Examining Early-Stage Funding Options: Equity, Revenue-Based Financing, Debt

Elizabeth Yin, the co-founder of the pre-seed Hustle Fund, knows what it takes for a startup to secure funding.As a former partner at 500 Startups and manager of their Mountain View accelerator, she has reviewed 20k-plus startup pitches over the years and has helped founders raise hundreds of millions of dollars .She’s been in the trenches. She still is. And even she knows that Founders have options when it comes to raising early-stage funding. In a recent blog post, she dug on VC, revenue-based financing and debt. Here’s what she had to say about the different startup funding options, with my takeaways…

1. Equity financing

Elizabeth: “Traditionally, you have a lot of tech startups flocking to venture capital firms to raise money, because VCs have done a great job, as an industry, in marketing themselves. But the vast majority of startups who seek VC funding are not the right profile for that type of funding. “

Me: Yes and Yes. This is what I always say.

Elizabeth: “What most people don’t realize is that this is the most expensive form of financing if you are successful. Why? Because your payback amount is delayed significantly and the amount you end up paying back is a LOT if you are successful.”

Me: It’s true. VC is expensive, especially if you’re successful.

Elizabeth: “People don’t realize that equity financing is one of the most expensive forms of financing — because you don’t feel it until years later. The flip side is if you raise equity financing and your company does go belly up, you don’t owe anyone anything. The investor is taking all the risk here as well.”

Me: There is that upside for Founders. Giving out equity for funding is expensive in the long run but also feels “low” risk since if you fail you don’t owe anything.

2. Revenue-based financing

Elizabeth: “Investors in this model make money by essentially picking companies that are generating fairly consistent revenue that have low default risk, and they are trying to target quick payback periods so that their IRR is high.”

Me: A pretty succinct description of what revenue-based investors are looking for and why.[For a much more detailed look into revenue-based financing and how it all works, check out the post we wrote recently for ChartMogul entitled, How Revenue-Based Financing Works and What RBF Providers Care About.]

3. Debt financing

Elizabeth: “This is the cheapest form of capital but also the riskiest to the entrepreneur. In debt financing, if an investor puts $100k into your company, he/she is looking to be repaid back with interest by a certain date. So, say we do a debt investment of $100k into a company, we might ask for $120k back after 1 year (the principal plus 20% annual interest).”

Me: Essentially debt financing locks in a return for the investor over a stated period of time, forgoing upside. This means that it should really only be taken by Founders who are confident they can pay it back over the term of the agreement. It isn’t for “build it and they will come” projects.

Elizabeth: “First off, usually debt is the cheapest form of capital and equity is the most expensive. Now you might think, “Wait a minute! 20% annual interest in this last example feels really expensive!” But when you compare the interest to the revenue-based financing model and the equity model, it’s not.”To compare all 3 of these financing options, we need to look at the returns on the same time scale:

• An equity investment of $100k that turns into $5m 10 years later has an average annual IRR of 48% per year.
• A revenue-based financing investment of $100k that turns into $120k in 6 months has an average annual IRR of 44% per year
• And of course, a debt investment of $100k with 20% interest after 1 year has an average annual IRR of 20% per year.

Elizabeth: “Even though it’s a much cheaper form of financing, founders are typically averse to debt. It’s a natural reaction, because in our personal lives, we go around saying, “Oooooh, debt is bad.” In our personal lives, debt is often bad, because your own cash flows are generally not growing faster than your interest rate. You typically are not getting 20%+ year over year raises each year.”

Me: Founders need to decouple their thinking around personal debt to fund their lifestyle (credit cards, student loans, mortgages) and debt to fund their business’s growth.

Elizabeth: “In a startup, if your revenues are growing 20% MoM and your interest rate is only 20% year over year, you are growing your business significantly faster than your debt. And so not only will you have the cash flows to cover this 1.2x multiple of investment, but cash that you can put to use today will make your company 9x (1.2^12) more valuable a year from now, while you are only required to pay back 1.2x of the cash you took in.”

Me: Yes, this is the ROI argument for debt, even if it costs 20+%. It’s simple math that Founders need to understand. We’ve created an open-source tool to help you understand the cost and value generation for one form of debt financing (revenue-based financing). The last worksheet in the file shows the value you capture from the financing based on customer acquisition metrics you provide.Note that the model is view only, so file → make a copy, no email required. And make sure to spend some time on the ‘Model Overview’ worksheet and reference it as you play with the model.) If the numbers don’t work and there’s no value capture for the company, they shouldn’t take the money and we shouldn’t do the investment. Read Elizabeth’s full postWhat do you think? Agree? Disagree? Have your own take? Let me know at bparks@bigfootcap.com or schedule some time to discuss.