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As I’ve written before, I’m very interested in revenue-based financing. I’m currently interested in two very different deals where RBF is on the table. There’s also been an uptick in interest in the model from several of may angel colleagues who have previously only invested on the classic Angel/VC equity model. I thought it would be worthwhile to write down my observations from having worked some concrete examples of RBF deals, though I have not yet made any investments on this basis.

At the suggestion of my colleague at Walnut, Jay Batson, I’ve been working with the paperwork (v3) from indie.vc. Not liking to reinvent the wheel, I plan to adopt this as my preferred RBF instrument for any deals I lead. Indie.vc claims to have developed this version with careful attention to tax consequences, in particular. I think this is a fine framework, but there are some insights I’d like to share.

Before I get into those details, though, here are some high-level observations about the RBF model:

• It really is different from the equity investment model: some colleagues wonder why one would chase a 3x return instead of the 10x to 100x we’re trying to find now. The counterargument is that in our traditional model we expect between 60% and 80% of our portfolio to never return any money. In RBF, if we’re doing it right, we identify companies that are much less likely to fail, so the eventual IRR will be similar. See the final point below for a bit more color on this.
• You don’t need a huge portfolio: if the premise is correct that the failure rate is much lower when using the RBF model to find and fund companies, then one does not need a huge portfolio in order to see the desired rate of return. One could easily imagine a successful portfolio with just a few companies. For a fund looking at RBF as its investment vehicle, this means that the fund size can be a good deal smaller and still be effective.
• You don’t need to reserve follow-on capital: one of the fundamental premises of RBF is that the company becomes profitable very quickly and can begin the investor payback period early. If this is the case, additional funding becomes a choice the company can make on its own time and its own terms. Because of the convertible nature of the RBF instrument, the early investors can ride along, or can be bought out by the company, as appropriate.
• You still need to really like the company and founders: this can’t be stressed enough, not every company is appropriate for funding, RBF or equity! One complaint I’ve heard about RBF is that early sales are often misleading and can’t be scaled. In selecting a company to fund one must look to see whether it has a repeatable, sustainable process. No amount of funding will help if they have not demonstrated an ability to execute well. You’ve got to love the founding team, and see that they have demonstrated the ability to make sales and build the business fundamentals in every way, preferably through adversity as well as when things are running smoothly. As for scalability, one should again recognize that the rate of growth expected can be much smaller for an RBF company than if they’ve taken equity, so some of the risk of failure and of revenue gaps associated with chasing the growth grail will be greatly reduced.

Now back to indie.vc. One way to think of this framework is that it’s a convertible note that gets bought back over time based on top-line company revenues. The contract can convert to equity based on a preferred equity raise of a trigger amount, and the price of the conversion is fixed at the outset.

As an example, a company might accept $500K for a 10% stake, with an investment buyback of 3x the investment, payments beginning after 24 months at the rate of 5%. A preferred equity raise of $1M would convert the RBF investment immediately. These are just example terms. Each deal will have its own parameters. Note that the percentage stake and investment amount imply pre- and post-money valuation.

First, I want to say that if things go forward as an investment payback, these terms work fine for me — we can negotiate all the terms so that investors and founders are happy with the prospects and, assuming the company performs reasonably, there’s a good outcome all around: investors make a healthy return, and the founders are left in control of their company’s destiny.

It’s the conversion that raises concerns for me. The way the paperwork is written, the conversion is at an established valuation. Should the company for some reason take money at a lower valuation, the RBF investors convert automatically to the round at their original valuation, a down round for them. To my mind this is a bit of a rude result: the company is growing faster than expected, so the original investors get extra dilution when a new equity investor agrees.

So if the conversion trigger is too small, or the ownership percentage is too small, should the company land a small equity round, the RBF investors will find themselves in the unenviable position of having invested in a really bad convertible note. 

Now this could just be considered a down round, they happen all the time. But there are cases where company management thinks they’ve got a rocket, but the investors convince them to raise through RBF. If the founders have not bought in entirely, and treat the RBF as a regular convertible note seed round, then go out shopping for an equity deal, they may well find one at a lower valuation than the RBF set, and they might be perfectly happy taking it. They would say that it isn’t a down round, just a conversion of an earlier investment by less-than-savvy investors, no problem.

When I get involved with a deal I don’t like to set up situations where the early investors' and the founders’ interests are not aligned as much as possible. By setting too high a valuation or too low a trigger, it’s too easy to encourage a dilutive funding, so I’m pretty sure it would happen sometimes. It’s really easy to solve either by adjusting the ownership percentage, the conversion trigger, or both. The basic RBF economics remain intact either way, but the equity round only comes in when the company has shown truly significant growth and has clearly exceeded the RBF nominal valuation. 

I should mention that I’ve heard that indie.vc does, in fact, set their trigger level quite high to avoid this issue.