Christensen explains that he has seen a new idea surface that has the potential to disrupt traditional Venture Capital. He explains that certain situations require more creative types of capital. For instance, when there isn’t a likely liquidity event for a company, traditional Venture Capital isn’t going to be interested. He uses the designation “royalty capital” as he explains a form of investing in which capital is repaid in proportion to revenue. When a predefined cap is met, the investment cycle is complete. There is no equity dilution of the company, and there is no requirement for a liquidity event. RHV refers to this concept as Revenue-Based Financing (RBF). His explanation is slightly different from RBF, however the core principles remain. Christensen highlights the primary benefits of this model:

• Flexible in payment (% of monthly revenue)
• Cap on repayment
• No equity dilution
• Interest paid with pre-tax dollars

Christensen merely gives a brief overview before moving on to the next topic. Yet there is much more to RBF than what he’s described. As highlighted in a recent article by the Kauffman Foundation, Six Myths About Venture Capital Offer Dose of Reality, the VC fund structure, fund life, and economic terms have remained the same for more than 20 years. That same report also reminds us that VC financing is the exception, not the norm, for startups. Historically, less than 1% of U.S. companies have raised capital from VCs. RBF can better serve a selection of the 1% with a better aligned investment structure. RBF also offers a solution for the 99% that are struggling to find the right capital structure to meet the needs of their businesses.

The timing is right for RBF. Startups are monetizing faster than ever, the 2012 Halo Report states, “63% of 2012 angel group deals were in companies with revenue”. It’s unknown how many of those companies would better served by RBF, but I would speculate a reasonable percentage.

I appreciate Christensen bringing awareness to this investment structure. For him to propose its potential to disrupt VC lends credibility that RBF is one of the latest evolutions in venture capital.

Offering a royalty deal is now starting to become quite popular on Shark Tank. You’ll see deals where an investor will offer to invest $x for an ongoing royalty of $x per product sold. The reason the investor counters with this proposal in lieu of an equity investment ($x for x% of the company) is because they see minimal chances for a liquidity event (an exit). It’s mutually beneficial for the investor and entrepreneur to use a royalty or revenue share investment structure in that scenario. This is also a nice structure for the entrepreneur and founding team because there’s no equity dilution (a main selling point that Kevin O’Leary likes to mention) or battle over nailing down a valuation. Plus it offers flexibility, the business isn’t tied to fixed re-payment schedule. For example, if zero products are sold, zero royalty payment is due that month.

But (you knew it was coming), here’s the catch. Generally the royalty they are proposing has infinite duration. This has the potential to make the financing VERY expensive for the business. That’s where we’re different. Our Revenue-Based Financing (RBF) investment structure is designed with a cap on your payback obligation. Once that amount is paid we’re out of the picture. You have a clear expectation of the cost of capital from the get-go.

Because Shark Tank is a TV show designed for drama it’s not a true representation of the entire investing process (surprise!). There is little to no attention given to understanding if the proposed royalty is healthy and can be supported by the business. That’s all done off camera after the pitch has been accepted. Here at RHV, we spend a great deal of time analyzing a company’s financials and forecasts before proposing a revenue share percentage.

Shark Tank is a great way to see the basics of the pre-term sheet stage of investment. It also highlights some of the different directions funding can take. The recent trend in royalty deals on the show highlights several of the pros, but the structure shown on the show can bite the entrepreneur in the butt. By contrast, our founder-friendly RBF structure has similar positive attributes, but none of the bite.

What have you liked most about using Revenue-Based Financing (RBF) to help finance your business?

The flexibility is great. And if you have a high growth startup, paying out a % of revenue instead of using equity isn’t a problem at all.

Other than the financial investment, what value-add has Rock & Hammer Ventures brought DropShip Commerce?

The RHV team has been very helpful! From thinking about strategy, to making intros to partners, to helping recruit and hire a software engineer, they’ve been awesome to work with.

Have you been able to obtain other forms of financing to supplement Rock & Hammer’s investment?

Yes. We just closed on a Seed round of financing. Total amount was $2.25M. Combining RBF with equity financing worked really well for us.

What other types of investment have you considered, and why did you choose RBF for part of your needs?

We invested a significant amount of money from our spinoff, and then supplemented with RBF and equity. We liked that we could move quickly, and get some financing while we kept building the business, and then worked on further equity financing.

What is one piece of advice related to fundraising you would offer Utah entrepreneurs?

