[qi:101] Balancing the interests of investors and entrepreneurs is an ongoing topic of discussion in Silicon Valley. But while numerous efforts to create new types of investment classes aimed at removing this imbalance (for examples, see the Founders Fund, Adeo Ressi’s The Funded and the newly launched SharesPost) have recently emerged, they fail to address the root cause, that of founders and investors being trapped in illiquid investments. Seeking downside protection, such as liquidation preferences, makes sense as investors are being asked to take a long position that could range from years to never. This problem is compounded by the fact that it’s very difficult to value early-stage companies, especially in industries like information technology and cleantech, in which there are so many external factors at play.
What’s needed is an instrument — call it Class R stock — that’s halfway between a conventional investment and a loan. In exchange, a company would agree to pay a percentage of its gross revenue up to a negotiated multiple of the original investment, the logic being that while a company may operate at a loss for quite some time, it should start generating revenue before then, and that once that revenue stream gets going, there is a simple mechanism for calculating payments out to investors. This, in turn, makes the note easier to value via conventional means.
For investors, such a class of stock offers two benefits. One is that it guards against the risk that the business may be successful financially but never go public or be bought out in a meaningful sale. Building a successful, independent business is the goal of many entrepreneurs, yet the current investment paradigm considers that a bad outcome, that it’s not a success until you have an “exit.” This produces a lot of perverse incentives. With Class R stock, an independent company that starts printing money will be paying its investors out to some multiple of their original investment, so they receive their money and then some.
The second benefit is that this class of stock also translates into equity in the company, so if it’s sold or goes public, that equity becomes liquid, making its holders are very happy vs. merely satisfied. That’s a nice outcome to wish for, but statistically less likely.
Incentives need to be aligned so that investors and entrepreneurs are gunning for the same thing — a successful business — whether independent and owner-operated, bought out in an M&A event or taken public. A system like this would treat the equity component of an investment as a long-term speculative investment, while the cash flow component would be more like dividends in a mature company and thus easier to value. It would also turn startup investing from an-all-or-nothing proposition into one of all-or-something. Of course, there will be complete failures, but companies that find some degree of success will also provide some return to their investors. On the downside, it commits a company to sending a percentage of revenues to shareholders instead of just investing them internally, but if it means you can raise money on better terms, it’s worth considering.
What might this look like? Let’s say for rough numbers that a group of angels invest $500,000 for a 10 percent stake in an early-stage company and 5 percent of gross revenues with a 5X cap (total payout: $2.5 million). The company does OK and turns into a nice small business with revenues of $2-$3 million dollars a year. Happy with that, the owners decide not to sell or try to grow much bigger. The investors in this situation will be receiving $100,000-$150,000 per year (off $2-$3 million/year in revenue), which is not a bad annual return, and will get up to $2.5 million over the life of the agreement. In other words, everyone wins — the entrepreneur is rewarded for creating a viable business, and the investors do well without having to force a sale. And they still have 5 percent equity so that if, 20 years later, the founder retires and the company gets bought, they are very happy vs. just merely happy.
This does not, of course, eliminate the risk that the investment is simply bad, but in the middle ground between bankruptcy and an IPO, where millions of small businesses reside, it would provide a return for investors. That compares with today, which finds them stuck, waiting for a big payout that may never come.