Posts from Entrepreneur

Revenue Based Financing

Back when we were doing our MBA Monday series on Financing Options For Startups, I got an email from my friend Andy Sack. Andy was one of the first entrepreneurs we funded by in the mid 90s with our Flatiron Fund. He's done something like a half dozen startups since then and he's a veteran in the very best sense of the word.

Andy said "You missed an important option Fred – revenue based financing. I've got a new firm called Lighter Capital that does just that". I said, "Can you write a blog post for MBA Mondays explaining how it works?" So today, we have a guest post/advertorial on Revenue Based Financing from Andy/Lighter Capital. I hope you like it.

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Fred’s series on alternative financing options has been awesome to follow, especially because it broadens the discussion of how companies can fund business growth when they can’t (or don’t want to) raise venture capital or bank debt. Fred’s original list missed one option – revenue-based finance – that's near to my heart and I’ve been encouraging entrepreneurs and angels to consider, and Fred graciously let me offer my insights here.
 
Disclaimer: I am founder of Lighter Capital and have a self interest in educating and promoting the use of this new type of financing called revenue-based finance.  I’m also a serial technology entrepreneur and believe this type of financing has real advantages to traditional debt and traditional real advantages over equity for the entrepreneur.

A revenue-based finance (RBF) investment provides capital to a business by “selling” an ongoing percentage of a company’s future revenues to the investor.  For simplicity, you can think of it as a revenue share type of arrangement. Investor gives capital to company in exchange for a small percentage of gross revenues. RBF lives as a hybrid of bank debt and venture capital. This kind of financing has been around for a while in non-tech industries such as mining, film production and drug development, but it’s recently been gaining traction in the world of growth finance and early-stage technology funding.
 
I want to explain how an RBF structure is different than traditional funding sources, detail what situations could be better suited for an RBF structure (for entrepreneur and investors alike), and offer a word of warning about the businesses that aren’t a good fit for the structure.
 
First, let me explain how a revenue-based loan works:

Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing "interest" payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues. In a world where business costs such as software and infrastructure are increasingly becoming “as-a-service” and adjust with the ebbs and flows of a business needs, RBF payments automatically ramp up and down along with a business. It’s the inherent variability of RBF that makes the structure so appealing so appealing.  Imagine if your business loan payment reduced to zero if your business revenue dropped to zero for an unanticipated quarter, and then automatically kicked backed on when your revenue returned. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.

So, when does it make sense to raise revenue-based funding?
Revenue-based loans are, by nature, most appropriate for companies already generating revenues but without hard assets typically required to get bank loans. It’s especially applicable for companies that have lumpy, seasonal, or hard to predict revenues.

 
For entrepreneurs, revenue-based loans are attractive to founders who are allergic to dilution and loss of control.  The structure of RBF is often non-dilutive to founders and does not require a board seat. The financing is obtained without having to agree to a valuation, which leaves management in control of the company and typically requires no personal guarantees from management.

RBF means you can grow without swinging for the fences

For investors, funding using an RBF structure provides an opportunity to get a return on their investment without needing an exit. While this is clearly an advantage for investors, it also means company founders shouldn’t get as much pressure from investors to “swing for the fences” and the projected return due to the investor can be lower as the entrepreneur repays the investor more quickly.

As Fred has mentioned before, big exits are rare for startups. Some ideas have the potential to be home runs, but others are better suited to operate as smaller, standalone businesses. For the companies in the latter category, raising money from VCs who expect the big exits can misalign goals. A revenue-based loan has the potential to better align incentives for investors and founders in these cases. With that said, if you’re a pre-revenue, startup still figuring out your business model or considering some kind of “go big or go home” strategy, there can be realadvantages to working with the equity-based venture capital or angel investors. Similarly, certain businesses, especially brick-and-mortar and manufacturing-focused businesses may not have the margin profiles to pay monthly payments of 2-5% of revenues.
 
An RBF structure isn’t limited to specific funds – angels, VCs or banks could theoretically provide capital in this manner, but the risk/return profile of RBF doesn’t always fit the investor’s needs. Similarly, RBF may not be the best funding option for all businesses. In the right circumstances, the hybrid approach of revenue-based finance for startup funding can have advantages over traditional debt or equity, but there are admittedly situations where the more traditional options still make sense – such as restaurants or infrastructure-heavy startups.
 
