David Teten
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Of the Inc. 5000 companies, only 6.5% raised money from VCs and 7.7% raised from angels. Where else can fast-growing companies get funding?
More and more startups are pursuing revenue-based VCs, but it’s not a good fit for everyone. A new category of investors has emerged offering a hybrid between VC and revenue-based investment (RBI), which we call “flexible VC.”
From RBI, flexible VCs borrow the ability to reap meaningful returns without demanding founders build for an exit. From traditional equity VC, flexible VC borrows the option to pursue and reap the rewards of an outsized exit. Every flexible VC structure allows founders to access immediate risk capital while preserving exit, growth trajectory and ownership optionality.
Our categorization is not a technical one. Rather, we want to accommodate the wide variety of instruments currently offered by flexible VC investors, detailed below. As two fund managers employing flexible VC, we think it is a healthy addition to the ecosystem and will yield more predictable and stable healthy returns for investors.
Flexible VC 101: Equity meets revenue share
This is currently the most common investment structure: The flexible VC investor purchases either equity ownership, or a convertible right to equity, and a right to regularly scheduled payments based on a percentage of revenues.
By tying payments to actual revenues, founders and investors remain aligned around the company’s real-time performance, good or bad.
“Too often, investment structures force the management team to make decisions between misaligned growth and investment (return) objectives. This structure allows for alignment on the front end, and real-time flexibility for performance metrics,” says Samira Salman, a family office investor and advisor.
Payments are commonly delayed for a grace period of 12-36 months. John Berger, director of Operations and Impact Solutions at Toniic, observed that this has clear investor benefits: “The grace period became a feature because it benefits investors in regions like the U.S. where there can be tax differences between short- and long-term gains. It has moved from its origins as a tax benefit and can be viewed as a feature that benefits founders.” After the grace period, the return payments begin, often lasting until a return cap is hit, such as 2-5 times the original investment.
To account for these revenue share payments, the investor’s ownership (or convertible right to ownership) is simultaneously reduced. Once the return cap is reached, the investor is typically left with a residual stake — a fraction of the pre-revenue share ownership. At any point, should the founder wish to pursue a traditional equity VC round, or get bought, the revenue share is paused, and the investor’s then-current ownership converts to equate to a traditional equity VC investor.
Flexible VC 102: Variations
Flexible VCs have created structures based on other company performance metrics than revenues, such as profits or founder salaries. These different company performance metrics provide a slight variation in how the investor and founder relationship is defined. For example, profit-sharing structures ensure payments do not begin until the company is profitable, though likely delaying returns to the investor and complicating payment calculations.
Similarly, when flexible VC structures are based off of the founder’s own compensation (often via salary or dividends), investors are specifically tying their returns to the financial success of the founder. This translates less directly to company performance compared to a revenue or profit share, but offers uniquely personal alignment. These variations in founder alignment allow flexible VCs to specialize in the types of companies they work with.
The state of flexible VC
In all these cases, capital is provided to fuel forecasted growth without creating a commitment to a particular vision for future funding rounds, exit goals and associated blitzscaling. The founder retains full control over whether they want to optimize for hypergrowth (usually at the expense of profitability) or for organic, profitable growth. Flexible VC opens up a new risk capital option for bootstrappers, minorities, family-owned and countless other founder segments left out by the traditional funding landscape.
A range of small VCs are deploying with flexible VC structures, but we believe the total amount of AUM deployed with this strategy is well under $50 million. Similar to the explosion of seed funds in the past decade, we (and some limited partners too) believe these Flexible VCs are on the forefront of what will become a major segment of the venture ecosystem.
We detail below the major categories of VC:
| Funder category | Equity ownership | Returns primarily based on | Composition of returns | Example VC |
| Equity VC | Yes, typically preferred equity.
15%-20% sold per round. On average, founders own just 43% of equity by Series B, declining thereafter. |
The value ascribed by subsequent investors (in a secondary); buyers (acquisition); or the public markets (IPO). | Volatile, uncapped. | Andressen Horowitz, ff Venture Capital, HOF Capital, Sequoia. |
| Flexible VC: Revenue-based | Yes, nonvoting common shares (if converted).
