Revenue-based financing is a strong alternative structure for high-risk investments in emerging markets
With few exceptions, venture capital has used the same preferred equity structure for decades. While this “one-size-fits-all” approach to financing has its advantages, it is often an inappropriate structure. This is particularly true in non-OECD countries, where private equity markets are not as robust.
VC Financing – The Portfolio Company’s Perspective
From a portfolio company’s perspective, there are a number of drawbacks to a traditional VC financing via preferred stock. Some of these include:
- The pressure to achieve the “big win” via an IPO can significantly distract the company’s senior management from the company’s long-term growth and profitability.
- The preferred stock issued in a VC financing crowds the company’s capital structure, making it more difficult to issue stock options to employees or utilize equity instruments to pay service providers.
- Founders and other early investors may be significantly diluted
- Preferred stock’s class voting rights may make a company less nimble
- Anti-dilution and other protections may put a company in a difficult position.
- Interests may not be aligned. For example: a VC investor may achieve a decent return from a trade sale that results in other common stock investors receiving little or no proceeds.
This has left many startup and early stage companies looking for alternatives. Revenue-based financing (RBF) may provide another option, allowing companies to achieve growth and profitability without the issues created by typical VC financing.
VC Financing – The Investor’s Perspective
The VC model is based on just a few portfolio companies in a VC’s portfolio engaging in a highly lucrative IPO. As IPO exits have become less common, the traditional VC model has come under pressure. In place of IPOs, we have seen an increase in trade sales. However, trade sales are not as lucrative because they do not result in significant valuation increases. Some investors may prefer this, but in general it is a riskier proposition than selling shares for cash.
Without the huge bounce provided by IPOs, the VC model has begun falter. While some alternatives exist, such as venture debt, the industry continues to apply the same investment strategy. It is time to consider other options. While the standard VC model can provide significant upside in the case of an IPO, in most other cases the upside is limited. Preferred stock also involves limited downside protection because debt will rank ahead of it if a portfolio company becomes insolvent. Revenue-based financing (RBF) provides an excellent alternative to this structure.
The International Dilemma
In the international context, particularly in non-OECD countries, the above issues are exacerbated by a significant lack of exit alternatives for startup companies. IPOs are much less common and trade sales are not prevalent either. From the investor’s perspective, this means that there is a much lower chance of achieving the upside from such liquidity events. From the company’s perspective, this means that the valuations are likely to be lower than they would be in countries with robust private equity markets.
This results in a dilemma: even more than in the United States, there is a desperate need for investment in early stage companies in emerging markets. The lack of available capital has a significant, adverse impact on the development of these countries’ economies. Unfortunately, traditional VC financing is not a viable option for most early stage companies in these markets. RBF provides a potential solution.
Revenue Based Financing
RBF involves the issuance of a security by the company that entitles the holder to a fixed percentage of annual revenues of the company typically in the 6%-10% range. Payments to the investor are capped at a fixed multiple such as 3x-5x. Once payments have reached the cap, the loan is considered repaid in full. RBF investors will often maintain a small equity stake after repayments
RBF is an entirely different structure than a traditional VC financing. It includes the following benefits for a startup company:
- No dilution of existing equity holders.
- No class voting/veto rights associated with preferred stock.
- No pressure to achieve a quick sell of investor shares.
- Better investor/company alignment.
- Generally cheaper and faster.
RBF is also different than traditional cash flow based or asset based lending. In particular, founders are not expected to issue personal guarantees. The RBF instrument does not carry a fixed or floating interest rate and is also flexible: if a company later decides that another type of equity financing is appropriate, RBF does not impede the capital structure or create an overhang. Since RBF’s returns are based on the company’s sales, the revenue growth that additional financing provides will benefit the RBF investor. Thus, the company’s, RBF investor’s and equity investor’s interests are all aligned.
From the investor’s standpoint, RBF has significant benefits as well. Investors have a lot more downside protection than with preferred stock because an RBF instrument ranks as debt. At the same time, investors enjoy considerable potential upside – much more so than with a typical loan. Perhaps most importantly, an IPO, trade sale or other liquidity event is not necessary to achieve this upside. If there is a liquidity event, warrants or other equity kickers provide the potential to achieve some of the enhanced returns.