Alternatives to VC: Reconsidering the Startup Financing Paradigm

Venture capital (VC) financing is a highly competitive process that backs only 1 percent to 2 percent of all startups that apply for funding, leaving many searching for financing alternatives.  In this two-part feature, SSTI examines the typical VC model, its advantages and limitations, and next week will highlight alternatives such as revenue-based financing, venture debt, crowdfunding and a new financing model for cleantech proposed by Massachusetts Institute of Technology researchers.

Conventional VC Model

Due to the highly competitive process, VC firms can be very selective in their process with many only investing in startups with the potential to become unicorns (high-growth startups with valuations of $1 billion or more) that also will offer a quick (less than five years) return on investment (ROI) through an acquisition or an initial public offering (IPO).  The conventional VC model is structured in a way that reflects those demands. 

Many VC funds are commonly structured as a 10-year partnership where outside investors (or limited partners) provide capital to a group of fund managers (general partners) to make investments in high-growth startups. During the first five years of the fund, the VC fund’s general partners try to make between 10 to 20 investments in startups with the remaining five years focused on harvesting their ROI.

Due to the high risk of startup investments, most VC general partners expect the majority of startups to not make any ROI; some might break even or make a modest (2x to 4x) ROI; and, one or two might be wildly successful (10x+ ROI). The one or two wild successes must be sufficient to make up for the investments in all of the failed companies, in addition to returning a premium for the length and illiquidity of the investment.

The VC model is a multi-step process with a small initial round of financing, typically a seed-stage investment (approximately $1 million), followed by several rounds of funding of approximately $10 million (called series A, B, C, etc.). Once those rounds have been completed, the VC fund managers may make a final late-stage growth round of more than $10 million – these investment rounds can reach into the hundreds of millions of dollars. In addition to capital, the majority of VCfunds offer portfolio companies with services including management consulting, teambuilding, and networking, to help the startups reach their potential.

In return for the financial investment and services, the VC firm takes an equity stake in the company (typically about 20 percent). Upon a successful exit (acquisition or IPO by the VC-backed startup), they will reap their financial ROI.

Limitations of the VC Model

Since many VC funds need to focus on startups with the potential for a significant ROI (10x or more of the total investment), many startups that have not shown the potential to make those types of returns, especially companies that are intended to address real-world problems for both the developed and developing world (e.g., cleantech, social impact startups), cannot successfully compete for funding. Due to time constraints, VC funds also are less likely to target startups in areas such as pharma products that will take more than 10 years to realize the ROI due to regulations and other factors.

Other factors that limit the number of startups suitable for VC financing include:

• Stage of investment – VC firms have started to move toward later-stage investment;
• Area of expertise – VCs typically invest in startups that they have experience or expertise in (for emerging fields this is especially a problem); and,
• Stage of technological development – technologies that need significant time/financial commitments to develop a commercially viable product or are applying during the production process also are not very appealing to most VCs.

This leaves the model well-suited for some technology areas, such as medical devices and software, but less so for other areas.

Conversely, for many startups, the VC model also has many drawbacks that make it a poor model for their success. The most significant problem is the emphasis on exits for VC firms and the pressure that places on the startup. This focus can create external pressures for startups to accelerate their process and sometimes miss the opportunity for a business model/technological pivot that would allow the company to reach its potential. In many cases, this impatience can lead VCs to pressure the startup’s management team to focus on being acquired instead of an IPO or remaining a privatelyheld company that generates revenue without stakeholders. By focusing on the acquisition, VCs can be placing their own interest in front the technology or startup teams.

Alternative Models of Startup Financing

In next week’s Digest, SSTI will highlight some alternative financing models including:

• The patient capital model for cleantech startups from MIT researchers;
• Revenue-based financing (sometimes called royalty-based financing);
• Venture debt; and,
• Crowdfunding.

In addition, we will discuss the potential that these alternatives have for the field of tech-based economic development.