‘VC is Broken’, Royalty Based Finance and ‘Class R’ Stock

Since last fall’s economic downturn, dozens of pundits of various stripes have announced the death of venture capital as an asset class. And it’s true (as Paul Kedrosky and the Kauffman Foundation have convincingly argued) that the class is grossly overcapitalized and will have to shrink radically to produce the kinds of returns investors rightfully demand for the type of risk being taken.

But if you look beyond the billion-dollar funds and their challenges, the early-stage investment environment isn’t just surviving, it’s thriving. Checks are being written, great new companies are getting funded, and entrepreneurs are getting the cash and support they need to grow.

Perhaps most exciting, with the persistent drought in public offerings and an equally sharp slowdown in corporate M&A activity, new investment methods are emerging that better align the interests of entrepreneurs and early-stage investors around the core metrics of success for any real business: revenue and operating margins.

A few weeks back a friend shared a recent HBS paper by Clayton Christensen (among others), applying his “disruptive innovation” framework to the venture capital business. Most of the paper covered the familiar ground of overcapitalization in a context of declining costs of technological innovation. But the part that caught our attention was the description of Royalty Based Financing (RBF), with the specific example of a firm called Royalty Capital Management, created in 1992 by an investor named Arthur Fox. In its simplest form, RBF is secured lending, but rather than requiring a fixed coupon and repayment period, the lender obtains a claim on a fixed percentage of gross revenues until an agreed-upon multiple of invested capital (typically 3 – 5x) is returned. RBF investors trade steeper default, timing and rate of return risk for richer potential returns than those offered by traditional business lending.

Just today, GigaOm ran a thought piece by Brian McConnell titled “Class R (Revenue) Stock: A New Class of Investment” that essentially reprises the strategy practiced by Royalty Capital, but with a hybrid debt-equity model geared to earlier-stage bets than traditional RBF lenders would typically take on:

“Let’s say for rough numbers that a group of angels invest $500,000 for a 10 percent stake in an early-stage company and 5 percent of gross revenues with a 5X cap (total payout: $2.5 million). The company does OK and turns into a nice small business with revenues of $2-$3 million dollars a year. Happy with that, the owners decide not to sell or try to grow much bigger. The investors in this situation will be receiving $100,000-$150,000 per year (off $2-$3 million/year in revenue), which is not a bad annual return, and will get up to $2.5 million over the life of the agreement. In other words, everyone wins — the entrepreneur is rewarded for creating a viable business, and the investors do well without having to force a sale.”

The innovation here lies in bringing the RBF approach to riskier, earlier-stage investing, where investors retain an equity position as an option on a future liquidity event, while receiving a portion of the expected return in the form of cash flows. And the fact is, most well-run businesses look more like the firm in this example – growing, profitable, but not a shoot-the-moon success – than like the Google and Amazon.com rocket rides that the traditional venture industry is geared around.

We haven’t yet done a deal like this at Founders Co-op, but we’re trying it on for size, and – at least for some of our investments – this model may wind up being a better fit than the traditional venture approach. Most of all, we love the idea of breaking the mold in our industry – early-stage investing – in the same way we hope our companies shake up the status quo in theirs.