For Investors it’s All About the Exit
I’ll gladly pay you Tuesday for a Hamburger today. – Wimpy
Here’s a common scenario that most first-time capital seekers experience. They write their business plan, finish their prototype, add all the suggested window trimmings, and then start talking to potential angel investors. Some of these prospects will initially behave as if they are seriously interested in funding the deal. The entrepreneur then has a series of meetings with them and plans to ask for the check at the next one. That’s when things abruptly change. Suddenly the investor stops returning calls and responding to emails. In the minority of cases, they will tell the entrepreneur that they have decided to pass on the opportunity. However, more often than not they will simply become unavailable.
Why does this happen so often?
The answer is that the investor eventually concludes that he just can’t see how the most important part of the process will occur. I refer of course to his exit from the company. It’s extremely important that you understand that investors don’t make money by giving you money or by waiting patiently for years as you spend it. They only make money if there’s a profitable exit.
The Most Important Thing From the Investor’s Viewpoint
That’s the key in equity-based deals: the exit or “liquidity event.” Typically the best exit is an IPO where the shareholders end up with free trading shares that can be sold at a high price. The next best exit scenario is an acquisition by a much larger company which can afford to pay top dollar for the company.
Unfortunately, IPO and acquisition type exits are rare. This is because most entrepreneurs don’t have companies with the potential of achieving either of these liquidity events. No matter how great you deal maybe otherwise, if the investor doesn’t believe you can IPO or be acquired, he’ll pass on the deal because he doesn’t want his money locked into your company forever.
Many first-time entrepreneurs understand that investors are looking for deals with big pay-off exits, so when asked about them respond with a perfunctory and unconvincing, “Oh, we’ll either IPO or be acquired.” That’s when they sound like Wimpy with his half-hearted promises to pay for a hamburger today next Tuesday.
The Revenue Royalty Certificate Solves the Exit Problem
Since the vast majority of companies will not achieve the success necessary to create the all-important liquidity event for investors with an IPO or acquisition, there has to be another way to enable capital extraction. That way is revenue-based financing or as it’s more commonly known: revenue royalty financing.
In a nutshell, the Revenue Royalty Certificate (“RRC”) is basically a loan rather than equity investment. However, it’s a loan with a difference. Rather than having fixed monthly payments which must be made hell or high water, the RRC pays the loan back over time as percentage of its top line revenue. This means that the lender gets paid first. The typical royalty will be in the 1 to 5% range of monthly revenue. The dollar amount will go up and down with revenues.
Where the confusion comes in about revenue-based financing is that often the company will throw in an equity kicker to the lender to sweeten the pot. This is done in the event that the company succeeds beyond all the initial expectations and does go public or is acquired by a Fortune 500 company that pays top dollar. Let me illustrate why the equity kicker is added as the “icing on the cake.” Just imagine of you had been Google’s first backer and used an RRC. If I recall correctly the first funding round was $100K. Under an RRC, the lender might have received back $200K 0r $300K over several years. Now imagine how bitter he would have been to see the company succeed so wildly, go public, and then continue onto to become the Internet’s dominant force.
That’s why you often add the icing to the cake.
Revenue Royalty Financing Can Save Your Deal
To sum up, revenue-based funding solves the exit or liquidity problem for companies that are expected to be, in baseball parlance, singles, doubles, or even triples, but not home-runs. Revenue-based financing structures, such as RRCs, can be helpful in closing investors who are dragging their heels because they don’t see how they will extricate their principal and profit from an investment.
I’ll be writing some more on RRCs to fund startup and expansion.