Addressing the Inflection-Point Funding Gaps

Entrepreneurs familiar with the venture capital model sometimes equate venture capital (VC) funding to a treadmill in that it becomes hard to step off gracefully as funding accelerates.

Seed funding tests a thesis and allows for initial growth. Beyond that, Series A funding begins the scaling process and subsequent rounds fund more and more growth. The catch is that it is hard to step off the “treadmill.” Once entrepreneurs start to spend their Series A funding, they are committing to a high-growth/high-burn strategy, which can result in a spectacular, outsized exit, but often results in the opposite. If the growth doesn’t come, not only can entrepreneurs find themselves on the outside looking in on the companies they founded and nurtured, but both the entrepreneur and their investors might walk away with little to show for their efforts. The difference, though, is that the entrepreneur and other employees have a single shot at success (for at least that point in time), while the VC’s portfolio approach allows multiple zero-return investments to be offset by one 10x return.

This does not mean that VC funding is bad or that companies should avoid it – it can be a very helpful tool for growth, when the path forward is clear, and the market opportunity is massive. However, like any tool, it is important to remember it is best used at a particular time and within the right context. Often, when VC rounds go bad, they are raised either before the size of the target market is clear or before the scope and strategy of the sales opportunity is proven.

Consider a typical growth initiative to expand into Europe. One can lean on prior experience or research to scope the opportunity, but it often isn’t truly known until after expansion initiatives have commenced. Before proving the market scope and market-specific sales strategy, it can be hard for a company to raise venture capital. Sometimes though, VC funding can be raised without proof points, but by their nature they tend to be ill-fitting rounds and they tend to be highly dilutive, as the VC will trade valuation for risk. Moreover, once funds are raised, they are expected to be deployed – usually within 12 to 24 months. If the company must spend this capital before they’ve figured out how to properly invest in the market, they often head down a misguided path that absorbs resources and time, with limited success.

However, though most entrepreneurs are unaware of it, there are a growing number of alternative funding options out there that allow for investment in new growth opportunities, but in a more forgiving (and less costly) manner. These alternatives allow companies to take a more deliberate approach to test, iterate and refine initiatives, prior to acceleration. Once the right path forward is established, the company can choose the best way to fund that next stage of growth.

A New Tool for an Established Market

When most entrepreneurs think about non-dilutive -- or really any non-equity -- financing, they assume their options begin and end with venture debt. However, venture debt investments (at least before a company reaches some level of scale and profitability), are typically add-ons to equity funding rounds that offer a relatively cheap source of financing as an alternative to larger equity commitments. For startups and early growth-stage companies that are in between equity rounds or who haven’t raised much equity – think companies with $2 million to $20 million in revenues –venture debt is not typically an option.

Revenue-based financing (RBF), however, is a new but increasingly available option for growth-stage companies, that allows them to access non-dilutive capital, right-sized for the specific needs of their business and aligned to revenue performance that provides funding ahead of, or entirely in lieu of, an equity round.

Though the RBF market is still small, RBF financings can take several different forms. Some strategies, for instance, specialize in short-term financing for consumer-oriented companies, whereas others target longer-term investments for enterprise software companies. Generally, for the latter, RBF structures tend to be back-end weighted over a long period of time (typically as much as five-years), with returns to lenders typically capped at between 1.5x to 2x the original commitment.

As the name implies, payments are tied to a percentage of company revenues, underscoring the flexibility of the structure and equity-like alignment with growth. As well, certain RBF strategies can allow for multiple tranches of follow-on investments, and in some cases other investment formats such as growth equity. However, warrants aren’t customary, which is the case for most venture debt arrangements.

The upshot for founders is that revenue-based financing allows for a more deliberative approach to expansion before funding “high-growth” initiatives without any evidence the efforts will pan out.

Funding the Proof Points

Revenue-based financing allows founders to effectively “fund the proof point.” If they’re pursuing expansion, for instance, they can demonstrate their ability to sell into the new market. If they’re scaling a team in a new geography, they can show that their recruitment efforts are successful and yielding desired productivity gains. If these initiatives fall flat, the company can simply reassess the strategy and fall back to what was working previously.

In some cases, companies will leverage revenue-based financing at multiple inflection points or even to obviate the need for dilutive investments altogether. For instance, when Riverside Appreciation Capital initially invested in Doctor.com, the funding was designed to help the company begin to sell upmarket. Management had been considering a traditional Series A, but believed with time they would be able to sign on larger clients with stickier engagements. The RBF facility provided capital for the company to invest in early expansion into the enterprise, which did indeed yield significant revenue growth and enhance retention. The company secured a $5 million Series A round several months later, in an efficient fundraise process that resulted in a strong valuation.^[1]

Fast forward three years, and in 2019, Doctor.com was again desiring a fundraise to help with expansion into two new markets. Instead of equity, it secured a $2.5 million RBF arrangement and the subsequent organic growth precluded the need for any additional equity or further dilution. This strategy paid dividends to both management and the pre-existing investor base when the company was sold.

It may go against the conventional wisdom, but a more deliberate approach to navigate key inflection points doesn’t have to translate into slower growth. In fact, when revenue-based financing yields conviction and proves out a given strategy, entrepreneurs can often scale even more quickly, efficiently and with greater potential for success in the long-run.

[1] Doctor.com Closes $5 Million Series A Financing Led by Spring Mountain Capital via prnewswire.com