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[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 […]

[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.

  1. Er, but a company could be turning a huge revenue and still not be profitable. See Facebook. If they were paying investors 5% on revenue they’d be out another $10 or $20m or so per year. Since they aren’t making money they’d have to raise _additional_ funding to pay back the previous investors, which is bad for everyone.

    Wouldn’t it make more sense to pay out a percentage of profits? No one’s going to be “happy” with $2 to $2.5m revenue if expenses are $5m. And we already have a system for paying out a percentage of profits: dividends.

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    1. Exactamundo

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    2. And if you’re going to pay a percentage of profits, you’ll probably want to make it contingent up on BoD approval which starts to smell a lot like any regular Convertible Preferred stock, except that it’ll will actually pay the dividend.

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    3. This sounds like it would incent the kinds of crooked accounting practices that we see today in the movie industry.

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    4. Class P (Ponzi) Stock: One of the oldest class of investments.

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    5. Mike, this is the standard approach, makes absolute sense.

      – If the CO. is operating barebones trying to ramp up revs and not spending much on sales & marketing, then sucking out any gross revenue could be counter productive.

      But on the other hand, when tech companies used to in the good old days spend wads on SG&A without any profit in the pipe, maybe it could make sense to remunerate capital in a way that could be treated like an expense while offsetting ownership rights.

      We all have seen tons of Co’s spend themselves into oblivion while investors and bankers bit their nails… Investors could have a choice: get back some cash at a lower “valuation” with a lesser claim on equity, or wait for pay-day and sit tight.

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  2. There are secondary buyers already in the market why the rush to come up new solutions? Many of these investments are illiquid for a good reason lack of transperncy comes to mind and it usually takes 5-7 years for these to pay off. Most of the inventory that the new “so called exchages” will see are crappy companies.

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  4. Here is a different kind of stock idea – probably not as liquid but oriented towards startups and innovation:

    http://bit.ly/startupfunding

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  5. Agree completely. I’ve been thinking about doing something similar to this for my second tech company i’m about to form, but using debt and warrants b/c i’ve used those before. Probably may not be able to structure as well with those vehicles as what you are describing though. Paying out from profits doesn’t work because you will likely try to reinvest any operating margin you have to continue to grow, so no profits. But you can’t manipulate revenues (well you can, but you know what i mean). An entrepreneur just needs to factor in that cost when pricing their product/service.

    An investor would presumably be giving up the opportunity of getting a higher % stake for the revenue percentage, so if I were them I would want some additional protection in case the company gets sold big, early before revenues were substantial. Maybe a traditional preference payout of this class of 1x or 2x.

    And as an entrepreneur, I would want some mechanism (preferably designed upfront) for investors to pass on taking their revenue payments in return for more stock – for those investors that would rather increase their risk profile. If this vehicle isn’t looked to as a way to buyout investors – which it isn’t – then investors should be able to reinvest their revenue share.

    If in the next few months we do execute a structure like this i’ll update the comments.

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  6. Walking through the math, say that company sells for $10 million the day after the “group of angels invest $500k”. Would the angels get $2.5 MM (5 times $500k) from the acquirer to buy out their Class-R rights, and then the rest of the $10 MM ($7.5 MM) would be divided among all investors?

    If so, the angels would get $2.5 MM + 10% of $7.5 MM ($750k), or $3.2 MM, which is 32% of the $10 MM takeout price. That seems like a lot?

    P.S. In your example, I think they still have 10% equity (not 5%)?

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    1. Bob,

      The revenue share and the equity stake are separate items. In the case you describe, yes, the money is pretty expensive, but the more likely scenario is you slog away for years before you get bought, or not at all. This is especially true of service oriented businesses.

      The example I outline is intentionally simple. In reality, you would have additional provisions, for example, an option to forgo revenue share in leiu of options to increase your equity position, buyback options for company founders, and so forth.

      One thing I like about this is that it forces both sides to think realistically. If you invest $500,000 in a business to obtain 5% of its revenue, you need to see a path toward $2-3 million per year for that to look interesting. While the amount invested, percentages paid out, would vary, comparing the return on this type of investment against other investments is pretty simple. The investor still has significant upside from the equity stake they obtain, but that’s illiquid, so the revenue share will help to compensate for being stuck in an illiquid investment, potentially for years.

      It’s true that this can be expensive, and in an ideal world of course you’d want to reinvest all of your cash flow back into the business, but money always bears some sort of cost, whether it’s interest, dilution, tricky provisions that can result in loss of control, etc.

      Brian McC

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      1. Vested for Growth has invested in NH based companies using a similar deal structure that relies in part on a percentage of future gross revenue (this can be on top of debt or warrants). We call it royalty financing. One benefit we have found is that the Internal Rate of Return (IRR) may be in fact higher than you think given the time value of money. With equity, getting nothing for months and then a payday may not be that dissimilar to getting something the month after you close. Its an easy calcluation to do with excel – @IRR. But this clearly limits the type of businesses we choose to invest in – only those that have significant enough GPM – better than 25% and only those that are established – more than $2 mil in revenue and a good sales pipeline. But it has proven to be an excellent deal structure for later stage companies. Of late I am seeing more angel back deals that want to avoid going the VC route and see royalty financing as the best path for their later stage portfolio companies that are doing well and don’t want to dilute their positions, but need some additional capital for fuel. They may not yet be profitable because they are positioned for growth, but could be if they were forced to reorient…We just closed on such an investment this past month and I see more of this in the future.

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  7. [...] Gigaom recently published a post about a new kind of stock that provides for a return to investors regardless of whether the company has any type of exit.  While interesting, it is a complete waste of time. [...]

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  8. This plan doesn’t make any sense. An investor has a shitty upside.

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  9. Paying a percentage of profits to shareholders… i don’t think this is a very new idea… in large, established companies, this is called a dividend.

    The counterincentive that this creates is the following:

    * startup investors are trying to get homeruns in their portfolios to generate fund returns. a 2x, 3x, 5x is ok.. but not what they’re in the startup investing business for.

    * so taking money out of profits rather than reinvesting that cash into something that could yield that homerun bet is a counter incentive to investors.

    * startups are i would argue sometimes in the same boat, sometimes they’re not. but that’s why FF shares are so interseting.

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  10. [...] Liquidity is top of mind for many Silicon Valley insiders, and that is why we organized this event — to have a frank and in-depth discussion about a topic that we at GigaOM have been and will be talking about for a long time. From closely tracking the ideas proposed by organizations such as the National Venture Captial Association to venture industry insiders such as Paul Kedrosky to the one proposed by serial entrepreneur Brian McConnell earlier today. [...]

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