Creative Financing for Your Startup

The Great Gaping Valuations Chasm Between Entrepreneur and Investor

I first started working with startups back in the late 1980s and can guarantee you that the one problem that never goes away is the Grand Canyon-like chasm between the entrepreneur’s and investor’s respective valuations.  Without getting bogged down with unnecessary detail, it usually breaks down like this. Whether the first-time capital seeker is looking for $50,000, $500,000, or $5,000,000, they always seem to settle around the magic 20% mark. That is they convince themselves that their startup is worth so much that whatever the amount being sought is, it should only require the surrender of 20% of the total equity.  Fair is fair, right?At the same time you can rely on angel investors to expect the magic 51% number. In other words, whether the amount being sought is $50,000, $500,000, or $5,000,000, the investor invariably believes and expects to be offered 51% of the equity.

That’s the perennial startup valuations gap and it’s a lethal deal-killer.

Revenue Royalty Certificates Solve the Valuations Problem

Revenue-based financing solves the problem by making the valuation question irrelevant. This is because it’s really a form of debt. The Revenue Royalty Certificate (“RRC”) pays back the loan with a royalty on the company’s revenues. Here’s a simple example. A startup may need a $100,000 loan to get up and running or an established company may need it to launch a new product line. The company then cuts a deal with the funder to pay them back $200,000 or $300,000 over a realistic time frame so as to not overburden the company.  Obviously the bigger the amount the longer this period will be in most cases.

Sticking with our example, a spreadsheet shows that the loan can be safely paid back plus the agreed upon ROI at a royalty rate of 5% of revenue over X years. This means that every month 5% of the top line goes to the funding source. The funder gets paid first.

Without startups there is usually a moratorium on payments for six to twelve months to allow the company to gain traction.

Here’s a final point. Equity financing makes the most sense when the company truly has the potential to hit it big.  In the vast majority of cases, the potential is far less. Most startups will not be the next Google, Amazon, or Facebook.  It’s these other types of companies that make the most sense for revenue-based financing.

Be sure to check the other posts under the Revenue-Based Financing category here at there are other benefits as well to RRCs.

 

 

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8 Responses to Revenue-based Financing: Let’s Avoid the Valuations Gap

  • We used to refer to that instrument as a revenue bond and used them when there was an expectation there would be no bottom line profits for an extended period of time (like a company that is expecting to go through several successive rounds of financing before hitting profitability).

    It was also a handy model when there was concern or disagreement about the definition of net profits and/or what should or should not be included in the expenses of the company before splitting the net proceeds.

  • How does the SEC view Revenue-based financing e.g. do the participants have to be “qualified investors”? Can I offer $5000 Revenue Units to 10 or more participants?
    please reply to peter@iagewell.com

  • Peter, revenue-based financing is debt so the SEC doesn’t enter into the picture. You also don’t have to limit yourself to accredited investors for the same reason.

    Yes, you can break up an RRC into units just like you would in a limited partnership. If you need $100K, you can, for example, offer ten $10K units or twenty $5K ones. Or one hundred $1K units.

    Bear in mind that I’m not a lawyer and only speaking as a layman who has conducted business in the USA and Canada. IOW, it’s best to run it past your lawyer as laws do change over time.

    • Guys: small but critical correction here. Under the Securities Act of 1933, the definition of “security” has ALWAYS included “note”. There are exclusions not applicable here–such as for large notes and publicly traded companies, etc. But in the start-up context, the “investor” is always at risk because s/he is providing risk capital: if the products don’t get built or don’t sell, investors get zip. Also, it’s a classic “investment contract” — the investor is relying upon others to make money for him/her. SEC v Howey; SEC v Joiner. This has been settled law since Joe Kennedy was running the SEC. Sorry. BUT: compliance (i.e., disclosure to qualified and/or accredited investors, doesn’t have to be all that difficult.

  • We are focused on large scale commercial projects and utility scale solar farm projects. We have been working with a new company EternaTile that has a new integrated solar roof system that fills a huge global void in the existing solar product portfolios for commercial and even residential markets. They have achieved what Dow Corning and Uni-Solar have failed to do.

    We are working with them to help them get funding to bring their product to market. They have turned down multiple offers already and we want to help them partner with the right funding partner as all funds are not created equal. Perhaps your RRC would be a possible option. Please contact me if this is something you would like to discuss.

  • Where can I find the firms that offer revenue based financing are they nation wide or in selective parts of the country.

  • Looking to acquire several assisted living, acute care and home healthcare companies. Can this type of funding be used for that purpose?

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