Aligning entrepreneur and investor incentives

In the last post, I talked about how revenue-based investments are a lower cost of capital than traditional equity.  In this post, as promised, I’ll explain how they also better align the the incentives of investor with the entrepreneur.

To start with, always remember to put yourselves in the other person’s shoes when raising money.  Investors invest to make a positive return on their investment.  (This is true even in the world of impact investing, where mission may come first, and where financial return may be traded off, but that that financial return is always present and important.)

How does this return come about in traditional equity investing?  From the exit.  The all important exit, which 99.9% of the time now is an acquisition.  In a acquisition, what drives the value of the acquired company?  Growth.  Not revenues.  Not margins.  Not profits.  Growth!

Simply put, a company with growing revenues has a value.  A company with growing revenues and good margins has a higher value.  A company with growing revenues, good margins, and profits, an even higher value.  Take away the growing revenues, and the company may be worth less than the cash it has on hand.

Does this seem ludicrous?  See Yahoo, a public company with billions in revenues and margins and profits, but with its business valued at less than zero.  Being private doesn’t change this rule of valuation, it just hides it from the public.

Back to equity investors, if they need an exit and if that exit is based on growth, then their incentive is to see your startup grow.  As quickly as possible, as more growth equals more value.  All that is great, as long as you are growing, but with rare exception, startup growth isn’t steadily upward.  It’s bumpy.  Sometimes it plateaus while dealing with the growth the staff, or as it crosses the chasm, or when it loses its first early customers, etc.

Those investors, at their first sign that growth is slowing have an incentive to sell the company.  I’ll repeat this as it’s key.  If the company looks like the growth is slowing, your investors no longer have an incentive to help you make a successful company, but instead start looking for an acquirer to buy your company before anyone notices that the growth has plateaued.

A few, rare, experienced venture capitalists may want to ride out the bumpiness with you, but I’ve only heard a handful of such stories in my 20+ years of startups.

Looking back at revenue-based investing, the incentives are completely different.  Those investors have made a bet on gross revenues.  Revenue growth for them is good, but not imperative.  If revenues start of plateau, those investors’ incentives don’t change.  They don’t worry about 100% loss of their investment as a zombie.  They can instead either live with what might be a slower rate of repayment and thus a lower rate of return, or they can step up to help the entrepreneur grow revenues.

Reread that last paragraph, as it’s not the norm for startup investors.  Revenue-based investors have just one incentive, to see the company earn revenues.  More is better, but some is still fine.  Depending on the terms of the investment, an acquisition might juice the rate of return, but it’s not required to have a return.

This is a big deal for entrepreneurs.  Revenue based investment structures provide a lower cost of capital and a set of investors who have their incentives aligned with the entrepreneurs.  What entrepreneur wouldn’t want that?

The only real flow is that revenue-based investments are not the norm.  Of the tens of thousands of startup investments made each year, only a few dozen take that form, and most in the seed stage from my accelerator, Fledge, and in growth capital stage from companies like Lighter Capital.

No doubt more to come as this win-win structure shows more proof of success.