I don’t mean to pan you with my comment, but I just want to present a couple of points that are wrong in principle with a Class ‘R’stock:

1. When you buy a ‘Class R’stock as you defined it, you are buying a share in revenue. Now, in principle, if you are entitled to a share in revenue, you are a cost to the firm, not an investor. You become one of the creditors of the firm, at the same level as vendors. So, in case, the company goes into liquidation, this is excellent for the so-called investors, because you are going to get your money first. But..

2. Investors are fundamentally different from creditors. They are not providing a service to the firm, but you are in the game for a return on your investment, and as such, it’s wrong for them to be at the same level as a creditor. Of course, one can rewrite the debt covenant to reflect the seniority levels in payment, but investors in a VC-funded firm, and hence a growth oriented firm, as rightly pointed out by some people above, should invest in the risk of the firm as well.

3. Investors in such firms usually look at having some sort of control at the board level to guarantee the future of their investments. Buying an R share would basically place them above the seniormost debt-holders and right below the creditors, which means they would have to logically cede control. In which case, a revenue share cannot translate into equity, as you said. Any banker/analyst looking at this structure would straight away put this in the debt portion of the balance sheet, which increase the gearing of the firm. (In fact, I would put it under Current Liabilities.)

4. This is all disregarding the fact that, a firm not making profits probably has a unwieldy cost structure which needs to be refined, or needs to invest more money into pushing their marketing efforts. If the investors siphon that money away, they are basically going to handicap their investment in the medium-term.

5. And, most importantly (I promise this is my last point), as an equity analyst, I would be very, very, very worried about the governance structure in the firm. In theory, the investors in the Class R stock wouldn’t care a damn, whether the company turns in a profit, as long as the company turns in revenues (above a certain threshold as defined in the covenant.) So, in essence, there is no incentive for the VCs to push the firm to an optimal size, and all they would be concerned is to grab as much marketshare/revenue till they can shove off their toxic asset onto the next donkey, which I am guessing would have a very forbidding cost structure. I don’t know if that’s me, but this sounds horribly similar to the credit crisis we still haven’t emerged from. Using a class R share destroys the relationship between a principal and agent that an equity stake brings about, even though it’s a simple mathematical innovation.

http://wnwek.org/

- 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.

VCs already screw companies with shitty deals, lets not give them any other ideas.

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

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.

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%)?