5%-20% initial stake, with 50%-90% of this redeemable. |
Gross revenues (generally 2%-8%). | 2x-5x return cap + path to uncapped equity returns. | Capacity Capital, Greater Colorado Venture Fund, Indie.VC, Reformation Partners, UP Fund, Versatile VC. |
| Flexible VC: Compensation-based | Yes, via conversion rights at a valuation cap. | “Founder earnings” (Founder salaries + dividends + retained earnings). | 2x-5x return cap + path to uncapped equity returns. | Chisos. |
| Flexible VC: Blended Return | Yes, via conversion rights at a valuation cap. | Profits, founder salaries, and/or dividends declared. | Typically ~3x+ return cap + path to uncapped equity returns. Discretionary dividends and salary share built in. | Collab Capital, Earnest Capital, TinySeed. |
| Revenue-share investing | No. | Gross revenues (generally 2%-8%). | 1.35x-2.2x return cap. | Novel Growth Partners, Lighter Capital, Rev Up, Corl. |
Flexible VC versus other venture capital models
Flexible VC investors offer founders some of the same advantages as equity VCs:
- Aligned incentives. Whether it is a breakout success or complete failure and loss of capital, investors are along for the ride. When the company hits potholes, flexible VC investors usually don’t have the nuclear options of firing management and/or doing a recapitalization. Their only option is to work with management to try to fix the problems.
- Few strings attached. Founders have autonomy to spend the funds in whatever way they like.
- Long-term alignment. Many flexible VCs retain a small residual stake in the company after the return cap is reached, driving alignment well beyond the horizon of the revenue share, similar to the long-term orientation of equity VC.
- Seed-stage compatible. Like traditional equity VC investors, flexible VCs accommodate early-stage investment risk within their portfolios better than a traditional RBI funder.
- Eligible for favorable treatment under qualified small business stock exemption, if structured as equity. This applies if the investment converts into common stock; details are beyond this essay’s scope.
Flexible VCs also offer investors some of the same advantages as RBI:
- Clear return expectations. The return cap is a stated multiple of the investment, typically 2x-5x.
- Early liquidity. Equity VC is a “get rich slow” business. Flexible VC creates early liquidity that can be either reinvested or distributed to LPs.
- Improved financial management. All parties want the company to be able to afford the payment obligations and, ideally, deliver a quick return. As a result, unfounded hockey-stick graphs and unicorn promises give way to financial fluency, realistic expectations, frank conversations about what a business can credibly achieve and transparency.
- Profitability is prioritized. The revenue that is going to grow the company immediately is the same revenue that is going to get investors to their return cap. If the company is profitable, the revenue share becomes increasingly affordable. This drives an earlier focus on profitability than is typical for a company backed by traditional equity VC.
- Founder retains control. Flexible VCs typically purchase nonvoting common stock, if they purchase stock (one even assigns their voting rights to the founders). This keeps the founder in the driver’s seat of the company.
- Attractive to women and underrepresented founders. See Why Are Revenue-Based Investors Investing in Women & Diverse Entrepreneurs?
Flexible VC also offers some unique advantages:
- Straightforward equity interface. If an equity round is needed to fund breakout growth beyond what the flexible VC funds, the mechanics of including a flexible VC in an equity VC round are predetermined and simple.
- Prepared for blitzscaling, but neither required nor expected. Blitzscaling typically means prioritizing user growth over revenue growth and revenue growth over profitability. Tim O’Reilly, CEO, O’Reilly Media, argues, “Blitzscaling isn’t really a recipe for success but rather survivorship bias masquerading as a strategy.” With flexible VC, not every company is expected to achieve breakout growth, but that possibility is accounted for up front.
- Particular application in impact capital. Our research has found that impact investors appear to be particularly interested in flexible VC. An impact investor typically needs some economic return to function, but doesn’t necessarily want the company as a whole to exit, given exits often have a negative impact on the company’s founding mission. Flexible VC allows impact VCs to thread this needle.
That said, nothing is cost-free. The unique disadvantages of flexible VC include:
- Risk of friction between founders and investors. Like any obligation, fixed or flexible, friction can arise if the founder has difficulty making payments. When a traditional-equity-VC-backed company doesn’t meet milestones, the investors may walk away (the most common path), restructure or fire management. However, they don’t usually push the company to pay out cash at a time when the company may be feeling cash-constrained.
- More complex cost of capital calculation. If the company grows profitably or raises another VC round, the return cap gets repaid ahead of schedule. This causes the cost of capital for flexible VC, often calculated through IRR (similar to an interest rate), can be higher than that of venture debt or traditional RBI. Inversely, if the company has slower than predicted growth, the effective cost of capital is automatically lowered. If the company fails, the investor normally gets zero, as in traditional equity VC.
- Co-investor friction risk:
- Earlier investors. Earlier investors come in at a riskier stage and through equity, and may be uncomfortable with a later investor getting any compensation before them.
- Co-investors. Flexible VC terms have not been standardized, which may make the investment harder to syndicate. Most flexible VCs lead rounds and often take 100% of the round to mitigate this risk. That said, Jonathan Bragdon, general partner at Capacity Capital, points out that flexible VC terms “twin” well with equity providing less dilution while still providing investor assistance.
