The Black Lives Matter movement has brought to the fore the inequities ingrained in our society. In my field of investment, it is a long term problem. While we’ve made some progress in funding more companies led by women, people of color, or other disenfranchised entrepreneurs, it has been slow, and it’s still an uphill battle. I’ve been looking at Revenue-Based Financing (RBF) as one mechanism that allows more companies to become successful without having to take over the world, and some groups like Founders First are using RBF as a funding model to help underrepresented entrepreneurs. But there’s still a large gap for seed stage companies before they become eligible for even RBF investments.
I was impressed recently when I watched a segment on Youtube where Jon Stewart told Howard Stern about his experience on the Daily Show trying to increase the diversity of his staff. One thing he said that really intrigued me is the notion of tributaries. Jon was bringing on unpaid interns, many of whom became part of his staff as a consequence. But as a consequence, many of his staff had come from privileged backgrounds, i.e. those that could afford to take an unpaid internship. By paying his interns he was able to recruit from a far more diverse population and over time diversify his staff.
In my research on RBF, I’ve discovered a ton of activity. While it’s still very early in the development of this investment model, it seems clear to me that one or more of the vehicles being used will succeed and provide a great path forward for this finance model.
But the seed-stage funding problem still exists. Every one of the RBF funds or investors that I’ve found still requires the company to get from idea to a run rate of $10K MRR, minimum, most a good deal higher. So how is an entrepreneur supposed to make it to that MRR? Well, for “trust fund kids” this isn’t really a problem, but for others who might not have a rich aunt in Oregon, it just isn’t going to happen.
I believe there will be a “river” of funding becoming available on the RBF model within the next few years, but there are no “tributaries” for the less privileged.
I’d like to make the largest impact I can with my small investment dollars, and I am happiest investing at the seed stage – both my money and my experience are able to make a bigger difference at the seed stage than later on when the company has already figured things out. So I want to help build the systems that will fill the tributaries into either the RBF or equity investment rivers.
It seems to me that most of the tools to do this are already available: I’m talking about convertible debt or SAFEs. These deals allow investors to participate very early, before a company has demonstrated enough value or consistency to raise “real” investment. The issue with these today is that they’re structured to convert into an equity round – the triggers for conversion are all stated in those terms, and the expectations of investors is that they will so convert if the company gains traction. So as they stand today they are not an appropriate vehicle for seed-stage RBF, but the changes need not be drastic, we just need to add clauses that trigger conversion (at a discount) into the next round, whether it be an RBF financing or an equity investment. There are many details to be worked out, and it’s unclear to me whether the discount should be the same for equity as for RBF, but some of these issues can be hammered out now, and for other issues we will learn with experience what actually makes sense.
One major advantage that I see for doing things on this basis is that the whole accounting superstructure is deferred until the RBF (or equity) round is closed, when it actually becomes someone else’s problem — RBF investors need to have established financial management systems in order for their investments to work. This keeps things very simple indeed, which is a huge win.
So where do we start? Well, it’s still important to identify the ideas for companies that look like they will have the kinds of margins that will support a follow-on RBF. Prime candidates that jump out are tech-enabled services and straight SaaS niche products. These are the companies that usually get the cold shoulder from equity investors as not being in big enough markets, but are wonderful businesses.