Why a revenue-based model is the best choice for investors in 2020?

It’s not only WeWork’s debacle (that) exposed by the company’s failed IPO attempt. Uber, Lyft, and Slack are just a few examples of companies with less than stellar performance after going public this year. Their stock prices have been stumbling because of their earlier approaches to high growth with no profitability on the horizon. Are investors to blame? Can this issue be addressed? New investment models, such as revenue-based financing, can provide a safer alternative both for young aspiring companies and their investors.

Wonchang Terry Choi, Investment Analyst at 13 Ventures, a New York-based growth-stage venture firm

Avenues for startups to borrow capital in NYC are growing, according to a recent note by PitchBook, a Seattle-based private market data provider. New structures, such as revenue-based financing, are gaining popularity. It is not only less dilutive, allowing founders and early investors to make the most of their ownership, but if managed properly, it can generate the incentives to set the company on the right path to profitability.

Venture Debt as an asset class is growing overall. Silicon Valley Bank (SVB), a major lender to startups, currently has around $10 billion in outstanding commercial loans to venture-backed companies. The bank’s loan book has more than doubled in the last 10 years. SVB’s flagship model is smart since the bank lends capital to companies that are either raising a priced round from renowned VCs or to companies that have closed a round recently. SVB leverages not only the due diligence made by VCs, but also their capital since the company’s new runway makes their loan more likely to be paid back. SVB is not alone, other companies – also publicly traded- like Hercules Capital operate similarly.

This is a great model from a risk mitigation perspective but I would say that it is too exclusive to some few companies – just as traditional Venture Capital – and it does not address the financing gap observed in the market between Seed and Series A rounds, where graduation rates have decreased from over 40% to less than 25% in recent years. Lenders should play a more active role and take the risk of bridging rounds and offer tailored terms to promising companies when they needed the most – when VC money is not available. But for many lenders, startups are still too risky of an investment and they wouldn’t fancy showing up alone to the party. To that, I can only say that it is our task as capital providers to step up, use all the tech and data out there to improve and make the best underwriting.

Young companies need a new breed of lenders that understand their business (ideally industry-focused) and who can provide value beyond what equity investors offer. VC funding can lead to high dilution levels to founders and early investors – ranging from 10 percent to 25 percent or more – in every round of financing. Lenders should be able to reduce dilution. We should become also a senior financial advisor to our portfolio companies and should bring the tools to help the company grow robustly but also profitably and hence sustainably.

In contrast to traditional term loans, a revenue-based investment loan model would mean that repayments are tied to the borrowers’ monthly revenues. This structure is flexible since payments adapt to the reality of the market and the company has a lower default risk.

We, lenders, should be board of observers and never board members. We should support founders if they decide to keep their business or have an exit but only if they decide to manage it profitably. We should never request personal guarantees and make the capital available when needed so that founders can focus on building and not on fundraising. From our perspective, this model is here to stay. Revenue-based investments have grown while angel and seed financing have slowed across the U.S., according to PitchBook. The bifurcation of early-stage VC has just started and will continue, even more now that so many stories hit the newsstands. This opens a window for new revenue-based investment products to take hold, allowing companies to grow organically without the need to get into a unicorn costume or to run a fundraising marathon.

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(Featured image by Lorenzo Cafaro via Pixabay)

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