- Later investors. Whether debt or equity, later investors may have varying interpretations of the obligations and ownership rights of a flexible VC.
- Doesn’t fit into traditional VC funds. A traditional VC fund may have difficulty investing via this structure. This is already inciting fund structure innovation from investors.
- Less established regulatory framework.
- Lower level of community familiarity. Zack Mueller, attorney, Ireland Stapleton Pryor & Pascoe, PC, points out that almost “no one, from LPs to entrepreneurs to attorneys, has much experience with these instruments. Generally speaking, uncertainty and unfamiliarity with novel investment structures leads to slow adaptation.”
- Collections risk. Zack Mueller observed, “The key is determining what the flexible VC instrument is [debt, equity, etc.], as that will determine how easy collection is for the investor.”
- Short track record. Marco Cesare Solinas, VC analyst with Blue Future Partners, said, “From the LP perspective, another disadvantage is the lack of track record given the early stage of the concept. It will probably take some time to have valid proof points.”
We have a ways to go before the industry has agreed on a standard template, in the way that traditional equity VCs typically use the NVCA template. Some players have proposed templates:
- Earnest Capital Shared Earnings Agreement v1.3.
- Indie.vc has open-sourced their investment structure, now on version 3.0, which they co-developed with Fenwick & West.
- Santa Clara University shares their demand dividend structure.
- Womble Bond Dickinson has released a white paper on Performance Aligned Stock and a term sheet on Impact Terms.
- (If you are working on any other flexible VC templates, please contact us.)
Emily Campbell of The Campbell Firm PLLC, a New York City law firm, said, “The blended [VC] model has a lot of appeal for entrepreneurs … These types of investment models can allow more of a balance between the entrepreneur’s goals and the investor’s goals.”
Before raising capital, we encourage founders to dig into the nuances between different flexible VC structures. Some firms provide tools to model investment, e.g., Capital’s Cost of Equity estimator; Lighter Capital’s Cost of Capital Calculator; Indie.VC’s Cap Table Comparison Model; 645 Ventures’ cap table simulator; and Bootstrapp.co’s Comprehensive Cost of Capital Calculator. A similar, open-source, highly visual tool focused on VC is Venture Dealr. Another tool is NoteGenie.io.
83% of all entrepreneurs haven’t, and in many cases can’t, raise capital from traditional venture capitalists and banks. We think flexible VC is the solution for many of them.
How to build or invest in a startup without paying capital gains tax
Appendix: Formal comparison of common growth capital sources
We summarize below how flexible VC compares with standard industry practices for traditional equity VC, venture debt and RBI. To oversimplify, we plot flexible VC below on a continuum of increasing risk. That said, John Berger observes, “I can easily make a low-risk, debt-like flexible VC deal, or a high-risk equity-like deal, and I can do it using the same term sheet with different terms. I don’t think the risk continuum story is right. These are more like derivatives — they can be whatever you put them together to be. This is more about having more flexible structuring options to align investor and company interests when those interests are not well-aligned with other structures.” For simplicity, we didn’t include a separate column for convertible notes (e.g., SAFEs) that are intended to become preferred equity anyway.
| —> Individual company bankruptcy risk —-> | ||||
| Traditional equity VC | Flexible VC | Traditional revenue-based investment | Venture debt | |
| Typical business stage | Pre- or post-revenue. | An already proven business model and its already valuable assets. | Typical minimum of one year’s profitability and six-figure revenue. | |
| Typical business model | Years of unprofitable growth with ongoing VC subsidy. | Typically stable, high margins; repeatable sales model; clear path to profitability; and high-growth potential. However, some investors are using these tools in earlier, higher-risk companies. | Profitable or backed by large VC fund. | |
| Governance | Board seat, typically retained until company exit. | Typically promissory note or nonvoting common stock, with covenants. | Hard covenants with potentially strict penalties.
Cash collateral. Soft power (Material Adverse Conditions and investor confidence clauses). |
|
| Minimum requirements | Early-stage: Co-founder with engineering/product background from top-tier university or major technology company.
Growth stage and beyond: clear pathway to outcomes of over $1 billion. |
Clear use of proceeds and roadmap to profitability. | Over $5 million in revenues and two years of profitability is common.
