Equity-only investing hurts both VCs and startups

To back transformative innovators, early stage investors will need to start innovating too. Despite its popularity, the equity-only strategy, on average, disappoints.

The common line of thinking in the venture world is that it’s OK if seven out of 10 of my companies fail, as long as one or two home runs deliver a multiple of the whole fund. Those long-shot outcomes are so rare, though, that as the Kauffman Foundation found in a 2012 report titled “We Have Met The Enemy… And He Is Us”, the average VC fund in their survey failed to return even investor capital, after taking fees.

This equity-as-the-only-option approach can also be bad for companies  —  and therefore bad for innovation. When an investor has an equity stake in a company, they have massive incentive for that company to reach substantial scale as quickly as possible. This “growth at all costs” mentality has led lots of startups to forsake reliable unit economics, or real business models that could get them on a path to sustainable growth and long-term profitability, for the sake of meeting the required user metrics required for their next round of funding.

Put another way: Picture a steady, stable company that is growing predictably and focused on unit economics to achieve profitability but is not reaching 5x, 10x, or 20x annual growth rates. That company is going to get a lot of pressure from investors if it’s not poised to attract a buyer within five to seven years or to go public within 10. But steady, stable, profitable companies are good for our economy  —  and are great for the founders that start them and the investors that choose to back them.

Making things worse, alternatives to equity have become scarcer for many young companies. The default option if you need to raise money for a steady-growth company has always been debt  —  getting a loan. But traditional debt has been harder to secure in recent years, particularly for early-stage ventures that still have a fair amount of risk. Small business loans as a percentage of total bank lending have dropped 50 percent over the last 20 years.

A reliance on equity limits investors’ choices to a narrowly defined growth profile  —  and causes them to miss out on non-traditional, but still high-potential, companies. Rather than executing the traditional “all or nothing” VC strategy, investment firms and entrepreneurs should explore non-equity structures such as revenue share agreements or flexible debt.

Revenue sharing helps companies trapped in no-man’s land

To demonstrate the efficacy of alternative investment strategies, I’d like to talk about a company called Spensa Technologies, a precision agriculture company in Indiana. When we first worked with them, equity wasn’t a great fit for them: they were primarily a hardware company (with enabling software) and didn’t initially forecast the 20X growth and a visible exit target that investors require. They were going through early customer validation and market development, so a loan didn’t make sense for their business either. They were among a growing class of successful, well-run companies that were in a no-man’s land for funding.

Rather than leave this company in purgatory, we were able to work out a revenue sharing deal structure that gave the CEO runway to build the business and gave us a small percentage of Spensa’s revenue once they passed specific milestones ahead of our projections. They repaid our initial investment faster than we had underwritten, and as their model shifted towards a software business with a faster growth trajectory and higher margins, we were glad to participate in their Series A and subsequent rounds.

If you’re not sure if your business is a good fit for venture funding – don’t rush to take it. There are lots of paths to growth, and different types of capital along the way.

Flexible debt works for young startups

Outside of the U.S., we’ve also found flexible debt to be an effective tool for companies that share some of the hesitations around equity but may not yet have the track record that would get them affordable debt locally. This flexibility has included interest triggers based on company performance or a set period of time after our initial investment, prepayment options to account for fluctuations in exchange rates, and not requiring excessive collateral or personal recourse.

The fact of the matter is that taking an equity-only strategy significantly narrows the field of vision for a venture capital firm’s pipeline. There are huge numbers of undiscovered and overlooked, high-potential companies in need of capital. They may be too early for traditional debt but have growth prospects that could deliver attractive returns if appropriately capitalized. We often talk about innovation in venture capital in the context of new and transformative products and services. But as those of us in the investment community branch out to overlooked places and under-capitalized industries, we need to innovate in structures and processes ourselves.

Victoria Fram is Managing Director at Village Capital.

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