Risk of Revenue-Based Finance vs Equity and Debt
December 20, 2010 2 Comments
People often ask about the comparative risks/rewards between traditional venture capital (equity-based funding), bank loans (debt) and revenue-based funding. While there are many ways to evaluate the broad concept of “risk” (ranging from Modigliani-Miller theorems to pop-psychology), one approach is to simply ask “what happens if I succeed or fail?”
Viewed this way, risk depends on whether you’re an investor giving out money or an entrepreneur receiving it. If you’re an investor, the comparison can be visualized below:
For the Investor
Equity based venture capitalists (VCs) have the greatest potential upside if a business they’ve funded succeeds. Granted, those businesses have to be acquired or go IPO to “succeed” in the eyes of a VC. However if they do so, a VC’s upside is nearly unlimited. Think “Google IPO.” On the flip side, if a venture fails the VC stands to lose everything (100% of the invested capital). In other words a VCs upside is tremendous but its downside is total.
In contrast a bank faces moderate gains if a venture/borrower succeeds. The bank merely receives its expected payments. If the business fails a bank’s potential losses are mitigated by any collateral or personal liability that’s been secured against the business, entrepreneur and cosigners. Banks don’t stand to gain more than expected, but they don’t stand to lose as much either.
Between debt and equity is revenue-based finance (RBF). If a venture succeeds, the RBF investor more quickly receives repayments up to its maximum payback “cap.” Their returns can never exceed the predetermined limits of the deal. If the business fails, like VCs an RBF investor stands to lose almost everything; although the RBF investor recoups its share of revenue generated before the business failed.
For the Entrepreneur
Things look very different from the perspective of an entrepreneur seeking funding. In this case, bank loans offer the highest rewards if the business succeeds. This may seem counterintuitive, but think of it this way – payments to the bank are the same regardless of whether the business is a base hit or a home run. So if a bank loan is all that it takes for the next Google to become… the next Google… that fixed repayment was a bargain.
In contract, bank loans end up being the worst possible arrangement if a business fails. The bank may seize the entrepreneur’s business, home, collateral, ruin the entrepreneur’s personal credit and similarly invade the wellbeing of any unfortunate cosigners to the loan. Think “homeless grandmas.” Short of debtor’s prison (which the US thankfully abolished in 1833) it’s hard to imagine a worse downside scenario for entrepreneurs than what’s risked with debt.
At the other end of the spectrum, equity-based venture capital offers the least rewards to entrepreneurs if things go well. Successful businesses end up relinquishing whatever portion of their upside was doled out to VCs. Sometimes this is less than 10% of the victory, sometimes it’s over 90%. It can be a hollow victory indeed when an entrepreneur’s blood, sweat and tears amount to little more than a pat on the back and a 3rd home for their investors. Nevertheless, entrepreneurs often tolerate this cost because the downside risk of equity is relatively low if the business fails. No entrepreneur’s credit is ruined, nobody’s grandma loses her home.
On the upside, RBF is sandwiched between debt and equity. Again, if the business does well an entrepreneur probably pays more to an RBF investor than would have been given to a bank (but only up to the pre-negotiated limit or cap). Yet if a business fails the entrepreneur is almost in the same situation as with a VC, except for any cash that may have been paid out to an RBF investor prior to the business’s collapse.
Before RBF, investors and entrepreneurs had to settle for extreme highs and lows between equity and debt. Today RBF offers a third choice – a middle ground. For investors who want better-than-debt returns without the downside risks of equity, RBF hits a compelling sweet spot. It’s also a much welcome alternative for entrepreneurs who want to better guard against the downside risks of debt in exchange for higher-than-equity rewards if a business thrives.