99% of the brands in our industry are not suited for traditional venture capital financing. Yet, repeatedly, founders show up to investor meetings hat in hand with structures and terms that necessitate an exit to monetize the investment. Most get a no, and the few that get a yes find themselves accelerating forward in a way they did not intend.
Traditional venture capital is all about the grand slam. One or two investments return the lion’s share of a fund. A venture capitalist expects exponential growth, game-changing potential, and true disruption.
Most founders can’t offer that, and this is where we, as an industry, go wrong. Either we fund brands and demand exponential growth when it is unlikely they have that potential, or we fail to fund them. Both are bad for our industry, and this should not be a zero-sum game.
Don’t get me wrong—venture capital plays an essential role. We need funders and founders willing to bet big. But for the 99% of those who don’t fit that big bet model, we need a funding mechanism that allows entrepreneurs to build great brands and businesses.
Most emerging brands don’t have access to commercial banks, a situation that is likely to be exacerbated by recent developments. Asset-based lending is an excellent way to fund working capital. However, it is often out of reach for early-stage startups that have yet to build the needed inventory and receivables to make ABL viable for both the funder and founder. Impact investors, venture debt, and grants are options but often hard to come by.
There is an alternative way—one that leverages structured exits to create self-liquidating investments. Structured exits are risk capital agreements with a specific achievable plan for how investors will receive their return, such as variable-based payments such as percent of revenue or COGS or profit sharing, dividends, or other payment types.
One example is the CARE (COGS Agreement Retaining Equity) we developed and offer as an open-source template. The founder and funder agree to an investment amount, a return expressed as the COGS payment cap, and a percentage of COGS. Each quarter payment is made based on the agreed-upon rate of COGS, which is repeated until the COGS payment cap is reached. Each quarter the investor benefits from cash flow and takes risk off the table. The CARE does include a Warrant provision allowing the investor to participate in any additional potential upside. However, an exit is optional for the investor to see a return.
Other options include redeemable equity or variable-based convertible notes. The investor purchases redeemable equity shares, and the founder can repurchase an agreed-upon percentage at a specific multiple or price. Repurchase payments are scheduled or variable-based, such as a percentage or revenue, COGS, or EBITDA.
The typical convertible note structure requires at least two third-party transactions. The first is “qualified financing,” a priced round of a specific size that triggers the conversion of the note. A second is a liquidity event, an exit. A variable-rate convertible note does not require either but allows for both. The founder and funder agree to an investment amount and a return expressed as the total obligation. For example, a funder invests $250,000 at a 2X multiple, making the total obligation $500,000. Again, using a variable-based payment such as a percentage of revenue, COGS, or EBITDA, payments are made monthly or quarterly and continue until the obligation is met. However, if “qualified financing” occurs while the note remains open, the funder can choose to convert the remaining obligation into equity.
I offer the above as fodder for deeper exploration and discussion. My real purpose is to encourage us as an industry to better align the structure and terms of investment with the 99% of brands that don’t fit the traditional venture capital model.
Many founders are attempting to build great brands and good businesses. Let’s fund them in a way that makes sense and stop trying to put rocket fuel into Toyotas.