If you’re a first time entrepreneur, don’t try to fundraise. It’s a waste of your time. Go get some traction, get some revenue, and then all options–especially RBF–open up for you.

In terms of startup lessons learned, what is one piece of advice?

Startups are about two things: action and growth. Don’t just have an idea, don’t just talk. Act. Find ways to turn roadblocks into hurdles so you can continue taking action. And Grow. If you’re not growing, you have nothing but time wasting action.

I’d also encourage you to check out Jeremy’s blog; Adventures in Entrepreneurship with Jeremy Hanks where he shares his thoughts and ideas with other budding and successful entrepreneurs.

GroSocial is a social media marketing software company based out of Orem, Utah that helps small and medium-sized businesses find new customers through popular social networking sites such as Facebook and Twitter.

What did you like most about using RBF to finance your business?

Without question, avoiding unnecessary dilution–especially early on–was what I liked most. RBF sounds scary the first time you hear about it. People will tell you “it’s like a payday loan” and “the interest rate is astronomical”. The funny thing is that most entrepreneurs and advisors to entrepreneurs seem to forget the fact that equity financing is hard to come by. Further, debt financing isn’t even an option–especially for early stage startups. For GroSocial, RBF was an awesome fit. It allowed us to defer the valuation discussion with future equity investors to a later date when we had a little bit more traction.

How did the flexibility of RBF benefit GroSocial?

Down months meant we paid less, good months meant we paid more. The variable nature of the monthly payments was hugely beneficial in helping us manage cash.

Other than the financial investment, what value-add did Rock & Hammer Ventures bring GroSocial?

Chris has been awesome. Aside from capital, Chris served as an invaluable board member. He knows his stuff and brings a unique point of view to the table as a former entrepreneur that has been through the startup game before. Chris is hands-on and adds value without being a burden to his portfolio companies. We were able to land sizable partnerships that I’m confident we wouldn’t have landed thanks to introductions from Chris.

Was the promised cost of capital savings (compared to equity) realized?

Absolutely. Looking back, had I been able to predict the timing of our exit, I would have taken more of our total financing in RBF to avoid additional dilution. Taking a decent chunk of our total financing via RBF resulted in each shareholder realizing a greater return.

What advice related to fundraising would you offer other Utah entrepreneurs?

You’ve heard 1,000 times that traction is important so I don’t need to repeat that; however, it is worth mentioning that traction plus metrics/relevant data obtained through your traction sells. As you pitch investors, remember that investors put their pants on one leg at a time. Be extremely confident and don’t allow yourself to be intimidated. Most of them know far less than they’d like you to think they know. Personal wealth or prior business success does not denote omniscience.

What is one aspect of running a successful startup you underappreciated at first but later realized was critical to your success?

Being clear on why you’re doing what you’re doing matters immensely. Entrepreneurs that are clear and passionate about their purpose behind creating and managing a startup have more staying power. It doesn’t take too long before you’ll run into several challenging bumps in the road that will lead you into wanting to give up or chase bogus opportunities. If your purpose is clear–and isn’t lame like “getting rich” or “achieving personal independence” or something like that–you’ll be able to weather virtually any storm that comes. Start a company to create change. Change the way people do things and take pride in the way you make that happen.

The image above represents the investment decision-making process at most companies.  Let’s walk through each of the stages.

First, someone comes up with an idea. Since they can’t build or launch the idea on their own (or if they can, it’s too politically risky), they work through a series of stakeholders to refine and gain consensus on the idea – this typically involves lots of opinions and compromise. The higher paid the person, the more they need to influence the idea, as they believe that’s why they’re paid so much money. Working it’s way up the chain, eventually an idea gets executive support and is funded.

At this point, the idea is a shell of its former self. From here, the company builds the idea. This usually involves a long requirements process and lots of estimation (later we find out this is wrong). By the time the idea is built, it has gone over the initial estimated timeline, is incomplete, and everyone is anxious for it to launch.

Clearly, the company has invested substantial time and money to build the idea.  If the timeline isn’t exceeded too much, often companies will perform fake research to help justify the large amount of time and expense invested to further convince everyone the idea is great. This usually manifests itself as focus groups, where users are shown the idea, asked for feedback and then someone compiles a report that includes the positive feedback, but moves any critique to an appendix.

Now it’s time to launch – crack the champagne! For the few companies that do pay attention to metrics after launch, there is usually significant enough confusion because of “external factors” and other ideas that were launched at the same time to ensure no one is accountable.

