The 0-55 rule works like this: borrow from the Fed at 0%, collect 0.55% interest on short-term treasury securitites with no risk, and … nothing. That’s it. Don’t bother lending out to businesses or consumers.

Well … boo. But you can’t blame them for responding to incentives, I guess.

Here at RevenueLoan, our incentives (and constraints) mean that we MUST invest our funds into revenue-based financings for small, growing businesses. So if your local megabank is too busy robbing from Peter to pay Paul (er, borrowing from Ben to lend to Timmy?) to write you a small business loan — maybe you should apply online with us.

Patrick and Dan from Next Step are experienced operators and angel investors in high tech. Much like our own story at RevenueLoan‘s founding, they discovered the RBF model as part of their investing work and conversations, and found several situations where the revenue-based model would have worked better than traditional equity.

With legal advisory help from Ed Cavazos and Andrew Gajkowski of Bracewell & Giuliani, who are rapidly making a mark as thought leaders in the RBF practice in Texas, they founded the firm and have been actively looking at investments in the $250-500k range, primarily in Texas.

Welcome to the Next Step team — interested folks should check them out, and we hope for their success as we all continue to prove out and define the emerging RBF marketplace!

The short answer is – these companies ($2-$15M) are tweens.  They’re the Miley Cyrus’s and Justin Bieber’s of startupville.  Like girls ages 10-13 who are “too old for toys but too young for boys,” startups between $2-15 million can need money that’s “too small for institutional investors but too much for grandma.”

Imagine you’re a $2 million company looking to raise, say, $300K.  That’s a number few VCs or mezzanine debt-types get excited by.  It’s “too small to be interesting.”  Meanwhile it’s too much for grandma (at least my grandma) and the local credit union thinks it’s a lot of money for a new business unless they can saddle it with draconian covenants, personal liability and collateral liens.

This leaves few options for tweens other than RBF and equity-based “angel” investment.  Seen this way, the choice gets narrowed down to (a) giving up a percentage of revenue (RBF), or (b) giving up a percentage of ownership (angel equity).  Now what?

The choice depends on what you really think about your business.  If you think it’ll be a disaster or mediocre at best, it may make sense to give up a percentage of ownership to an angel investor.  This is especially the case if there’s no chance in Sam Hill you’ll ever get bought or go IPO.  In this scenario your business keeps the cash and the investor gets nothing.  Of course, to get this money you’d have to lie through your teeth, all the while convincing the investor you had every expectation of a massive acquisition or IPO in the near future.  In other words, you’d have to be a lying, cheating fraud.

Yet things change if you really think your business is something special.  Something with huge potential.  Something worth investing in.  In that case you’d be hard pressed to give up even a scintilla of ownership if there was any alternative.  Think about it – equity in a great company can appreciate astronomically more than any fixed financial instrument.  For example, Apple stock has appreciated around 380% over the past five years (that’s an average of about 76% per year).  If you really thought your company was the next “Apple,” why on Earth would you give up those rewards by frittering away your equity?

If you’re really the next Apple or something like it, RBF can be a better option – if for no other reason than you don’t have to give up equity.  Instead, you give up a percentage of your revenue up to a predetermined maximum.  That’s right… a maximum.  In other words, you keep your equity (and its upside potential) while raising cash that’s hedged by a maximum possible obligation if all goes well.

Myley Cyrus says “if you believe in yourself anything is possible” (although I’m pretty sure she borrowed that quote).  So like any tween, your choices are a function of your self-expectations.   If you think your business will be the lowest ranked meth addict in cell block 6 someday, you may want to sell out now because it’s only going to get worse.  But if you think you have the next American Idol, Glee cast member or Twilight heartthrob on your hands, you may want to give RBF a second look.

Author: Thomas Thurston

This isn’t because entrepreneurs are somehow inept.  It’s because cash flow is deceptive, subtle and sneaky.  Cash flow and profitability aren’t the same – cash flow can kill profitable companies.  One day your clients pay net 30, then something happens and you start getting paid net 45, 60 or even 70. Meanwhile your own business is in flux.  You may start pushing out payments to your suppliers.  And this is when things are relatively calm.  Next an anticipated revenue stream vaporizes… say a big order is canceled.  An unexpected expense shows up.   Suddenly you can’t make payroll.  Welcome to cash flow hell.