If you’re considering raising money from angel investors, I’d suggest discussing this in the event that it may align your incentives better or at least help avoid some of the painful valuation negotiations. There are a few funds –Lighter Capital and Next Step in Texas, among others focused on this type of structure and I’d suggest taking a look at those options as well. There are clearly different scenarios where any number of Fred’s financing alternatives could prove more appropriate for your business, but the revenue-based loan structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee.

#MBA Mondays

What We've Lost And What We've Gained

I shed my tears when Steve Jobs stepped down less than six weeks ago. That's when I knew it was over. The news came to me last night during a board dinner. My 18 year old daughter kik'd me. I asked her if she was sure. She said "it's all over twitter". I interrupted the lively dinner conversation. "I've got some important news. Steve Jobs has passed away". Six entrepreneurs and VCs in that room. Among the best I've ever worked with. And not one of us said anything for a minute or two. What can you say?

The iconic entrepreneur of the information age is gone. We are all mortal. Steve more so than his peers it seems. But really he had no peer. There are great entrepreneurs all over the place. But Steve was better than all of them. He is a role model for entrepreneurs everywhere. And so many entrepreneurs use him as such.

So we've lost the man. He will no longer bring us great products. He will no longer bring us the future in the present.

But we've gained a legend. He will inspire others to bring us great products. He will inspire others to bring us the future in the present.

May he rest in peace.

#VC & Technology

How Much Money To Raise

A Stack of BillsImage via Wikipedia

I spent some time yesterday talking to an entrepreneur about this topic and I thought I'd share what I told him with everyone.

When your company is growing really fast, doubling employees year over year, adding users and customers at a very rapid rate, you don't want to raise too much money. If you raise three or four years of cash, there is a very good chance that by your second year, you will be sitting on cash that you raised when your company was worth considerably less. That's not a good thing. It's too dilutive to you and your co-founders and angels.

I've got two basic rules of thumb. First, try to dilute in the 10-20% band whenever you raise money. If you can keep it to 10%, that is great. You might have to do more, but try hard to keep your dilution below 20% each round. If you do two or three rounds at north of 20% each round, you'll end up with too little of the company.

Second, raise 12-18 months of cash each time you raise money. Less than a year is too little. You'll be raising money again before you know it. Longer than 18 months means you may well be sitting on cash that you raised when your company was worth a lot less.

These rules are most applicable in the early stages. When your company gets above 100 employees and valued at north of $50mm, things change. You may need to have more cash on your balance sheet for working capital reasons and you may not be increasing value at quite the same rate as you were when you were smaller. You might want to raise 24 months of cash or more at that stage.

But for the seed, Series A, and Series B rounds, I think 10-20% dilution and 12-18 months of cash are ideal. It's what I advise our portfolio companies to do and it is what I advise other entrepreneurs to do.

#VC & Technology

Financing Options: Friends and Family

This is the first in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don't know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn't need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don't want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won't lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don't have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I'd suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there's a reason why these people will back you when nobody else will.

#MBA Mondays

First Time vs Serial Entrepreneurs

I've been thinking a lot about the differences between first time and serial entrepreneurs. We invest in both and do not have a preference betweeen the two. But there are significant differences.

The best first time entrepreneurs have been stewing on their idea for quite a while. It is a personal passion of theirs and they bring to it a fresh take, a stubborn insistence on their approach, and they obsess about the idea 24/7. They often get the right product into the market at the right time and they capture the user's attention and usage with that product/market fit.

Where first time entrepreneurs often struggle is when the product works so well that they have to quickly build a company to support the product. Most of the time, the first time founder has not spent anytime thinking about what kind of company they want to build, what kind of people they want to surround themselves with, what kind of culture they want to create, etc. The first time founder often has no experience recruiting, managing teams, and building organizations.

Serial entrepreneurs, on the other hand, often struggle with the founding idea and getting to product/market fit. They start the second and third and fourth company because they love startups and they don't know any other way to work and be productive. But they often lack that passion around a singular idea that drives first time founders.

But when serial entrepreneurs do settle on the right idea and find product/market fit, they are usually terrific at building the company. They know when to step on the gas and where. They know how to recruit, manage, and structure organizations.

