Between banks and venture capital, some start-ups look to a pay-as-you-go model

Courtesy of Laloo’s - Laura Howard-Gayeton of Petaluma, Calif., sought revenue-based financing in order to catch up on orders for her goat-milk ice cream last spring.

For the owners of Laloo’s ice cream company in Petaluma, Calif., business was sweet in early 2011. The five-year-old company had recently secured a major customer in Whole Foods, giving Laloo’s a chance to become one of the country’s few nationwide boutique ice-cream brands.

There was just one problem: Laloo’s makes its ice cream with goat milk, and goats produce less milk in springtime — which also happens to be when grocery stores order inventory for the summer ice-cream season.

“We get five times the orders coming in, and our cash flow is low because we’re coming off our lowest selling point, which is winter,” owner Laura Howard-Gayeton said. “Last year, we realized we really needed a line of credit to draw on.”

To fill the need, Laloo’s turned to Lighter Capital, a firm that provides a type of start-up funding known as revenue-based financing. The arrangement falls somewhere between traditional bank loans and venture capital: A firm invests a few hundred-thousand or million dollars into a start-up, and the start-up pays it back from its monthly earnings rather than through an IPO or exit.

Howard-Gayeton said that her bank viewed Laloo’s as too much of a risk and that she didn’t have time to wait for a Small Business Administration loan to process.

“While it’s not the cheapest money we could ever borrow,” she said, “for us, Lighter Capital was the most nimble, pain-free experience.”

Lighter is one of about a hundred groups in the recently formed Revenue Capital Association. These firms tend to invest in businesses that venture capitalists and angels pass up, and that don’t qualify for — or don’t want — a bank loan.

Jeff Schrock, the managing director of Seattle’s Union Bay Capital and a board member of the association, said the difference between his organization and a venture capital firm is, roughly, that the latter invests in a company or team, while a revenue-based firm invests in a product.

“If you have a great product that has attractive unit-level economics, it works,” he said. “We are trying to grow businesses that are overlooked by capital markets — the hundreds of other gazelles in the herd that are fantastic businesses. There are a lot more of those than there are Googles and LinkedIns.”

Between bank loans, equity

Gavino Morin, a founder of Hellfire Games in Austin, got a green light from Sony in 2010 to develop a new game and needed a fast, large influx of cash to hire programmers. He was hesitant to pursue a bank loan with fixed payments, however, because video game revenue can fluctuate. Instead, he went with Next Step Capital Partners, an Austin revenue-based financing firm.

Like other entrepreneurs, Morin was attracted to the system because a revenue-based firm wouldn’t ask him to give away shares of his company.

“This way, we don’t give up equity in the company,” he said, “and when it’s based on revenue, you build a lot more flexibility into your payment system.”

In general, businesses backed by the arrangement pay a pre-determined percentage of their revenue — 3 to 5 percent, for example — to the investor until the entire principal is repaid, plus a return. The returns vary but are almost always higher than those of a typical bank loan: Lighter Capital, which makes investments of $100 to $250,000, said its return is usually 18 to 20 percent, but Schrock said he has seen returns of up to four times the original investment.

“Clearly, if the company could go get a bank loan, they would do so,” said Dan Keelan from Next Step. “But a bank is looking for three years of profits. We’re just looking for ‘profitable.’ We look at it on a prospective rather than retrospective basis.”

In another departure from many banks, most of these firms don’t ask for personal guarantees, which means entrepreneurs don’t risk losing homes or personal assets if the company fails to make money. However, many revenue-based firms do say they’ll attempt to recover their investment by taking over what’s left of the business assets if the company goes under.

In the past, films, albums and new pharmaceutical developments have been the types of enterprises that sought revenue-based financing, but the model is beginning to gain traction among start-ups, as well. Patrick FitzGerald, a professor of entrepreneurship at the University of Pennsylvania’s Wharton School of Business, says that’s partly because less-experienced entrepreneurs have trouble showing the kind of reliable track record banks need to make loans.

That, combined with banks’ general post-recession tentativeness, made for an opening in the investment marketplace.

“Revenue-based financing ebbs and flows with banking numbers,” FitzGerald said. “Banks right now are insanely reluctant to give out money, and when you have a dead end, someone has to provide an open road.”

A few cons

Of course, the revenue-based model, like bank lending and equity, has its drawbacks. For investors, the returns are relatively modest compared with those a venture capital firm might see with a high-flying portfolio company.

“There’s no public offering at the end of the rainbow in revenue-based financing,” FitzGerald said. “If everything works out well, people still get paid, but not overwhelmingly so, so it’s not as sexy.”

Several firms said they have successfully served as co-investors alongside a venture capital firm. However, some analysts say the addition of a revenue-based financier to the investment mix might not sit well with other investors because the revenue-based firm gets paid out first.

“My experience is that equity investors in a start-up like to see everyone similarly situated so that no one gets a priority return over the investors,” said Jonathan Aberman, managing director of Amplifier Ventures in McLean and co-chair of Startup Virginia. “Where companies are more mature or able to operate without equity investors, revenue-based lending could work well. But I think that the circumstances where it will work are limited, and entrepreneurs should be careful in how its use shapes future financing plans.”

Another downside is that as they pay investors back, entrepreneurs have less capital to reinvest in their company.

“Any kind of really, really high-growth company where the business model is predicated on rapidly acquiring market share requires substantial reinvestment in the business,” said Jay Kesten, a law professor at Florida State University. “If the success of the company depends on rapid expansion, paying back their revenue might hurt their plans.”

For Howard-Gayeton, at least, the critical factor was rapid access to capital, not rapid growth: When she recently got another big customer, she said, Lighter gave her an additional sum on top of the first investment — within a day.

“Having that kind of relationship is really important,” she said. “We don’t have the manpower to be pushing a lot of paper around.”

The numbers on revenue-based financing

3-5%

About how much of their revenue companies that use revenue-based financing have to pay their investors

$100-250,000

About how much Lighter Capital typically loans to companies in need of revenue-based financing

20%

Lighter Capital’s usual return on investment

 
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