Investing for Singles, Not Home-runs
Classic angel investing is reliant on “home run” returns: 10X, 20X or even more at exit. This is because angels know they will have failures, and our successes must make up for those failures by producing a very high return. We wait for the payday, often years, sometimes many years.
But there is another way. Revenue-based capital, sometimes referred to as revenue-based finance or RBF produces periodic cash returns to the investor independent of an exit. Generally speaking, an RBF portfolio produces a return of 2X – 3X. While at first blush this seems modest, in fact most studies show diversified angel portfolios produce returns across the entire portfolio of about the same multiple.
How RBF works:
1. An investment is made.
2. Regular payments of varying amounts are made back to the investors by the company that received the investment.
3. The payments are based upon the company’s cash receipts (not receivables or other sources of cash).
4. Payments continue until a pre-determined amount has been paid.
While there are many variations of RBF, in the simple version the investor receives payments monthly until a multiple of the investment has been paid. For example, an investor might invest $100,000 in exchange for the right to receive 5% of the cash receipts related to sales until $250,000 has been paid in total. Once the sum of all payments equals $250,000, the contract terminates and the investor has no further financial interest in the company. While RBF may be structured over any period, typically cash flow begins within weeks to months of making the investment and continues for three to five years.
Unlike typical equity investments where the investor expects their return to increase the longer the investment is held, RBF financing has a fixed and pre-determined multiple. Return comes in a regular cadence, usually monthly or quarterly until the full multiple has been paid. Like equity investing, the actual interest rate equivalent return (or internal rate of return “IRR”) cannot be determined until the investment is fully paid. However, on a portfolio basis, the IRRs should be approximately equivalent to those expected from a diversified portfolio of traditional angel investments.
The main advantage to the company is that the capital is non-dilutive, meaning the founders are not giving up any ownership. The disadvantage is the company must service the capital monthly, perhaps depleting precious cash. However, in the right situation, the margin from increased sales resulting from additional capital will more than service the debt.
The advantage to the investor is periodic cash flow beginning shortly after the investment. The disadvantage is the investor gives up the potential for a major exit event since the return is capped. However, since the investor begins to receive cash shortly after the investment, and since the companies appropriate for RBF are post-revenue, the risk of loss is far less than with equity investing. If the investor takes few losses, then the cash returns over a shorter period may make up for the lack of big exits.
To use a metaphor, traditional angel investing is for home runs. When swinging for home runs you will have strikeouts. RBF investing is for singles. And if you hit a single each time you come to bat and rarely strike out, you can produce similar results.
Denise Dunlap and Kevin Learned, the partners in Loon Creek, have many years of traditional angel investing experience between them. Here is what Kevin and Denise have to say about their experience:
“We’ve personally experienced the highs and lows in angel investing. As administrators of our local angel funds, we were looking for alternatives to the all-or-nothing equity investing model. In 2019 we decided to experiment with RBF, and together with long-time RBF investor Molly Otter we formed Sage Growth Capital. That experiment has been a success and Sage is now offering revenue-based capital to angel-backed companies throughout the U.S.”
Where does RBF fit in the capital stack?
RBF is most often deployed between a seed stage round and a later equity round. In this situation, RBF can enable a company to raise non-dilutive capital as a bridge to a later round. When deploying this capital leads to an increase in sales and margin, the company may very well be able to raise equity later at a higher valuation than would have otherwise been possible. Meanwhile, the investors enjoy regular cash flow, something that becomes increasingly attractive to many angels the longer they invest.
If you are curious about RBF, and/or if you know of a company for which this type of capital would be appropriate, visit the Sage website for more information or reach out to firstname.lastname@example.org.
Loon Creek specializes in syndicate formation and management services for private investors (and for the companies in which they invest). You can learn more about our services on our website.