The traditional form of startup capital is “preferred equity”, with investors expecting a “10x” return on their investment. Specifically, they expect that the company will someday be acquired at a high-enough price that their investment will them at least 10 times their money back.
- $50,000 invested –> $500,000 (or more) returned
- $100,000 invested –> $1 million (or more) returned
- $500,000 invested –> $5 million (or more) returned
In revenue-based equity investing, the investor buys equity in the company, but the company repurchases that equity using a small percentage of “top-line” revenues, returning only 2x-5x.
- $50,000 invested –> $100,000-$250,000 returned
- $100,000 invested –> $200,000-$500,000 returned
- $500,000 invested –> $1-$2.5 million returned
For all but the fastest growing unicorns, this is a win-win structure that aligns the interests of the investors with the entrepreneurs. Both want to see the company grow their revenues.
The faster revenues grow, the faster the investors get repaid. The faster they are repaid, the sooner they have their return to re-invest in that company or other companies. And while revenues are growing, the company is happy too, as growing revenues is the path to profitability and fiscal sustainability.
Meanwhile, the investors do not need to worry about acquisitions. In preferred equity, the potential acquisition determines the value of the company. In revenue-based equity, the value is irrelevant, no acquirers need to exist, and instead everyone can focus on building a great company instead of making decisions that may or may not lead to an acquisition.
Returning to the example investments from above, a $500,000 startup investment in the traditional 10x form costs the founder(s) $5 million. In the revenue-based form, at 4x, it costs $2 million. That is a $3 million difference. That is $3 million that stays within the company. That is a 60% lower cost of capital!
If you are an entrepreneur, would you not want to pay $400 instead of $1,000 for the same airline ticket? Or $4,000 in rent instead of $10,000 in rent? Or $400,000 in development or equipment costs instead of $1,000,000?
If you are an entrepreneur, why are you paying $10 per $1 of capital when you could be paying $4?
From the investors point of view, this 60% discount may seem foolish, but only on the surface. Break out a spreadsheet and you discover that the return on investment (as measured as internal rate of return) is the same in both styles, as capital is returned far earlier in the revenue-based structures, and return on investment is dependent as much on time as on total cash return. Take a moment to think through the risks, and you discover that being paid back from revenues greatly lowers the investment risk. Lower risk and equal returns. What investor doesn’t want that?