Alternative to VC: Capital Models to Achieve Economic Prosperity

In last week’s Digest article – Alternatives to VC: Reconsidering the Startup Financing Paradigm – SSTI examined the conventional venture capital (VC) model as well as its advantages and limitations. In this installment, we will highlight alternatives such as revenue-based financing, venture debt, crowdfunding and a new financing model for cleantech proposed by Massachusetts Institute of Technology (MIT) researchers. We also take a look at the potential that these alternatives have for the field of tech-based economic development.

Revenue-Based Financing

Revenue-based financing or royalty-based financing (RBF) is a flexible type of financing structure where a company sells a set percent of its future revenues to the investor in exchange for a capital investment. At its root, RBF is a blend of debt and equity focused on companies with no to limited assets. Unlike the typical fixed bank loan, the monthly repayment amounts are based upon a percentage of revenues. This allows the company to shift the repayment of the loan from a fixed monthly expense to a variable expense.

The RBF model is especially effective for companies that are generating revenue, but lack the assets necessary to collateralize a traditional bank loan. It also can be effective for companies that have the potential to generate revenue within one to three years. Another benefit of the RBF model is that it does not dilute the existing shareholder’s equity. Since no equity is exchanged, the startup will remain appealing to future rounds of investors.

Venture Debt

Over the last 20 years or more, venture debt has been an important, but under-recognized, financing model for startups. It is a form of debt financing for equity-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. While there are a number of venture debt models, the three most common include:

• Growth Capital – used for working capital and/or any other business purpose;
• Accounts Receivable Financing –useful for companies that are generating revenue and assets in the form of accounts receivable; and,
• Equipment Financing –  used specifically for the purchase of equipment.

Proponents contend that venture debt is a form of risk capital that is less costly than equity when structured appropriately. The three primary benefits for both startups and investors include:

• Reduce dilution of the company’s value;
• Extend a company’s runway to achieve targeted milestones; or,
• Accelerate its growth with limited cost to the business.

For startups, the venture debt also offers three additional benefits:

• Avoids setting a valuation (in the event of a down round);
• Prevents the need for a bridge round or a down round to get through a tough period without creating a negative signal to existing/future investors; and,
• Acts as insurance in case it takes longer than expected to hit the next milestone.

Crowdfunding

At its most basic level, crowdfunding focuses on connecting startups and small businesses with potential investors, consumers, and other key stakeholders to help support business growth through some online platform. There are four common forms of crowdfunding:

• Equity-based – In return for a capital investment, the contributor receives a small amount of equity in the company;
• Donation-based – The contributor’s donation goes towards a charitable cause/organization and the contributor typically receives a tax deduction for their contribution;
• Lending-based (sometimes referred to peer-to-peer lending) – The contributor makes a loan and the contributor is repaid for their investment (typically with interest) over a predetermined period of time; and,
• Reward-based – The contributor receives a tangible item or service in return for their funds (many times this can be considered a pre-purchase of the product).

The advantages of crowdfunding campaigns typically include:

• For equity-based crowdfunding, there is a broadening of the pool potential investors;
• For reward-based crowdfunding, the campaign acts as a proof-of-concept or market validation for the startup’s product(s); and,
• For lending-based crowdfunding, the startup can receive an important capital infusion without dilution of equity.

The negatives of crowdfunding – specifically equity-based – focus on the dilution of capital if the term sheet is not properly structured. For reward-based crowdfunding campaigns, the primary issue revolves around the pre-order of products and other rewards. In many cases, startups can be overly aggressive in their abilities to fulfill all their orders leaving some customers disappointed.

MIT Financing Model for Cleantech

In Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation the authors propose a model in an attempt to move beyond the VC model and find a better fit for cleantech startups. The authors propose a new financing model focused on targeting patient capital providers in partnership with federal/state funding sources. The model is based on multiple steps:

• Engage private investors such as pension funds, foundations, family offices, and sovereign wealth funds;
• Develop regional public-private partnerships that offer favorable technology transfer terms from the national laboratories; and,
• Increase support for federal programs including ARPA-E and the Department of Energy’s national laboratories.

While private investors may not be able to make large rounds of capital investments that VC funds do, they may still be a better fit for the startups because they will:

• Allow the companies to grow at natural rate compared to the accelerated VC model; and,
• Will not push as hard for an M&A event because they are not seeking as significant returns on investments to appease limited partners.

The model is aided by significant investments from public-private partnership and federal sources to achieve the process. These groups are able to offset the loss capital that would occur without raising VC funding.

Alternative Financing Models and TBED

Each of the financing models described have potential applications to the field of tech-based economic development (TBED) and the economic prosperity of communities across the country. To support startups as they search for alternatives to VC, TBED organizations and other key stakeholders (e.g., local, state, and federal agencies) can help startups understand these financing options – including the advantages and disadvantages – as well as actually use these models to make investments in startups.

TBED organizations that do not make investments in startups can provide information and services to help educate startups on these and other alternatives to VC. Conversely, organizations that make capital investments could consider these as potential alternatives to their traditional capital investment structures and/or they could use them as complementary financing models to help improve the appeal of their portfolio companies. For many TBED organizations, there is potential for revenue-based financing (RBF) or venture debt financing models to help companies expand their runway without diluting their equity.

In addition to these direct activities, TBED organizations, states, and federal agencies play an important role in facilitating alternative financing models for tech startups. Through corporate partnership and other private-public partners, TBED organizations can work with other non-traditional institutional investors (such as family offices, pension fund managers, banks, private equity, etc.) in their region to make patient investments in startups, such as cleantech or pharma startups, to receive the best form of capital for their venture.

Like the VC model, TBED organizations must consider how best to employ these models within their practice as well as which models fit best for the startups.