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.
With 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.