Participation funding — Win-Win Funding for Young Companies
This time period has been eventful, including attendance at CEO Space and discussions with many companies about the topic of the last two posts: how to raise funds for a young business without 1) giving up a lot of ownership nor 2) burdening the company with a loan having fixed repayment schedule and high rates of interest. We’ve suggested a solution to many companies and they like it. We’re now calling this flexible solution “participation funding” rather than “community-based revenue sharing” as described in the last few posts. This post explains how participation funding is a great solution for most young companies.
Here are the problems we as investors have been addressing: A very young company with little operating history (or a startup with no operating history) has to give up a large percentage of its equity (ownership) to raise the funds needed for growth or expansion. This leaves little additional stock for further rounds of funding. It also reduces the control of the founders. You could end up with a win for the investors, while the company founders lose.
Some early stage technology companies with valuable intellectual property (such as most of those funded by Tech Coast Angels) having great prospects for an IPO or acquisition can take this chance knowing how much the company will be worth in a few years. The problem is, this situation applies to only about 3% of young companies. These are the companies that my professional venture capital friends and sophisticated angel investors prefer.
For the other 97%, I believe a company should prove itself in the market before selling significant amounts of equity. This way, valuation of the company is higher — which means the percentage of the company that is sold for a given amount of investment is much less.
That said, what is the alternative for the 97% of companies who shouldn’t sell much equity early in their history? Traditionally, the answer has been a convertible note. This is a loan which can be converted to stock at a later date, say one to three years down the line. This allows the company to prove itself before it has to put a price on its stock. The problem with convertible notes is that if the investors don’t convert to stock, the company has to pay back the note at a certain specific point in time, plus interest. There may also be hefty interest payments along the way. This may be an unmanageable burden on the company.
Here’s another problem with convertible notes: If the company doesn’t pay the interest and principle on time, the relationship between the company founders and the investors becomes adversarial. Think about what happens if you can’t pay the note back on time. There may be letters from attorneys and lawsuits. In the end, the company may win the battle by making new promises and delaying repaying for a long time but the investors lose. This results in another win-lose or worse a lose-lose relationship. This is not what we seek as investors, nor what company founders really want.
Another more subtle problem with convertible notes is that that investors really don’t have a large incentive to actively help to market and promote the company. They may provide valuable coaching, but not much active help in creating a buzz around the company. This is because the returns from the stock (if the investors choose to convert to stock) is many years in the future if ever. If they don’t convert, the returns from the loan are fixed regardless of how well the company does.
So what’s the answer? As investors, we sought a way of supporting young companies (both startups and young growing companies) that would have the following win-win benefits:
- There’s little sale of company equity until company valuation can support it;
- Founders don’t give up control of their company;
- Payback to investors is flexible – based upon company cash flow rather than a fixed burden;
- There is substantially reduced chance of an adversarial relationship between founders and investors;
- Investors participate in the promotion of the business;
- The relationship between founders and investors is socially enjoyable and adds to their prestige in the community;
- The contribution that founders and investors make is recognized in the community.
For company founders, let me summarize the most significant of these items in different words:
You keep most or all of the ownership of your company while it’s unproven;
Payback to your investors is flexible based on available cashflow;
Your investors have an incentive to actively promote your company and create a buzz for you.
This has all the appearances of a win-win relationship. Let’s turn appearances into reality now.
The way to do this is through the funding method called participation funding. For those of you with financial experience, this is similar to, but not the same as selling “participating preferred stock.” The latter is a traditional solution favored by some venture capital firms when the founders of a young company don’t want to give up as much equity as the VC’s want. The VC’s settle for a lesser amount of equity than they want (in the form of preferred stock) and also require that the company pay back a fixed percentage of the investment each year. To reduce the burden on the company, interest payments can be deferred (resulting in a mouthful of a name — “cumulative participating preferred stock.”) The problem is, this may result in the worst of both a loan and sale of equity. The founders still give up a large part of the ownership while also being burdened with a fixed interest payment.
In contrast, with participation funding, founders and investors are both pleased:
- Investors make a loan to the company rather than purchasing stock (a “participation funding note”);
- The loan repayment to investors is based on some form of cash flow measure — hence the investors are participating in the cash flow;
- Investors get made whole (their principle is paid back) in a few years;
- Investors get a chance to make 2X to 5X on their investment (acceptable for low-risk investments);
- Investors get a chance for a “home run” by converting some of their investment to stock;
- Investors have an incentive to take an active part (to participate) in the promotion and marketing of the company.
To accomplish these goals, the company offers a “participation funding note.” In essence, this is a loan that enables the investors to participate in the company’s cash flow and also participate in the marketing of the company. This is a flexible version of a convertible note. Here are some of the key details:
Unlike a traditional convertible note, the actual loan repayment schedule in a “participation funding note” is highly flexible, with as many variants as there are companies. Repayment can be based on gross revenue, gross profit (revenue minus cost of goods) or operating cash flow (OCF), whatever is needed to create a win-win relationship between company founders and investors. Payment percentage can start out small in years 1 to 3, then grow over time as cash flow grows in year 4 to 6, then shrink again during the last few years of repayment, say years 7 to 10. If repayment is based on revenue, there may be some concern among company founders that repayment will leave no cash for investment in expansion. To address this concern, repayment percentage can be dependent on the company reaching certain revenue targets, or can be computed on revenue above a certain threshhold. The point of all of this flexibility is to allow both company founders and investors to be comfortable and enthusiastic about the repayment plan.
Investment returns are typically capped. Typically companies and investors agree to cap returns at 2X (twice the initial investment) to 5X for more risky companies. Given the reduced risk of a participation funding note, and the enthusiasm investors have for the company, these kinds of returns are normally acceptable and even exciting to the investors.
Investors love a stock kicker — a big win for investors if the company is a real winner in the market. To give investors this home run without selling much stock early in the company’s life, a “participation funding note” will normally have a provision to convert the remaining balance owing at any given time to stock, at the investor’s option, if the stock acquires a value based on a later round of funding. Like a traditional convertible note, there will usually be a discount, so that the early investors can purchase stock at a somewhat lower price than later investors, normally 20% to 30% discount. Everyone gets to win if the company is a winner.
This was not the post to write about how investors can participate in the promotion of the company, nor how the process leads to social engagement between investors and founders, increased prestige, and recognition for everyone’s contribution in the community. I’ll pick up with these topics in a later post.
Key takeaway: If your business in the 97% that cannot afford to give away a large part of your company or is not a candidate for angel or venture funding, then participation funding might make the difference between success and failure. Repayment is base on profitability and the ability to repay without burdening the companies resources.
If you have any questions, feel free to contact me at [email protected]