Often requires that founders previously raised venture equity from a top-tier firm within the last six months. |
|
| Founders’ equity | On average, founders own 43% of equity by Series B, and the founders’ stake declines even further thereafter. | Assuming the company does not raise additional equity funding, the founder typically retains the overwhelming majority of equity. | Retain 100%. | |
| Investor and founders’ typical goal | Market share and user growth often prioritized over profitability, leading to a focus on next round optics and unicorn-sized exits in spite of failure risk. | Help enable company to reach profitability and long-term growth and scale, with option to “blitzscale” if appropriate. | Make sure company doesn’t go bankrupt and retains revenue to repay. | |
| Typical industries | Technology-centric businesses. | To date, has been mainly used in technology-centric businesses and impact investing. However, structure is relevant more broadly. | Technology-centric businesses. | |
| Transaction costs | Legal costs typically $5,000-$50,000. | Typically well under $10,000. | ||
| Cost of capital | Often misunderstood as cheap due to unclear return expectations. Cost of VC funding to a unicorn CEO can easily be the equivalent of paying well over 100% annual interest, though no investor return is guaranteed in a company failure scenario. | 20%-30% is a common target IRR for investors. If a company exceeds projected revenues, the effective rate increases. No investor return is guaranteed in a company failure scenario. This does not account for the value of any residual stake investors may retain after full redemption. | Mezzanine lending (a rough comparable) has an 18%-23% required rate of return.
2x in three years or 3x in five years is a common heuristic, equating to 18%-30% interest. |
Asset-backed loans and bank loans have a cost of capital running from 4.3% to 15%. |
| Financial management obligation | Low; a surprising number of Series A/B startups are missing basic financial reporting mechanisms. | Material, as founder usually has ongoing monthly payment obligations. | ||
| Time required to invest | Typically 1-3 months of due diligence. | Typically 2-4 weeks for investors who specialize in these transactions. However, these checks can take longer than venture debt or equity VC, given the lawyers and coinvestors are typically less familiar with them. | 2-6 months. | |
| Investors’ motivation to support founder | Very material, as long as company is seen as having unicorn potential. | Very material, as long as company is alive. | None, as long as company is not bankrupt | |
| Ability to terminate relationship (assuming company has capital) | Expensive, complex and time-consuming | Easy, except for addressing investor’s residual stake if any. | Pre-negotiated buyout option is standard. | Pre-negotiated buyout option is standard. Lenders sometimes take warrants. |
| Repayment schedule | None. | Flexible, contingent on company financial performance, and when relevant, residual equity upside. | Fixed. | |
| Impact on personal credit score | None. | None. | Yes (can be positive or negative) | |
| Downside risk | Lose control of your company. | Commitment to investor payments, proportionate to company performance, for several years. | Lose your house, burn your credit score. | |
| Personal guarantees | None. | None. John Berger observed, “In many countries (like the U.S.) you can’t force a board to make a redemption payment or dividend. So in deals that require them, I am seeing, and recommending, that the investor take entrepreneur stock as collateral to enforce performance. I expect we will see more of this because the enforceability of many of the structures have not been tested in courts.” | Sometimes. Typically 675+ credit score required. | |
| Diversity | Funds founders who are 94.8% white or Asian, and 89.9% male. | Attractive to women and underrepresented minorities (See Why Are Revenue-Based Investors Investing in Women & Diverse Entrepreneurs?). | Inherently poor, as many venture debt deals are predicated on prior venture capital funding. | |
| Investable universe | Only 0.5% of startups raise VC. | Can accommodate traditional VC-backable companies, as well as companies that plan to grow profitably. | Inaccessible to great majority of early-stage companies. | |
Further reading:
- The Evolution of Entrepreneurial Finance: A New Typology
- Impact Terms: Emergence of New Capital Providers — Exploring Alternatives to Traditional Expectations and Structures
- Vocabulary for the New Risk Capital Landscape
- Series: Overview of Revenue-Based Investing
- Fundraising Hacks: What type of capital should you raise, and how do you meet investors?
Thanks to Leeor Baskin, Google; John Berger, director of Operations & Impact Solutions, Toniic; Jonathan Bragdon, general partner, Capacity Capital; Emily Campbell, Esq., of The Campbell Firm PLLC; Keith Harrington, co-founder/managing director, Novel Growth Partners; Brian Mikulencak, tax alchemist at Blue Dot Advocates; Samira Salman, CEO, Salman Solutions; Zachary Mueller, attorney, Ireland Stapleton Pryor & Pascoe, PC; Pam Rothenberg, attorney, Womble Bond Dickinson; and Mark Newberg, president, Stockbridge Advisors for thoughtful comments.
Disclosures: Blue Future Partners is a member of the Advisory Board of ff Venture Capital, where David Teten was formerly a partner. David Teten was also formerly a managing partner at HOF Capital. Emily Campbell has provided legal services to David in the past.
Revenue-based financing: The next step for private equity and early-stage investment
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