Should your new VC fund use revenue-based investing?

You’re working on launching a new VC fund; congratulations! I’ve been a traditional equity VC for 8 years, and I’m now researching revenue-vased investing and other new approaches to VC. The question I’m asking myself: should a new VC fund use revenue-based investing, traditional equity VC, or possibly both (likely from two separate pools of capital)?

Revenue-based investing (“RBI”) is a new form of VC financing, distinct from the preferred equity structure most VCs use. RBI normally requires founders to pay back their investors with a fixed percentage of revenue until they have finished providing the investor with a fixed return on capital, which they agree upon in advance.

This guest post was written by David Teten, Venture Partner, HOF Capital. You can follow him at teten.com and @dteten. This is part of an ongoing series on Revenue-based investing VC that will hit on:

• Revenue-based investing: A new option for founders who care about control
• Who are the major revenue-based investing VCs?
• Should your new VC fund use revenue-based investing?
• Why are revenue-based VCs investing in so many women and underrepresented founders?
• Should you raise equity venture capital or revenue-based investing VC?

From the investors’ point of view, the advantages of the RBI models are manifold. In fact, the Kauffman Foundation has launched an initiative specifically to support VCs focused on this model. The major advantages to investors are:

• Shorter duration, i.e., faster time to liquidity. Typically RBI VCs get their capital back within 3 to 5 years.
• Consistency of returns. BJ Lackland, CEO, Lighter Capital, observed, “A well-run RBI fund will return more consistent returns for investors than a well-run VC fund, simply because the underlying assets have more homogeneous returns.”
• Antifragile, countercyclical model. We’re now late in the cycle of the historically cyclical equity VC industry. This should concern any traditional equity VC.
• Can work for all levels of growth and all funding histories. Lighter Capital has funded companies with growth rates ranging from single digits to >500%. BJ Lackland observes, “Our customers are 10% VC-backed, 45% bootstrapped and 45% angel-backed.”
• More attractive to women and underrepresented founders. Many of the leading RBI investors, including Decathlon Capital, Indie.VC, Lighter Capital, Corl, Feenix Partners, Clearbanc (which has a distinct model), and Founders First Capital report far higher rates of women and underrepresented founders pitching them and winning capital than traditional VCs see. I explore the reasons for this in “Why Are Revenue-Based Investors Investing in So Many Women & Diverse Entrepreneurs?“
• Lower likelihood of write-offs, assuming the VC is investing in companies with a clear path to profitability.
• Greater transparency to limited partners. The RBI VC is valuing a set of debt instruments, as opposed to a traditional VC who primarily relies on valuations markups attributed to a company by outside VCs. These markups are often somewhat disconnected from a company’s “true” value. For an overview of these concerns, see Scott Kupor’s “When Is a “Mark” Not a Mark? When It’s a Venture Capital Mark”.
• Under-addressed market. John Borchers, Co-Founder of Decathlon Capital, observed, “If you look at the Inc. 5000 data over the last decade, you’ll see that in any given year less than 10% of the 5000 fastest growing US companies have any institutional venture capital support. We think that this speaks to how large a market there is for RBI and other non-equity based approaches to supporting growth-companies who may not fit the traditional VC mold or be interested in taking venture equity.”
• Less pressure to paint a picture of the company as growing to the moon. Many VCs lose interest in a company when it is clearly no longer hypergrowth, even if it’s still a successful company by most standards, e.g., Evernote. BJ Lackland pointed out, “I was a VC many years ago. With RBI there’s a very different relationship between the entrepreneur and the capital provider. There’s less selling the big dream, pie in the sky, hockey stick forever. It’s more straightforward and healthy. This is because the RBI investor doesn’t sit on the board, isn’t the entrepreneur’s boss, can’t fire them from their own company, and doesn’t need to be sold a far off dream of milk and honey to provide capital. There’s no need to redline the business and put everything at risk to be a unicorn. Go big or go home makes sense for VCs, but doesn’t make sense for most entrepreneurs, nor for RBI investors.
• More intimate knowledge of portfolio company performance. A very common complaint of traditional equity VCs is they don’t have good visibility on their companies’ performance, until the board meeting (and sometimes even then!) Kim Folson, Co-Founder, Founders First Capital, observed, “RBI financing is more intimate than traditional equity. Our founders have immediate accountability as to the accuracy of their projections.” Many RBI VCs contractually require their companies to provide ongoing access to their financial data.
• Potentially can use an evergreen fund structure.
• Potentially could use SBIC financing. See Why The SBIC Doesn’t Work For Venture Capital Anymore vs. Small Business Investment Companies (SBIC) are an Attractive Alternative to Venture Capital. That said, I have not identified any RBI investors using this structure.

The disadvantages to the investor:

• Likely cap on returns. This structure scares many traditional VCs, because dramatic outlier outcomes are the drivers of returns in the traditional VC model. Every traditional VC aspires to a 5x, 10X, or 100x fund. But in practice, very few VCs will ever see returns like that. Any multiple above 3X is still very healthy and will put you well into the top quartile of VCs.
• Taxable as ordinary income, unlike traditional VC which is normally taxed as long-term capital gains. This means that a 2x return on paper can shrink to a 1.5x return after-taxes.
• Collections risk. When a company exits via IPO or M&A, the cash can literally be sent directly to the investor. In the RBI model, the company has to send the money to the investor typically in monthly tranches. Depending on the company’s financial situation, they may not be happy to do so. There’s a tension between the traditional desired “founder friendliness” of a classic VC and the relationship between a debtor and the debt collector.
• You need to be a licensed lender. John Borchers observes that if a traditional VC expands into RBI, they will need to become a licensed lender, adhere to different regulatory requirements, and are more likely to come under SEC oversight.
• Potentially fewer or no paper markups. Traditional equity VCs rely on new money coming in at higher valuations, which creates paper markups, allowing VCs to raise their next fund. For an RBI investor, valuation depends on how the RBI security is structured. If it’s structured as debt, then there’s no concept of a “markup” in valuation at all. Valuation is driven by the value of the loan, net of impairments, and the yield.
• Potentially harder to recruit employees. Many people are interested in working in equity VC, so much so that there’s a whole business (GoingVC) focused on helping people get jobs in VC. People are very excited about the opportunity to work with companies that very rapidly grow into industry leaders, even though statistically most VCs will not invest in such mega-winners. RBI funds cannot offer this same level of excitement.

Bryce Roberts, cofounder of Indie.VC, reports, “We started small, with a group of 8 companies who were given $100k each, and a focus on helping them raise their revenue, not their next round… Among those initial 8, we saw average 12-month revenue jump by over 100% (from an average of $250k the year prior to our investment) with that average growing to nearly 300% after 24mo.” In other words, his investments outperformed the typical VC portfolio.

Suggested further reading:

• Checklist for Launching a New Venture Capital Fund
• Syllabus for how to launch, manage, and invest a VC fund
• Microcredentials for the effective venture capital investor
• Fundraising hacks for VC and private equity funds
• Venture Capital compensation data and recruiters list
• How to negotiate a partner role at a VC or private equity firm

Note that none of the lawyers quoted or I are rendering legal advice in this article, and you should not rely on our counsel herein for your own decisions. I am not a lawyer. Thanks to the experts quoted for their thoughtful feedback.