Betting on “exits” is not the same as betting on success…
The Fledge investment is (currently) unique amongst accelerators. The underlying core idea is based on the structure from Y Combinator and TechStars, cash plus a few months of services in exchange for 6% of the outstanding equity. However, this is augmented by splitting this equity into two components, one structured as revenue-based financing (RBF), and the rest left in its traditional form.
The workings of RBF are most easily described in the form of a loan. The lender lends $D to the borrower. Rather than promising a fixed return over a fixed time period the borrower promised to pay R% of its top-line revenues each quarter, until a multiple of M times the loan amount is repaid. For example, $10,000 is lent, paid back from 4% of revenues until $30,000 is repaid, which is a 3x multiple.
There is no time limit in RBF. Higher revenues lead to faster paybacks. The faster the repayment, the higher the IRR.
Fledge structures its RBF not in the form of a loan, but instead as part of the equity investment. The company uses 4% of its top-line revenues each quarter to repurchase some of Fledge’s shares, until half of the shares is redeemed. The total repurchase price and total number of repurchased shares is fixed as part of the Stock Purchase Agreement, signed on Day 1 of the program.
Fledge lists both the cash provided to the company as well as the value of the program as the total compensation provided to the participant in exchange for 6% equity (common shares).
For Fledge Seattle, the non-negotiable terms are $20,000 in cash plus $17,500 in in-kind services. (The $17,500 is computed by taking the approximate $120,000 cost of running a session and dividing it by 7 companies, rounding up). Fledge sets the redeemable price at twice this value. Thus the Stock Purchase Agreement reads as $37,500 buying 6%, with half those shares redeemed using 4% of quarterly revenues for a price per share that returns $75,000.
Learning: Fourteen separate lawyers reviewed the contract in the first two sessions, and while every lawyer had a comment about something in the contract, none had any comments about the RBF.
Learning: Of the 44 fledglings in Fledge1-7 who have agreed to the structure, all found it a reasonable deal, with positive benefits in aligning Fledge’s investment interest with the entrepreneurs’ interest in growing revenues, rather than looking for the companies to “exit” as soon as possible. A small handful of interviewees balked at the terms, but none of them earned an invitation.
For the non-redeemable equity, Fledge needs a way to liquidate those shares before the underlying fund reaches its end-of-life. To do this, the Stock Purchase Agreement includes one additional term. The fledglings agree to repurchase those outstanding shares after the fifth anniversary of signing the agreement, at the market value of the shares at that time. Terms are negotiable, but no set to be no slower than the original redeemable equity.
Learning: Given the RBF structure of stock repurchase, none of the seven teams in cohort two had any objections to this term.
Learning: Fledge is only four years old and thus we’ve yet to learn how difficult it will be to negotiate those terms.
The expectations are for the fledglings to begin earning revenues within a year after graduating from Fledge, and to begin paying back the RBF within the first 3 years. To avoid dealing with the initial tiny stock repurchases, the companies are allowed to retain their revenues until the first 20% of the total repurchase has accumulated. After that threshold, repurchases must be made quarterly, given sufficient revenues.
It is expected that, on average, the fledglings will repurchase the RBF portion of the Fledge investment within 5-7 years after graduation. If a company “exits” before all the RBF shares are redeemed, Fledge receives the higher of the remaining redemption value or the value of the shares.
Companies are allowed to buy-out these shares early only upon raising a “significant” investment. There is no discount for this pre-payment. The reasoning is that a company raising a large equity investment has grown in value, and might “exit” before the full repayment, lowering Fledge’s return on investment. Similarly, limiting this repaying to money raising avoids a company from pre-paying the RBF days or weeks before an “exit”.
Benefits of RBF
The use of RBF provides a multitude of benefits for both Fledge and the fledglings.
Value. It provides a means of monetization of success, separate from and likely earlier than “exits”. It pays Fledge back for the value we provide to the fledglings upon their success.
Alignment. Unlike most early-stage investment, Fledge as investor and fledgling as investee have an aligned goal of increasing revenues. For early-stage companies, revenue growth is the path to fiscal sustainability.
Flexibility. Using top-line revenue eliminates the timing risk of traditional debt financing. Payments are made upon success, with faster repayment upon faster growth, and slower payment upon slower growth. This mirrors the value of an equity investment.
Control. Using top-line revenue as the measure for repayment eliminates management’s discretion on when to repay Fledge. Profits and dividends come after expenses, and Fledge has no control over how management chooses to spend its revenues. Top-line revenue is an unarguable and non-gamable metric, one, which all good for-profit managers aim to grow.
Living Dead. Traditional early-stage investment funds suffer from a multitude of “living dead” companies. “Living”, as in they are earning revenues. “Dead” not in terms of non-operational, but in terms of no growth or slow growth. Slow growing companies have relatively low values, and thus of not much value to equity investors waiting for “exits”. But as these companies do have revenues, they will continue to repay their RBF, and thus as long as they operate, they are potentially profitable investments within the Fledge portfolio.
Furthermore, given the “stranded” capital agreement in the Fledge investment, these companies may eventually return 4x or 5x or more, despite their “zombie” status.
Lifestyle Companies. Traditional early-stage investment funds bet solely on “elephants”, i.e. companies with an immense opportunity in a large market with high growth potential. This leads to the traditional results of (at best) 1 in 10 big successes, 3 minor successes, and a majority of losses.
With the RBF structure, Fledge can earn 3x or 4x or more from companies that grow to a few hundred thousands of dollars in annual revenues, providing a “lifestyle” to their owners and small teams. Many of the so-called “losses” of traditional early-stage investment funds are companies which look like high-growth opportunities early on, but which fail to find sufficient customers for that high-growth path, yet have sufficient customers to run a small, but profitable business.
Metrics. All the fledglings are contractually required to report their quarterly top-line revenues. Fledge also requests metrics on the size of the staff, and a few other key metrics. There is little public information about the true growth rates of early-stage companies, and in time, the trove of data will be a valuable source for future investments.
Downsides of RBF
The major downside in using RBF is that the occasional investment that would be a 10x, 20x, or bigger will return about half that return to Fledge. The other half will have been repaid (quickly) at 2x as part of the RBF.
The minor downside is the overhead involved in quarterly revenue reports, the related accounting, and the multitude of stock repurchases.
Learning: It does take some educational effort to explain the RBF investment structure to every invitee, and to message this in a simple manner to every potential applicant.
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