To those who actually use data to drive their business – by practicing, and embracing the results of, Lean Startup and Agile principles – this whole lifecycle seems wacky. As a guy who has spent time at dozens of companies large and small, I can attest that this is how decisions are made – with gut instinct and political maneuvering.

No business should make decisions like this. In the startup world, there is especially no room for gut instead of data.

Stay tuned for next week where we propose an alternative model for ensuring that you’re launching the right ideas to your customers, in the right way at the right time.

Apart from equity’s higher cost of capital, which we’ve discussed previously, entrepreneurs should consider three other  risks involved in accepting an equity investment in your company. Often, these risks are mitigated by ensuring you’re working with a trusted partner, however, the risks should not be ignored and represent the risks of accepting equity investment.  Revenue-Based Financing (RBF) can help mitigate these risks, which we discuss below.

First, your incentives may not always be aligned with those of your equity investors. Equity investors are exit focused, in that they need your business to sell in order for them to recoup their investment. While there are certain scenarios (such as secondary markets) that allow for equity investors to cash in without a sale of your business, they are not frequent. It’s important to understand that by accepting equity investment, you will be expected to sell or IPO your business at some point in the future. Even when this is known and accepted, the tension may be timing – how can you be sure that you won’t be enjoying the growth and your investor will believe it’s time to sell?

Second, equity investment requires you to set and agree on a value for your company. Your interests are misaligned with equity investors here – for a given investment size, you want to give up as little of your business as possible, and your investor is trying to get as much of the business as possible. If you’re a seed-stage deal, often times your idea may need some additional proving and revenues may be low. This results in a much lower and frequently disappointing valuation for your business, requiring you to give up more for less. Later stage companies are often in a much better valuation position, as their company and market have proof of traction.

Finally, if things go off the rails, investors could take control of the business. Some less-scrupulous investors may include control provisions that require their approval of spending and budgets. While this isn’t normal, it does occur, especially in the Utah investor ecosystem. Also, depending on the size of the equity round, if the investor ends up owning more than 50% of the company, they effectively have the ability to take over operational control at any given time. This case is not extremely common either. However, a frequent control that investors can and do utilize is the potential for future investment – if the company isn’t performing and the investors want to leverage their control, they can choose not to make another investment, effectively harming your business and signaling to other investors that the company is not investment grade.

Rock & Hammer’s Revenue-Based Financing opportunity provides an alternative financing option for entrepreneurs that mitigates these risks and helps prepare you for possible future equity rounds.

Because you’re making RBF payments based on revenue, we are incentivized to help grow your business, and are indifferent to an eventual sale or exit. RBF’s loan structure means that we don’t need to align on a value of your company – in fact, our capital can help grow your business to a larger valuation for a future equity fundraising event.

Finally, because we don’t own equity, our ability to control the business is extremely limited. We do ask for two key tools that help us monitor the health of the company, one is board observation rights, which means that we are non-voting member of your board of directors. Second is a commitment guarantee, which is a promise you make to commit to the company, even if things start to get rocky. We never request onerous control provisions and never require a personal guarantee of the loan. When things go bad, it’s in our best interest to help you fix the business, not take over.

Rock & Hammer’s RBF offering allows you to get the capital you need to grow without the risks and expense of equity financing. Find out more about Rock & Hammer Ventures or Revenue-Based Financing.

First, a commitment to the business and validation by your customers is necessary. Next, legal and accounting matters should be in order. Finally, three key documents that describe your business and plans should be developed.

Commitment

Investors are looking for a commitment to your company and your idea. This means dedicating yourself full time to the business. We will not – and neither will most other investors – invest into a business run part time or on the side. This only makes sense – if you’re not willing to commit to the business, why should we?

Commitment also means showing that you understand the needs and pain points of your customers. You should be able to show, at a minimum, preliminary results from the Customer Validation process. It costs nearly nothing – and will help you discover more about your product and market opportunity than you could ever learn by talking to investors. Assemble the results from your customer interviews to share with interested investors.

Legal and Accounting

Ensure that your legal structure is solid and has clear ownership and legal standing. Ensure that any significant business matters, whether with co-founders, customers or vendors are settled with written agreements in place.

You’ll be asked to produce financial documents both before a term sheet, and before funding closes. Show that you’re an aware entrepreneur by having key financial documents, including a balance sheet and P&L, available upon request. That provides a great impression and shows that you’re sophisticated enough to know that it is necessary.

