What kind of business are you building?

Real Businesses|Revenue-Based Investing

Aug 31, 2019

I hope you’ve had a good summer. I’ve spent some of it wrestling with a conflict in the way I make my living: I help startups to get investment-ready, but I often wish they were bootstrapping instead of going for investment. Because in many cases, it’s either the wrong thing for them to be doing, the wrong timing, or they’re going for the wrong kind of investment.

I’ll get back to that last point. But first I want to talk about the three different kinds of business you can start, and how to make the right choice.

The first is a ’lifestyle business’, which I would define simply as any business aimed at funding your lifestyle without getting a job.

Why would you want to do that? Simple, autonomy: the (relative) freedom to choose what you work on, how you do it, when you do it, with whom and for whom, and how hard you work. Or, as Seth Godin’s put it, you’ve just decided to “pick yourself”:

If you’re hoping that the HR people you sent your resume to are about to pick you, it’s going to be a long wait. Once you understand that there are problems just waiting to be solved, once you realize that you have all the tools and all the permission you need, then opportunities to contribute abound.
No one is going to pick you. Pick yourself.

I’ve run Slingshot Venture Development as a lifestyle business since 2001, and it has served me well. I won’t pretend that it doesn’t have its drawbacks. As with any other kind of startup, your income is precarious and volatile.

But the main problem with lifestyle businesses is that they are difficult to scale, because you are usually working on your own. Which is only a problem if you do need minimum scale to make the business model work, and/or you need investment.

The second type of business you can build is the traditional venture-capital funded startup. But this choice comes at a significant price, not just in terms of the equity you give away, but the loss in autonomy and the increased risk of failure. You lose autonomy not only because you are giving up control, but because you now need to follow your investors’ priority, which is to exit at a huge valuation. As Claire Lew puts it:

The minute you accept money from someone or an institution—be it an angel investor, a venture capital firm, or a bank—their interests inevitably bleed into your interests. Your interests aren’t your interests anymore. And they definitely aren’t your customers’ interests, either.

Which means that you have to significantly increase your risk in two ways: First, they will want you to focus on prioritising growth over profitability in order to build that high-value unicorn:

By nature of venture capital’s business model, a $100m business is considered a failure. Taking 10 years to generate multi-million dollar profits is a failure.

Second, you’re less likely to even get any funding at all—you’ve now given up the chance to “pick yourself” and put yourself back in the “permission” game (According to Bryce Roberts, co-founder of Indie.VC, only 0.6% of founders raise VC).

Real Businesses

It’s been very difficult under this model to build “real businesses” which fall between these two extremes. Meaning businesses that do scale, but ones which want to prioritise profitability over growth, built and managed by founders who don’t want to exit, but want to retain autonomy. As Bryce Roberts puts it:

Real businesses make products and sell them for a profit. They focus on customers, revenue and profitability not investors, valuations and the next fundable milestone. Real businesses prioritize their customer’s needs over their customer’s eyeballs. They have a functioning business model, not a believable financial model. Real businesses want to stay in business, not run for the exit. They create their own source of funding and don’t have to ask anyone for permission to exist.

Revenue-Based Investing

This may now be changing because of the emergence of revenue-based investors, as seen in the US. David Teten has just published an excellent series on this model. Here are a few of key points:

RBI is…designed to replace equity with a patient, flexible, long-term growth funding framework…providing capital that is paid back over time in the form of a modest, fixed percentage of monthly revenue.
Monthly payments equal a set percentage of monthly revenue (typically 1 to 9%). Monthly payments continue until a set dollar amount has been paid back, usually 1.3–2.5X the amount of the financing (this multiple is called the “cap”)

A similar—but different—model has been developed by Earnest Capital:

We invest via Shared Earnings Agreement, a new investment model developed transparently with the community, and designed to align us with founders who want to run a profitable business and never be forced to raise follow-on financing or sell their business.

What these models have in common is that they are designed to allow founders to retain ’optionality’, and focus on building profits instead of exits.

I’ve been asking around to see if anyone is following this model in the UK yet. Unfortunately, I haven’t found any examples. I suspect it’s because of the same reason convertible loans aren’t popular here, namely that it means investors have to forgo the tax-advantages of SEIs and EIS. But if you know of any, please let me know.

If I had huge amounts of capital, I would start something along these lines myself. But I don’t. However, I am close to launching a service to help founders transition from startups to ’real businesses’ with a colleague. Watch this space—and get in touch if you want to hear more.

In the meantime, here’s a list of the best posts to learn more these choices and the emerging funding options for real businesses:

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Paul

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