The capital market for startups has perhaps never been more attractive than it is today. Not only are venture capitalists raising more capital than ever, but new methods of financing startup activity are maturing. The result is a capital market that is increasingly competitive for startup attention, and business, which may lead to better prices for founders and their startups.
Venture debt is not new, but twists on this model are taking new prominence in how startups pay for their growth, for example.
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The expanding value of what young technology companies create could be helping change the market for how they are financed: Many tech startups build software, and the value of software revenues has grown in recent quarters. This means that when startups grow their revenues, they generate more value than in times past. In turn, that bolsters the value of shares in the company more rapidly than in previous market cycles.
Selling equity, then, is more costly than before. That fact may lead to startups not wanting to pursue equity-only transactions when possible. Why? Because if a company can borrow capital at rock-bottom effective rates, it will nearly always prove more inexpensive over the long term than selling shares in its business that have essentially uncapped upside.
TechCrunch held a panel on revenue-based financing at Disrupt the other week, from which we’ve pulled a number of quotes to help frame our thinking around venture capital investment and when startups may want to pursue other methods of funding.
With alternative capital concerns like Pipe attracting top talent while expanding to new markets, and Clearbanc rebranding to Clearco while raising $100 million earlier this year, it’s clear that the market for funds outside of traditional venture checks is maturing. Let’s talk about it.
Not just SaaS
While we tend to view the larger startup market through the prism of software, the recent Warby Parker public offering makes it clear that venture-level returns are possible for companies with a number of business models.
Pipe is a good example of how the model can work. As a business, Pipe provides a marketplace where startups can sell recurring revenues up front for cash, allowing young companies to bulk up their balance sheets without diluting their cap table. When Pipe raised $250 million earlier this year, TechCrunch reported the following:
Over time, Pipe’s platform has evolved to offer non-dilutive capital to non-SaaS companies as well. In fact, 25% of its customers are currently non-SaaS, according to Hurst — a number he expects to climb to over 50% by year’s end.
Examples of the types of businesses now using Pipe’s platform include property management companies, direct-to-consumer companies with subscription products, insurance brokerages, online pharmacies and even sports/entertainment-related organizations, Hurst said.
This model may be attractive to founders that are unable to raise venture capital or want to avoid getting diluted; but other business dynamics can make alternative financing models potentially attractive. E-commerce and DTC businesses that experience revenue seasonality may want to sell some of their future revenues — by percentage share or Pipe model — to cover expenses during leaner months or quarters. Traditional banks and credit cards are the classic options at risk of disruption here, though The Exchange doubts that many will bemoan their lost prominence.
Going global
Provided that the Pipe model continues to scale and generate returns sufficient to continue attracting the amount of buy-side activity that it has thus far, we can presume that startups in an increasing number of geographies will be able to access funds in advance of revenues, lowering their need for venture funding.
Other providers are cropping up as Pipe moves to expand its model to the U.K. Spain, for example, is home to Ritmo, which offers capital to startups on a revenue-share basis. The company expects to grow in both the European and Latin American markets.
Ritmo’s model is slightly different from Pipe’s, more an example of revenue-based financing instead of revenue pre-sales, but the result for growing companies is the same – capital sans dilution. (Notably, Ritmo is also expanding into business analytics tools that help customers manage cash flow; perhaps Ritmo will be able to guide its analytics customers into taking on capital from its financing business.)
There are other examples. Velocity in India, for example, offers up to ₹2 Crore, nearly $270,000 in revenue-based financing to startups.
Happy to compete
Venture capitalists are not too worried about the changing capital landscape. During Disrupt, Accel’s Arun Mathew said he encourages startups to do their own research “on what type of capital is good for which particular stage of the company [they are building], and which particular purpose [they’re] using it for.” If founders pursue all available options, he added, they will wind up with less dilution, and “more leverage over time” that could help keep growth rates high.
Translating that a bit, Mathew is noting that not every stage of startup growth carries the same risk profile. And that when a startup has, to pick an example, generated a material amount of revenues, it is less risky as a business. That opens new doors for the company to raise funds in alternative methods.
In reverse, startups will likely need venture capital and investor guidance the most when they are at their most risky, the seed and Series A stage of life. And less after as they can convert their growing revenue base into cash as needed. This doesn’t mean that startups won’t raise venture capital as they scale. Many still will, in part thanks to VCs paying more money for their shares — rising valuations — and also lowering their ownership targets. That the venture class is willing to pay more for less is in part thanks to the rising value of startup revenues, but also we’d argue a recognition that they have more competition than in previous startup cycles.
Maturing alternative capital sources
If alternative financing is able to compete against venture capital, it’s because it has become more sophisticated than mere venture debt. For instance, Clearco’s co-founder Michele Romanow made it clear during Disrupt that her company signs revenue share agreements, not loans.
“Debt is fundamentally putting more risk on a company: If you take out debt, and you don’t pay your debt holders back, the company is now owned by those debt holders. That’s actually a lot of risk,” Romanow said. “It makes sense when you’re doing things like equipment financing, or you have big physical assets that you can leverage against that asset. But that doesn’t exist in digital companies, like in an e-commerce company, there’s typically no assets in that sort of way.”
Not taking debt is undoubtedly less risky for founders, but how do capital providers de-risk the deal on their side? The answer, as it often happens, is technology. Again, taking Clearco as an example: “We do all of our underwriting based on AI, so we plug into your data sources, we see what kind of business you’re running, we look at your unit economics, and in 20 minutes, we can give you a term sheet.”
As we mentioned earlier, this model works particularly well when there’s product-market fit and predictable revenue. But as prediction abilities advance, we expect to see this type of capital becoming increasingly available to early-stage companies. For instance, Clearco is going after early-stage founders with ClearAngel, providing them with capital and guidance in exchange for a percentage of their future revenue. It would also make sense from a cap table perspective: As Romanow noted, seed investment often ends up being a startup’s most expensive capital.
Going hybrid
Venture capital is high-risk capital, and thus it is expensive. Falling startup risk has simply made some uses of venture capital less efficient, and thus less attractive from a cost/reward perspective. The smartest startups in the future will likely tune their capital intake as they scale, and their own risk profile shifts.
Mathew agrees, saying that the “strongest companies in [the Accel] portfolio broadly use multiple different pools of capital,” adding that in part that’s thanks to “a maturation in the financial services industry geared toward startups.” Agreed.
The venture investor also noted that large companies don’t use a single capital source. Correct. Big companies use shares, revolving credit lines and long-term debts to finance their operations and growth. As startups stay private longer — and thus become more like big companies than ramen-fueled new enterprises — and more capital competes for their attention, perhaps it was inevitable for upstart tech companies to be looking for cheaper capital.
The situation doesn’t worry Mathew, at least, who said the maturing market for startup capital is “a really, really great thing for the ecosystem in general.” More good news for startups? Yes, though at some point even these warm climes will revert to historical norms. And the venture firms of the world will still be on hand to plug any gaps that open up.
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