The Next Generation of Small Business Funding

vc

Each year entrepreneurs pitch Venture Capital firms in hopes that their startup company or business expansion will get funded by them. The vast majority do not get funded. Furthermore, “getting funding” almost always means the entrepreneur must sell a sizable piece of his company to the VC.

Getting funded by a VC is a dream, but it can easily turn into a nightmare for both the entrepreneur and the VC. Because the VC owns a piece of the company, if further rounds of funding are needed in the future it could mean diluting only the founder’s ownership, depending on how the contracts were setup. It’s not too uncommon for founders to eventually wind up with a minority stake in their own company and to lose control of it. For the VC, there’s a big chance of failure. They usually need an exit strategy, such as taking the company public to sell its shares to the marketplace or to sell the company to a private party. But before they sell it, they need to try to juice up the revenue of the company to max out the sales price. When maxing out revenue becomes the primary unconditional focus, it’s easy for the business to go in a very different direction than the founder had intended.

The above horrors can happen when an entrepreneur does get funding. Let’s not forget that most entrepreneurs seeking capital just don’t get funded.

These are problems. And yet the world has a way about finding solutions to problems and getting them to those who can benefit. Sometimes the solution can be so incredibly simple that it’s hard to believe. In the case of funding a small business, the solution I see is a matter of breaking the habit of selling equity.

Instead, sell revenue. A slice of your gross revenue, that is. Here are the benefits when raising capital:

  • Keep all of your company. Don’t sell it to investors.
  • A flexible payment. In a month with low sales, your payment to the investor is lower. In a month with higher sales, your payment to the investor is higher.
  • More long term profit is kept. Once you’ve paid the investor fully as agreed, you still own and control all of your company.

Here are the benefits to the investor:

  • A built in exit strategy. A revenue participation contract can have a fixed repayment period or a fixed repayment amount, similar to debt.
  • Lower risk. It’s easier to project gross revenues than it is to project profit. An investor whose repayment is a percentage of gross revenue only needs to be confident the entrepreneur can and will make the payments.
  • More winners. Because of the built in exit strategy, the investor doesn’t have to assume most of their investments will tank and thus doesn’t need to have an astronomical ROI for the slim few that succeed.

For example, an entrepreneur has a business with $100k in gross income and $48k in net income. He needs $50k to expand his business by hiring and training a sales force and getting a larger office. He projects that in 6 months the expansion will result in an increase to $400k in gross income and $250k in net income. So an investor pays $50k to buy the right to receive 20% of the business’s gross revenue each month until those payments total $100k.

The investor will make a 100% ROI once the repayment is completed. If all goes as planned, that 100% ROI will be paid in under 18 months. It could happen faster or slower, depending on how well the business performs as projected.

For the entrepreneur seeking capital, the chances of finding an investor (or investors) can significantly broaden when he can pitch a lower risk investment that has a built in exit strategy.

What’s more, this model is very compatible with smaller investment amounts. In today’s world, a startup with tons of potential might not be able to get VCs’ attention unless they need millions of dollars. With revenue participation contracts, an entrepreneur can seek out tens of thousands or a few hundred thousand dollars in capital from smaller local investors and businessmen. That also means the entrepreneur may be dealing with a kinder local businessman rather than heading out to Silicon Valley to deal with the sharks.

Reader Interactions

Comments

  1. I’ve always liked non-voting preferred shares with a stated dividend. If you must to get funded, add a participating feature (say, 20%?) with a cap. Your dividend payments can be made quarterly, semiannually, or annually, unlike debt that usually must be paid monthly. And if you can’t make the dividend, it’s ok, whereas debt strikes you dead. You’d probably have to agree to give board seats or voting rights for too many consecutive periods of not making the stated portion of the dividend, but so what? If that’s happening maybe you need the help.

    If your liquidation preference is 1.0, you give up no equity in the company. You give up cash flow of course, but in a business where cash flow is the point (commercial real estate, mortgages) that’s ideal.