When this happens it can be time to raise extra cash – smooth over cyclical gaps.  Most businesses find themselves here sooner or later.  When this happens, here are some options:

• Equity investment can be a terrible option here – why give up precious ownership of your company just to bridge short-term capital needs?  Feels like giving up part of your soul for chump change.
• Bank loans are what most people resort to, only now you have another minimum payment and debt covenants to deal with.  Your business was going through turmoil in the first place and you’ve been forced to add more risk and cost.  If you miss some payments your personal credit, home, business and anything else you laid down for the loan go up in smoke.
• Factoring is another option.  Here you sell a portion of your receivables to a factoring company in exchange for some of that money up front.  It’s like a payday loan.  This can be okay unless you need more capital than the small amounts factoring companies offer, you don’t want to give up control of your ledger, or you’re not willing to unleash their collections people on your clients.  That may tick your clients off.
• Grandma is a great way to go, should you be so lucky.  On the other hand, knowing my grandma I’d probably get better deal terms from a military interrogator.
• Revenue based funding (RBF) is another, newer, option.  You usually get a larger lump sum than factoring companies can offer, without personal liability, collateral or minimum payments, without unleashing collection agents on your clients, without giving up ownership in your company and without Grandma to reckon with.  Those are the pros’.  On the cons’ list, you usually have to cede three to five percent of your monthly gross revenue (a royalty) to the RBF investor until a predetermined maximum dollar amount or time period is reached.  If your gross margins can’t handle the royalty, RBF is a bad option.

This is the inferno through which you must crawl to escape cash flow hell.  All options come at a cost, but the goal here was to give a panorama of solutions and to highlight RBF as a welcome addition.  Alleviating cash flow problems on favorable terms is good for startups and the communities that depend on them.  Remember, when it comes to managing cash flow, the devil is in the details.

Author: Thomas Thurston

To play with this example let’s transport ourselves back to 2004, the year Google had its IPO.  Not only was Google a household name but it had crunched out an impressive $1.4 billion in revenue the year before.  Let’s also imagine that for some reason… say to buy new foosball tables… Google wanted to raise $220 million.

Option A is to sell some stock.  Google’s IPO kicked off at $85 per share, so to raise $220 million it would have needed to sell around 2.5 million shares (we’re using round numbers).  Today, seven years later, Google’s share price is around $624 (must be nice).   So today’s value of the 2.5 million shares Google sold is roughly $1.6 billion.   In other words, the hindsight cost of raising $220 million through stock was in excess of $1 billion.

Option B is to use RBF.  What if Google raised $220 million through RBF instead of selling shares?  Let’s say its RBF agreement called for 5% of monthly revenue to be repaid to the investor up to a maximum lifetime repayment ceiling of $660 million (a ‘3X cap’).  Looking back through Google’s historical sales since 2004, it turns out Google would have repaid the full $660 in less than 2.5 years.  The cost of raising $220 million through RBF was $660 million and the repayment time was relatively short.

Conclusion: It turns out selling stock would have cost Google nearly $1 billion more (around $955 million) than if they’d used RBF to raise the $220 million instead.  Rather than paying off its RBF obligation just after two years, selling stock would have also forced Google to indefinitely relinquish 2.5 million shares of ownership and control.

So if you think you’re sitting on the next Google, let this be a cautionary tale.  While selling stock feels like “free money” to amateurs the true cost can be through the roof.  It certainly pays to know your options.  If you still aren’t convinced… Google it yourself.

Author: Thomas Thurston, Growth Science International, LLC

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 3^rd 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.

Conclusion

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.

Author: Thomas Thurston is President of Growth Science International, LLC

Making matters worse, on a global scale a key source of early stage capital – microfinance – is facing a crisis.  Championed by Nobel Prize recipient Muhammad Yunus and his Grameen Bank decades ago, microfinance has evolved into a multi-billion dollar global industry.  Its tone has also begun to shift, from socially-oriented to profit-oriented.

