Regardless of your position, entrepreneur or investor (or both), you’ve likely noticed that the investment landscape is changing. There’s a move away from traditional venture capital and institutional funding toward micro-VC and super angel funds—smaller-scale versions of VC funds, typically in the $10-50 million range, that make a wider range of smaller investments. Furthermore, due to the roller coaster nature of financial markets, exits are being drawn out longer than the traditional three to five year range. This means angels are not seeing returns as quickly as they did in the 1990s and early 2000s. Not to mention, there’s another potential change on the horizon with the emergence of companies like kickstarter.com and recent legislation, including the JOBS Act which includes the CROWDFUND Act.
As a result, revenue-based funding has emerged in angel investing. Using this model, an angel invests money for a percentage of revenue in future years, rather than the traditional equity approach.
On the entrepreneur side of things, revenue-based funding means an influx of cash from the investor upfront, typically 10-20% of current revenue. The payout is generally based on a length of time or a maximum return. When both length of time and maximum return are fixed, the investment looks like a bank loan. When either the length of time or the maximum return is not fixed, then revenue-based funding looks very similar to equity funding. As far as risk and reward, revenue-based funding falls somewhere in between the bank loan and equity funding.
Advantages for the Entrepreneur
First, you don’t give up any equity in your company. Therefore, you don’t give up any control over the operations. Many entrepreneurs have a hard time giving up control over their ideas so this aspect of revenue-based investing can be very appealing.
Second, there’s no personal liability on you to pay back the investment. That’s right, no personal guarantees here. Again, this reduces your risks and is a very appealing aspect of this model.
Third, there’s no dilution. You won’t have your interest diluted even though you’ll receive loads of cash. Sounds great, right? Your other shareholders will also appreciate not being diluted.
Last, the payout amount and duration can be customized specifically for your business. Depending on the current financial status, maturity, projected revenue, among other things, you can structure the deal to further your objectives for your company.
Disadvantages for the Entrepreneur
This model only works for companies with a stable revenue. Also, the entrepreneur is limited to taking on a small number of revenue-based investors, due to the hit to the bottom line that this type of investment can result in as you take on more and more revenue-based investors. If the company does not have sustainable profitability, there’s a good chance it won’t be able to sustain a revenue payout. Software and service businesses typically have larger profit margins, at least 30-50 percent, and so these industries can typically sustain this investment model.
Note to Investors and Small Business Owners
Not all small businesses or investors will benefit from revenue-based investing. Investors need to be aware that the earning potential with a revenue-based investment is significantly lower than a typical equity-based investment. When the company thrives and ends up going public or selling off, you’re not going to see the return that a typical equity investor would. Nevertheless, the risks are significantly lower with this model, which is particularly appealing to many investors regardless of the lower return potential.