  2. Bob,

    I’ve generally found that the further a funding deal departs from utter simplicity, the more biased it can be for the benefit of the investor at the cost of the entrepreneur. It seems that most often an investor may be very sophisticated in deal structuring (because that’s his business), while an entrepreneur is not (because something else is his business).

    That said, I think that what you described may fly right over the heads of 90% of small business owners. For this reason, a revenue participation agreement alone can provide the simplicity that provides both the investor and the entrepreneur the clarity to find a point of fairness and do a deal that they both won’t regret.

    – Jeff

  3. I’m not selling “non-voting preferred shares with a stated dividend plus participation”. I’m selling (for example) “6% return plus 20% of additional profits”. Anybody should be able to understand that. How the investor is entitled to that (preferred equity, participating debt) is an implementation detail best not referred to up front lest confusion frighten the investor. You can disclose all that in the PMM.

    I agree that revenue participation is indeed simple. My concern with selling it is that the return on an annualized basis, which is how most investors measure their investments, is speculative, much like common stock. We all know common stock is the most expensive equity to sell, so I would expect revenue participation contracts to be similarly expensive money.

  4. I would argue that, to the contrary, revenue participation without equity or profit sharing is the least expensive to sell because it is essentially an unconventional debt instrument. Without sharing of company profits, an entrepreneur can whip up a 2 page contract and raise money from whomever he desires without needing to have a PPM prepared and without needing to restrict himself to contacting only accredited investors. Further, with a debit instrument that is not a security, he can actually network rather than restrict himself to pre-existing relationships.

  5. Debt instruments don’t share in company profits either, yet those are unambiguously securities. I’ve seen debt instruments with “piece of the gross” kickers, just like a percentage rent clause in a lease. Why isn’t a revenue participation contract a security?

  6. A revenue participation agreement can be a promissory note with special repayment. Notes are generally not securities unless warrants are attached or unless the note is intended to be traded/resold.

  7. Jeff – you have a good understanding of the benefits of RPAs to the company owner and the investor. Have you invested successfully using this instrument? If so, what has been your target company, and what ranges of repayment terms have you negotiated?

  8. Dear Jeff,

    If a parcel of property is purchaed with solo 401k funds, can it be improved (roads paved, landscaping), and can a house be built on it (for resale,rent, or later distribution to the 401k owner), as long as independent contractors are hired for all the work who are not disqualified persons? Also, at what point would such action cross the line between an individual investment and an unrelated business activity, thus incurring UBIT? This activity would be utilizing cash and not borrowed money.

    Also, I have gathered that land held in a 40lk can be appraised by an independent party and distributed and taxed on a fractionalized basis over a maximun of 5 years (20% of FMV a year), once the owner is 591/2. I am correct in this assumption?

  9. Bobby,

    Your first question is a good one. It doesn’t have a clear answer or a clear line drawn (yet). I will be posting a new article about this soon, so make sure you subscribe to my RSS feed.

    As for your second question, I don’t know because I don’t pay attention to property distributions out of a plan. Strategies that involve acquiring real property inside a plan and later distributing it typically maximize taxes and I focus on strategies that minimize taxes.

    Jeff

  10. Jeff,

    What is your realistic view on the talk of Congressional hearings to confiscate 401k holdings and convert them to Government-managed retirement accounts? Is this a valid concern, and if so, should current solo 401k holders diversify into real estate, on the assumption that property rights in this country (USA) are more established and less subject to change than ERISSA regulations?

  11. Bobby,

    That’s a very important question. My realistic view is that government confiscation is a legitimate threat. The self-trustee Solo 401k (that we, Nabers Group, setup for investors) is a great tool for protecting against confiscation, but not because of property rights trumping ERISA.

    In fact, I’ll be releasing some information on this exact topic very soon. Stay tuned!

    Jeff

  12. Jeff would it be possible to create a participation agreement where in which the investors used their Self Directed IRA’s to fund their investments? If so could they also contribute funds using a non-recourse loan in conjunction with the Self Directed IRA?

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