This increased focus on the bottom line is creating both an identity and operational crisis that has rocked the microfinance world.  For example, one of the largest microfinance markets in the world (India’s Andhra Pradesh) has begun to clamp down and regulate a number of micro-credit practices.  High interest rates and collections bullying have allegedly led to 30 suicides by impoverished entrepreneurs who couldn’t make their payments, and borrowers have protested by refusing to take new microfinance loans and by refusing to make payments until their grievances are addressed.  Some government officials have encouraged this civil disobedience, and India’s commercial banks have largely frozen credit to microfinance institutions.  In response, many of India’s largest microfinance institutions have sued to block regulation.[ii]

Last month during the Microfinance Impact and Innovation Conference 2010, a group of more than 250 academics from institutions such as Harvard, MIT, Stanford and Yale found increasing evidence that suggests microloans can further impoverish the poor.[iii] For example, Abjit Banerjee of the Ford Foundation and MIT studied 7,200 households in Hyderabad, India, for over a year and a half.  Loans of $250 were given to groups of women at a 28% APR, and little to no long-term positive impacts were found on family incomes or education (although there was some evidence of alleviated healthcare burden).[iv] As of 2009 there were 1,084 MFIs who had lent around $38 billion to over 74 million borrowers worldwide.[v]

Regardless of the motives behind microfinance, at the end of the day it’s just high-interest debt.  It’s a personal loan with a high APR for a small dollar amount.  As such, while it provides many positive benefits for entrepreneurs with zero alternatives, it’s inherently difficult to scale.  It doesn’t work for larger businesses that need larger amounts of capital.

This is where RBF offers fresh opportunity.  While RBF isn’t right for every company and there’s a range of ways (some better, some worse) to structure an RBF agreement, it gives entrepreneurs access to capital in a profoundly different way.  RBF creates a new set of tradeoffs.  It’s not just another loan, nor does it require the blockbuster growth needed for equity-based investing.

Unlike microfinance, RBF can provide capital for startups without strapping them with a high interest rate, personal liability and fixed payments they must service regardless of monthly revenue.  Moreover, unlike microfinance, RBF can scale.  It works for deals large and small.

It’s time the international development community, local investors and entrepreneurs gave RBF a closer look.  Not only does RBF hold the potential to create compelling financial returns for investors, but it can allow a promising generation of innovators to build better businesses, transform their communities and lead better lives.

So, what is it about royalty / revenue financing (RBF) that makes it non-dilutive to equity holders?

Simply put, it’s the fact that RBF trades growth capital for a part of current revenues, whereas equity trades for the residual long-term value of the business.

As a result, all things being equal, RBF is best when a company already has created a product and a strategy for selling it, but is limited as to how fast it can grow revenues with internally-generated funds under that strategy.  In effect, the RBF is funding the growth in revenue — fueling the money machine.

Contrast that with the classical case for equity, when a company is creating its product and/or its sales “machine.”  There is often substantial learning, experimenting, and iteration to be done.  In effect, the equity is funding the creation of the money machine.

Debt, too, plays a role, but is classically best when it applies to purchasing an asset with a well-understood value as collateral.  For the somewhat riskier, and more intangible, application of fueling revenue growth, RBF is (arguably) better suited.

Therefore, when a business is weighing “no dilution” RBF financing vs. the most flexible (but most dilutive and hence expensive) option of equity financing, the question should be about what the money buys.  Does it buy a variable (somewhat contingent) stake in the growth of revenues, or does it buy the residual interest in the long-term value of the company?  And, perhaps more importantly: which is the entrepreneur willing to sell?

Strategic Value Overrides Financial Returns

Dual emphasis on both strategic and financial objectives creates unique challenges for CVC practitioners.  For example, CVC investors often find themselves faced with highly strategic deals that have little financial attractiveness from an equity investment perspective.  In other words, due to their strategic missions, CVCs often invest in highly strategic businesses that no financially-focused VC would otherwise touch with a ten foot pole.  By one estimate, 65% of CVC investments were either for strategic value only, or with strategic value as the primary concern (vs. financial returns).

[i]

CVCs Favor Mid-to-Later Stage Firms

CVCs contribute a critical piece to the venture investing pie.  In 2000, CVCs invested around 16% of all venture capital that year.[ii] Compared with traditional VCs, CVCs also tend to do fewer seed and early stage investments.  For example, a 2006 study indicated that the percentage of VC investments in seed and early stage firms (20%) was around one and a half times larger than that of CVCs (13%).  In both cases, seed and early stage investments were a relatively small proportion of overall deals.

[iii]

Revenue-Based Funding for Strategic Deals

With an emphasis on highly strategic (and not always financially attractive), mid-to-later stage deals, CVCs have increasingly discovered revenue-based investing as an alternative to traditional equity-based venture capital.