I was talking about this dichotomy with another venture capitalist the other day. I likened it to the first album/second album issue with rock bands. So many bands struggle with the second album and there are many reasons for it. The first album is something they have been working on for years. These are the songs they played night after night in the clubs working their way up. These are the songs that got them their fanbase and got them signed. The album hits, people love it, and then they spend the next year touring like crazy to build their fanbase. And then they have to go back into the studio and write and record a second record in a matter of months. It is no wonder that is is terribly hard to produce a second record as good as the first.

Likewise, it is often hard for the serial entrepreneur to produce a second startup that is good as their first. It takes a lot of patience and collaboration with others, two things they probably did not use much of in their first startup.

As I said at the start of this post, we work with both first time entrepreneurs and serial entrepreneurs with equal interest. We love the ability of great first time founders to nail the product and get significant user traction quickly. And we work closely with them to build the company once that happens. And we understand that is an area they are uncomfortable with and need our patience and support with. We also love the serial entrepreneur's gifts around building the company and taking control of a market once they have gotten product/market fit. We work closely with them in their efforts to find product market fit and we understand those challenges and are patient and supportive during that time.

These observations are generalizations and certainly do not speak to each and every situation we've been involved in. But they do reflect our experience broadly and we think it is important to understand what situation you are investing in, where the challenges will be, and how best to support the startup. Those things will most likely be very different when working with first time founders and serial entrepreneurs.



#VC & Technology

How To Allocate Founder and Employee Equity

Joel Spolsky, co-founder and CEO of our portfolio company Stack Exchange, posted an excellent answer to the question in the title of this post on the Stack site OnStartups.

I'm not going to reblog the entire answer here. I'd encourage you to go read Joel's answer. However, I am going to highlight some of the most important points from Joel's post:

  • Fairness, and the perception of fairness, is much more valuable than owning a large stake.
  • Before factoring in dilution from investors, the founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer. [go read Joel's answer to understand how he sets up these layers]
  • It never makes sense to give anyone equity without vesting.
  • Ideas are pretty much worthless.
  • Nobody who is not working full time counts as a founder.

The thing I love the most about Joel's post is he throws darts into a lot of conventional wisdom about founder equity allocation. I particularly like his notion that the person with the idea should not command a premium on equity allocation.

What Joel's post makes clear is that founder equity should be for services to be rendered in the tough initial year(s) when the risk is highest and capital (ie cash comp) is nonexistent. It is not for coming up with the idea, writing a patent, or going without a salary.

And I second with emphasis the focus on fairness. Founding teams that allocate the founders equity fairly stay together a lot more than founding teams where one founder has a much better deal than the others. The same is true of venture capital firms. The most stable venture partnerships are those where the partners share in the carry equally or near equally. At the end of the day, this is as much about respect as it is about money. And when people feel disrespected, they are going to leave at some point.

Great post by Joel. I'm looking forward to the disqussion on this one.



#VC & Technology

When They Are Throwing Money At You

Companies get hot. And investors start throwing money at them. Entrepreneurs get calls and emails all day long from investors wanting to invest. After a while, the entrepreneurs start to think that they should take the money. Not because they need it, but because they figure if people are throwing money at them, it's probably a good idea to take some.

Given that we are in the "throwing money at entrepreneurs" period in web investing, I thought I'd say a few things about this.

1) Don't take money you will never ever need. No matter what price and terms the money is offered, it has a cost. Money is never free. If you have absolutely no need for the money then don't take it.

2) Money lying around tends to get spent. It is a very hard mental exercise to sock away a bunch of money and forget about it. If you think you'll just raise the money and put it away for a rainy day, just know that will be hard to do. And if you have team members who have ideas about how to spend/invest it, it will be even harder.

3) If you need the money, then raise it now. I have not seen a better time to raise money for web startups since the late 90s.

4) If you don't need the money, but have some ideas about how you could put it to good use, then do some hard work on those use cases. Flesh them out. Size them up. Build a plan. Then raise the money and execute the plan.

5) If your company doesn't need the money, but you sure could use some, then think about selling some secondary shares. But don't sell a lot. Maybe 10-20% of your position. I've come to believe that entrepreneurs putting away some money to protect the downside is largely a good thing. It allows them to take bigger risks and play for more upside.

