EBITDA margins / monthly cashflow to sustain the repayments under RBF.
3. Those where the payment sacrificed for RBF isn’t significantly impacting the investment in talent/resource needed to sustain and grow that start-up’s position in the marketplace.

Nonetheless, if I told you, blindfolded, of a business that does the three things above, as a VC you’d be interested, no? That’s a good business. Yes, there are the other questions of being a VC-type business, rapid scalability etc. But let’s say it was “VC-able” and it had the early positive financial indicators, surely as a VC you’d be worried of good businesses like that not coming to you as often as they once did due to the now founder-friendlier financing option out there?

There’s two things to consider to that assertion:

1. Companies rarely fit this mould and so VC money is generally the most sensible option. I don’t have the data but it would be interesting to know if RBF could have been an option for the successful VC companies of, say, the last 20 years at the time they went for their Series A.
2. Of course, there is more to taking some VCs’ money than just the cash. But as a founder, you’ve got to seriously ask yourself whether the perceived value-add, the network effect or even just having the name of ‘MegaSuccessful Ventures Fund LVIIII Jersey L.P.’ on your cap table is worth the hit to dilution.

So if more ‘good businesses’ could avoid VC altogether, how are VCs going to attract the good businesses? If VCs can’t attract the good businesses, how are they going to produce their great returns (remember a lot of VCs rely on just one company out of their 20 fund investments to shoot the lights out, pocket carry, and give them a strong basis for raising another fund)? If they can’t do that, how are they going to raise their next fund?

This is extreme, I know. There are many arguments against this. A lot of businesses presumably won’t meet the golden criteria above to qualify. But some will meet it, take it and pass on VC. Although this applies to a handful of companies in the VC-able market, let us remember it is the real minority of companies (100s out of 100,000s) that make a VC successful. The outcome? It becomes:

1. Harder for the established / brand name VCs to win good companies
2. Dramatically harder for the less established VCs to win good companies

There’s all sorts of behaviours that could proliferate from the above two outcomes. A clear-out of the crowded VC market as players (particularly software/e-commerce focused funds, the most crowded space of all) feed off less. Perhaps stapled financing options being provided by VCs to get their foot in the door with some equity uplift but a chunk of RBF to keep it founder friendly and win the deal? Who knows.

The current status seems to be that RBF is a threat to Series A VC but, with the current eligibility needed to get RBF, it will presumably (for the timebeing at least) take a relatively small number of companies away from VCs. But the RBF market will surely grow, the capital sums available under RBF will grow, the flexibility under which you can get RBF will surely widen as the market evolves and matures, which ultimately means more and more companies being allured by the tune of RBF, and more VCs (Series B and beyond now) being impacted. I don’t think this is going to replace later stage VC entirely, but RBF is only another (if not major) reason why it is certainly going to become a lot harder for VCs to compete for these companies. VCs may have to look in less conventional fields to find a newer species of budding unicorn.

Thanks to mentors, partners, friends Pietro Invernizzi, Finn Murphy, Patrick Ryan, Haoran Wang (and my wife) for their proof-read and insights.