While not every deal lends itself to revenue-based funding (RBF), CVCs can employ RBF structures in the case of highly strategic investments where a target business has no likely exit (i.e. M&A or IPO).  For example, many highly strategic portfolio companies have strong revenue and respectable growth.  However they may not be likely to create the “blockbuster” growth, followed by a prompt exit, that is required for sound equity-based returns.

In such cases, RBF allows the CVC to assist a strategic firm (with an RBF cash infusion) and to then enjoy financial returns based on a percentage of the target’s revenue.  Compared with the 15% of CVC deals that have no financial merit, or even the 65% where strategic value trumps financial prudence, RBF can lower the risk of pursuing strategic value.  RBF allows CVC to finally enjoy strategic and financial returns in deals without exits.

As RBF is best suited for investments in businesses with established revenue (since repayment is based on revenue), RBF also complements CVCs’ general preference for mid-to-later stage deals.  After all, mid-to-later stage businesses are more likely to have revenue than seed and early stage startups.

Better in Both Worlds

Historically, CVCs have faced daunting tradeoffs between strategic value and financial returns.  By favoring strategic value, lower financial returns have often hampered corporate enthusiasm for CVC in general – making fewer resources available for CVCs and the businesses that depend on them for capital.

This is the promise of corporate RBF.  By allowing CVCs to better enjoy both strategic and financial returns, a positive net impact is created for corporate investors and entrepreneurs alike.

With profound community, national and international importance on the shoulders of small business, the following summary highlights 4 trends in US small business credit and lending.

1. General Credit Use

The banking system is the largest supplier of traditional (vs nontraditional) credit for small businesses in the US.  In 2003, total debt owed by small firms to commercial banks was $718 billion.  In the five years between 1998 and 2003, the use of small business credit increased by an estimated 10%.[ii]

Bottom Line – The gross majority of small US businesses use some form of credit.  Overall credit use increased significantly in the five years between 1998 and 2003.

2.  Credit Variety

In 2002 and 2003, 41% of small business owners said they used credit cards (personal or business) for business expenses.  However those obtaining startup financing through traditional bank loans were a mere 11.4%, with more than 60% using nontraditional self-financing to get started.  Six traditional loan types accounted for 90% of small business lending debt, of which 36% were mortgage loans and 29% were credit lines (the two largest credit types used by small businesses).[iii]

Bottom Line – Small businesses primarily obtain funding through nontraditional self-financing, credit cards, credit lines and mortgage loans (as opposed to traditional commercial and small business loans).

3. Loan Amounts

A 2007 study categorized US small businesses into three groups based on loan amounts:

Borrowers seeking (1) less than $100K, (2) $100K-$250K, and (3) $250K-$1 million.

Of the three categories, borrowers seeking less than $100K received approximately 88% of small business loans.  However, the total dollar  amount of these loans was only 23% of all small business lending.  Borrowers seeking $250K – $1 million represented a mere 5% of small business loans, yet accounted for 58% of dollars borrowed.

Furthermore, total dollars lent to firms seeking between $100K and $1 million increased at nearly twice the rate (143% increase) of loans for $100K or less (59% increase).[iv]

Bottom Line – As a population, there were more small firms seeking small loans.  However in terms of dollars, small business lending disproportionally favored fewer, larger firms seeking larger loan amounts.

4.  Loan Availability

The number of US loans made to small businesses peaked in the second quarter of 2008 at 27.2 million loans.  Since then the volume declined by 17.8% (a drop of more than 4.8 million small business loans).  During that time the total value of such loans fell by $60 billion, to approximately $650 billion.[v]

Bottom Line – Fewer small businesses are getting loans and the total value of small business loans has significantly declined.

[ii] Small Business Administration, Small Business in Focus: Finance; A Compendium of Research by the Small Business Administration’s Office of Advocacy, Office of Advocacy (July, 2009)

[iii] Small Business Administration, Small Business in Focus: Finance; A Compendium of Research by the Small Business Administration’s Office of Advocacy, Office of Advocacy (July, 2009)

[iv] Small Business Administration, Small Business in Focus: Finance; A Compendium of Research by the Small Business Administration’s Office of Advocacy, Office of Advocacy (July, 2009)

[v] Maloney & Schumer, Small Business Employment: Bank Lending Restrains Job Creation, U.S. Congress Joint Economic Committee (September, 2010)