For the cost, you still can’t beat QuickBooks. It allows you to easily create reports for yourself and your investors, and makes it easier to get bookkeeping help as you grow, since it is the standard for most CPAs.

Business Documentation

You should have a one page executive summary describing your business and progress to date, the amount of funding your seeking, and the specific use of those funds. The amount of money you’re raising should strongly correlate to specific activities or initiatives – no one wants to invest in a business that needs “about 250k” because it “feels right.” We’d suggest using the executive summary from our Resources page, it’s an excellent example.

To show that you understand your business from end to end, you should also create a business model canvas. A business model canvas is a one-page view of your infrastructure, offering, customers and finances. It’s helpful in understanding your business landscape, and should be an evolving document used to ensure your team understands the strategy.

The third document you should be prepared with is a very simple pitch deck that introduces the market opportunity, the solution and the team. For software companies, include screenshots, a short demo video and test accounts, if possible. For everyone, be sure to focus on the value your product delivers to the market.

Wrapping Up

Be prepared for fundraising. As we’ll discuss in a future post, fundraising is a distraction that should be quickly eliminated to allow you to focus on building your business. By being prepared to fundraise, you will create documentation critical for growing your business, and show investors that you are savvy enough to trust with their capital.

In addition to the concerns about RBF hindering future equity fundraising (covered previously), we often hear that companies are hesitant to pursue an RBF investment as part of an overall equity round. Some seem to be under the assumption that the different financing type will impact their equity fundraising. Our experience shows that RBF does impact equity rounds – but in a positive way.

In addition to the clear benefits of RBF, the key additional value proposition in an equity raise scenario is that it helps lower your cost of capital for the equity round. Depending on your initial equity valuation and exit value, RBF usually has a lower effective interest rate than equity; providing some of your financing needs through RBF will lower the overall cost of capital of your fundraising round, and lessens the impact of the round on your ownership in the company.

We know that equity and RBF can go hand in hand – our portfolio company GroSocial recently raised a $1MM round that included a sizable RBF portion. This helped them lower their cost of capital while still receiving the financing they needed to continue their growth. You can read more about their experience in CEO Zach Mangum’s recent post on our RBF blog.

What have you liked most about using RBF to finance your business?

RBF has helped us preserve equity and keep our cap table clean. When starting a company, especially at the early/seed stages, it’s hard to raise money at a reasonable valuation–especially outside of Silicon Valley or other locations where capital is more accessible. RBF allowed us the flexibility to take on equity financing later at a valuation that made sense to our founding team.

Other than the financial investment, what value-add has Rock & Hammer Ventures brought GroSocial?

Rock & Hammer Ventures (RHV) has been great to work with. Chris has served on our board for almost two years and has provided tremendous value through making introductions to strategic partners, joining us at industry conferences and events, and providing sound marketing and product advice. Chris and team know what they’re doing.

Have you been able to obtain other forms of financing to supplement Rock & Hammer’s investment?

Yes. This was one of our biggest concerns when taking on RBF. Fortunately, we were able to take the capital and turn it into meaningful traction by acquiring new customers, enhancing our product, and expanding our distribution channels. In fact, we pitched several investors that appreciated the fact that we chose to conserve equity early on via RBF.

What other types of investment have you considered and why did you choose RBF for part of your needs?

We considered three investment types: equity, RBF, and venture debt. Equity, at the right terms, was a no-brainer. RBF was, too. Venture debt was less appealing to us. Personal guarantees, aggressive interest rates, and warrants were too steep for us. As a startup, we were more interested in a partner that would share in the good times and the bad.

How has the flexibility of RBF payments benefited your business?

First, the decision making process from RHV has been quick. The due diligence process was dramatically shorter. Legal is a breeze and inexpensive. Also, since payments are a percentage of revenue, good months are good for RHV, bad months are bad for RHV. It’s comforting knowing that if we have a down month we don’t have a massive debt payment hanging over our heads the following month.

What one piece of advice would you offer other entrepreneurs?

Find balance in your life. Contrary to what a lot of entrepreneur-martyrs will tell you, spending a reasonable amount of time working and a reasonable amount of time with your family or away from the office is not only good for you and your own physical/mental health, but it’s good for your company. Leave the office at a reasonable time. Note that I’m not advocating taking a vacation every month, leaving the office early, or never working long hours here and there to hit important deadlines. What I am saying is that if things aren’t right at home or in your personal/family life, you, your family, your company, its customers, and your employees will suffer because of it.