6) Do not let the fact that your competitors are raising money impact your decisions around fundraising. I have not seen one company beat another because they raised more money. Most of the time it is the other way around. The overfunded company loses most of the time.

7) Don't let this environment make you crazy. I understand the problem. We get calls and emails too. It is tempting to get caught up in the nutty market we are in. Focus on your business, your product, your team. Put all this stuff in perspective and don't let it take you mind off what matters. You need money to build a business but the money is a tool, the business is the mission. Focus on the mission.

The financial markets will come and go. Sometimes investors are focused on the downside. Other times they are focused on the upside. Right now it is the latter. But someday it will move to the former. That's how financial markets behave. End markets, the place all businesses get paid day in and out, don't whipsaw you like financial markets. Build a product and sell it to the end market and get profitable and create lasting sustainable value and you'll get to the pay window on your terms and your time frame.



#VC & Technology

Steve Blank in NYC Next Friday

Are you a fan of Steve Blank's Customer Development model for startups? I am. And next friday morning (Nov 12th) from 10am to noon, Steve will be speaking up at Columbia University in the Davis Auditorium in the Schapiro Center.

This event is hosted by our friend Professor Chris Wiggins and the Columbia Entrepreneurship Program and is free. Steve will be talking about his Four Steps To The Epiphany and the Customer Development Model.

I am trying to figure out how to attend. I'm already booked at that time next friday. But I am fairly certain there will be a number of people from our firm there. If you are an entrepreneur and want to get better at launching products and companies, you really should think about spending a couple hours listening to Steve.

If you want to attend, please save your place by emailing [email protected].



#VC & Technology

Phone Pitches

I exchanged some blog comments with Tereza yesterday. She's starting a web company and is raising angel money. She said she did some phone pitches against her better judgement and they didn't work out. I advised her not to do them anymore.

Here's my thing about phone pitches. They aren't very effective. I hate taking them and almost never do. I don't think they allow the entrepreneur to show themselves very well which is the most important thing of all.

And it is so easy to say no over the phone. There's no real human connection. It's easy to pay half attention or less on the phone. It's easy to fake that you are listening when you are not.

I admit that I am really bad on the phone. I always have been. It's not a medium that I like very much. So I am probably worse than the average investor. But even so, I think doing phone pitches is a mistake and you should avoid doing them.

I do think a short phone call introducing the opportunity at a very high level and making the case for an in person pitch is an important thing to do. You can accomplish that in a few minutes or less. It's basically an elevator pitch. But don't agree to do the whole pitch on the phone. Ask the investor make time for you in person to do that. That will determine if they have sufficient interest for you to invest your time with them.

And what about a video chat on skype or another similar service? I do think a video chat is sufficiently better than a phone call to make it a semi-viable alternative. If a plane ride is required to see an investor, then a skype/video chat is a decent first step. But again, you should do it with the objective of getting an in person meeting. 

But if you can visit the investor in person without getting on a plane, I think you should always opt for that over a conversation over the phone or skype. There really is nothing like the in person, face to face meeting when it comes to fundraising or any kind of high level sales effort.

Fundraising is such a hard thing to do, particularly for first time entrepreneurs without a track record and an investor following. Don't make it harder by putting a wire between you and the investor.

#VC & Technology

Getting The Band Back Together

We've backed a lot of serial entrepreneurs over the years. It is one of our favorite things to do. About half of our current portfolio is led by serial entrepreneurs who are working on their second, third, or fourth startup.

One hard choice an entrepreneur faces is whether to put the band back together.

On one hand, you want to bring some new blood and new thinking into the mix.

On the other hand, there is great value in reassembling a team that has worked together successfully before.

Dave Morgan, founder of Real Media, TACODA, and now Simulmedia, tells me that each time he has started a new company, he has intended to go with an entirely new team and each time he has found himself bringing back the bandmates within a year of getting started.

I saw Mark Pincus do that with Scott and Cadir, his co-founders of SupportSoft, about a year or two into the development of Zynga.

And I recently saw Mike Yavonditte bring together the product team he worked with at Quiqo into his new startup Tracked.com.

I don't think there is a right or wrong answer here. Assembling the team is such a critical part of startup success. But I do think it is worth noting that we have seen a tendency of entrepreneurs to go back to the well and put the band back together more often than not. And even when they don't do that initially, it seems that over time, it is impossible to resist that urge.

#VC & Technology