The new world of startup finance is very strange. Private equity is increasingly dipping down to finance startups. Meanwhile, venture capital funds are being forced to use every financial tool imaginable to stay involved in the growing pool of late-stage startups. PWC’s most recent MoneyTree report for Q2 2016 underscores this point.
One fund, Lighter Capital, is trying to get ahead of the trend, before the availability of early-stage capital hits an inflection point. The availability of early-stage capital is down this quarter with respect to this time last year. The fund wants to utilize an alternative financing structure to support a valuable niche in an evolving ecosystem.
Interestingly, the average check from the fund is $200,000. To most, this is a seed-stage investment. Availability of seed capital is on the rise, and there isn’t much need in the market right now. However, while the checks are relatively small, the fund is looking for companies that have an average revenue of $1.5 million. In that sense, Lighter Capital might be riding a trend more than defining one.
BJ Lackland, Lighter Capital’s CEO, explains his company’s model in the language of royalties. In exchange for capital, companies sign an agreement to pay a percentage of revenue, typically around 6 percent per month, until a pre-set multiple of the principal is paid off.
The duration of the loan influences the multiple. A short loan of three years might be 1.35X, while a loan of five years might be 1.8X. In practice, if the fund made 50 loans for $200,000 over an average of four years with a 1.5X multiple, the fund would make an 18.4 percent internal rate of return (IRR). Not so shabby.
To make its investments, Lighter has pulled together $120 million from Community Investment Management. Community is essentially a Limited Partner that is funded by large family offices.
Lighter funded 53 companies last year and expects to fund 100 companies this year. As of today, only 20 percent of the companies Lighter Capital has funded have gone on to raise VC. Only two investments from Lighter have failed completely, which helps make the lack of VC follow-on seem less like a warning sign.
Lackland noted that about half the follow-on VCs pay off Lighter upon investment; the other half simply continue to pay the royalties, especially if the round size is small.
Eight full-time developers created a proprietary dashboard for use in evaluating companies. Lighter uses data from LinkedIn and bank accounts to initially screen companies, then follows up with a few phone calls. Initial funding usually takes six weeks, but follow-ons can occur within a week. In a sense, Lighter “tranches” financing across an investment period, but doesn’t set benchmarks that companies would feel pressured about hitting. Instead, Lighter just looks for general revenue growth.
Lackland believes his model of revenue-based finance can help companies that:
- are likely to generate growth, but not at the scale a VC would be comfortable with;
- want to increase valuations before pitching to VCs in order to hold more bargaining chips in the negotiation;
- need to raise money quickly and want to be able to count on follow-on capital.
As with anything, benefits come with drawbacks:
- Companies are forced to invest revenue into paying back loans immediately. This money can often be used elsewhere.
- The need to pay back loans can put a founder in a position where he/she needs to prioritize short-term revenue over other growth metrics.
- Investor incentives are aligned with fostering growth but not generating home-runs. Because the investors returns are essentially capped at the investment multiple, risk-averse slow growth is more advantageous than a potentially aggressive flame-out.
It’s hard to argue with a method generating exits no matter how bearish you are on alternative financing. Steelbrick, a provider of a customizable pricing and quoting system, raised four rounds of financing after a $200,000 loan from Lighter Capital and went on to exit to Salesforce for $360 million. It’s not a billion-dollar home-run, but Lackland argues that the industry should be less focused on that goal if it can get a greater number of smaller exits to make up the difference.
On the backend, Lighter is VC backed, having taken on two rounds of financing for a total of $17 million. For these VCs, Lighter presents an opportunity to gain access to startup performance data.
Lighter just hired a new head of community to work on connecting and servicing entrepreneurs in the way an accelerator might. Because of the data Lighter has, it can provide anecdotal feedback to founders about churn or budget by looking across their portfolio to similar companies.
Ultimately, a solution like Lighter Capital will work for a company so long as priorities remain aligned.