Guest Post by author Zak Cassady-Dorion
The black hole of financing, the ‘missing middle’, and the ‘opportunity gap’ all refer to the same thing. There are a huge amount of entrepreneurs with great ideas and great businesses who are not able to grow sufficiently because they don’t have access to capital. Properly funded, these businesses could go a long ways to help rejuvenate the US economy. According to one source, over 700,000 fledgling companies that start in the USA each year don’t qualify for traditional bank, PE or VC financing. Even for the handful that do qualify, the terms of the deal are often onerous and collateral requirements keep them from bringing their innovative solutions to the market place.
As a consultant for early stage startups, over the last four months I have been involved with 3 different startups trying to raise capital. Both Equity and Debt funding is proving extremely difficult to source. VCs are often an exclusive club, one angel fund led by Ron Conway doesn’t even have a website and only accepts presentations from people in his network. Other VCs often times don’t respond to phone calls or emails unless they know who is calling.
Bank/debt funding can be just as difficult to obtain. In visiting multiple banks I received the same response: First we need to be in business for 2 years. Then we need 2 years of tax returns. Then we’ll need a personal guarantee for which they’ll need 3 years of tax returns and the founders’ credit scores.
The startups that I am working with have a team of highly skilled and experienced entrepreneurs who have had great successes in the past. Regardless of this, so far we have been unable to obtain the needed financing. At about the time that I was realizing this problem is when I heard about Revenue Based Financing (RBF). I spent the next three weeks of my life learning everything there was to know about RBF. I read all the blogs, news articles, and talked to all of the thought leaders on the subject.
After all of this research I’ve concluded that RBF is a great way to fill this opportunity gap of funding. I’ve spoken with the startups I’m working with and they are very interested in RBF. The only issue is that both of these companies are pre-revenue. The current model of RBF, as designed by Arthur Fox, is set up for companies with existing revenues between $1 million and $10 million. RBF is a great way for companies in this sector to obtain funding but as the system is set up now, RBF is not being used as much as it could be for pre-revenue startups.
In order for RBF to come into this arena there are going to be some issues that will have to be dealt with. One of the benefits of RBF to the lender is that the loan starts making an ROI almost immediately. RBF for pre-revenue companies is going to be more risky, there will be no immediate ROI, and so in order for it to work some adjustments are needed.
One option that has been experimented with in the past is a hybrid of debt and equity. A company receives RBF and they also give equity to the investors. This equity has traditionally been in the form of warrants. Often times these warrants are never cashed in because the businesses are never bought out and they never go public. This is clearly not enough to incentivize RBF companies to invest in pre-revenue companies.
If the entrepreneur offers a dividend paying equity share that would start paying dividends after the loan has been paid off it might help to get investors to take on the extra risk. During the life of the loan the dividend would be reinvested in the company and after the loan is paid off the dividend would go to the investor. This added incentive may help to get investors to take on the extra risk of pre-revenue companies.
Also, because the payback is tied to future potential revenues, if the company ends up not producing revenues the investor receives nothing. One way to deal with this would be to have the entrepreneur payback the loan plus a very minimal interest rate in the case the business fails. Again, without sufficient assets (which is often the case) this caveat would have little teeth.
In developing this model of RBF for startup companies we will all need to be careful not to bring too much equity into the mix. One of the benefits of RBF for the entrepreneur is that they don’t have to give up control as they normally have to with traditional equity financing. The more control that is given away to the investors the more the deal will look like traditional equity funding and the more the benefits of RBF will go away.
There is clearly a huge opportunity for RBF to provide the much needed capital to startup pre-revenue companies. The specific term sheets and structure still need to be worked out. However, if investors are willing to experiment with different options, the person that gets it right will have a model that could revolutionize the way startup companies receive funding.
I am currently working with a new startup that is trying to do exactly this. Because the market opportunity is so large we are going to want to share all of the lessons we learn, both successes and challenges, with everyone else out there. The more RBF for startups catches on the better it will be for everyone involved.
RBF is clearly a way to take down these barriers to funding and provide capital to startup companies. RBF is a great way to start filling the black hole of financing. With innovative minds and thought leaders involved in RBF we are sure to see great things. It is clear that our economy needs a boost and RBF is a way to get needed and well deserved money into the hands of entrepreneurs that will use it to grow their businesses, create jobs, and drive our country out of this recession.
About the Author: Zak Cassady-Dorion is a serial entrepreneur and MBA graduate from the Thunderbird School of Global Management who lives in San Francisco. Passionate about entrepreneurialism and its power to rejuvenate the world economy, Zak focuses on helping companies and startups improve their focus and efficiency in business development, strategy, marketing, sales, and operations initiatives.