October 26, 2020

Who will invest in your startup? [Part2]

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October 26, 2020
By Brad Furber

It’s possible you’ve already attracted funding. Now, however, you are widening your search to some of the more sophisticated players within the venture finance ecosystem. What are some of the later stage, less dilutive and innovative opportunities that exist to help you extend your runway and get access to the capital you really need to grow and scale your venture?

Traditional Venture Capital Firms 

With the emergence of more and more angel, super angel and micro-VC firms participating in the pre-seed and seed stage financings, more traditional VC firms have shifted their investment focus further up the capital structure to Series A and beyond. These traditional VCs are institutional money – limited partner investors, with general partners compensated through a management fee and carried interest.  These firms invest other people's money, and are simply another type of fund manager, specifically, an alternative asset manager.

With the rise of tech startup ecosystems in many different cities and countries around the world, more and more traditional VCs are comfortable operating beyond their home base. The result is that more international deals are getting done with a partnership between traditional VC players providing growth capital, with a combination of FFF, angels, accelerators, micro VC and other sources of funding providing pre-seed and seed stage capital.

In addition, the total value of funds raised by VC firms has been increasing rapidly over the past decade.  In Europe, for example, the total value of funds raised increased by 4X from 3.5 Billion Euros in 2010 to 14.8 Billion Euros in 2019.  The average VC deal size worldwide has increased from $2.2 Million in 2012 to $8 Million for early stage VCs in 2019, and from $5.9 Million in 2012 to $10.3 Million for later stage VCs in 2019, respectively.

In the current market, outside of certain industries such as biotech, companies that do not already have product/market fit and are not already at a point where they are legitimately growing and scaling with a proven business model are unlikely to fit the investment parameters of, or attract capital from, most traditional VC firms.

Corporate Innovation Units and Corporate Venture Capital 

Another important player in the innovation ecosystem are corporate innovation units and corporate VC (aka “CVC”) funds. Corporations have learned the hard way that at any given time there is likely more than one startup somewhere in the world that has the potential to significantly disrupt their business model or make them irrelevant.  Accordingly, corporations want to monitor and engage within the startup ecosystem, generally more for offensive and defensive strategic reasons than purely financial return on invested capital.

One of the ways corporations can engage with startups is to set up innovation challenges with prize money for entrepreneurs and companies to collaborate and co-create new products, services or business models. Another way corporations engage is by sponsoring one or more internal or external business accelerators.  Finally, some corporations have taken the initiative to utilize corporate funds to invest directly in external startups.  This may be directly from the corporation’s balance sheet or through a dedicated entity or fund. (Note that CVC is not an investment made through an external fund managed by a third party.)  In addition to providing capital in exchange for an equity stake, the corporation may also provide some form of expertise or distribution capability with a view towards gaining a specific competitive advantage.  Whether it is through a corporation innovation unit or corporate VC fund, the basic objective is to engage in structural collaborations with external ventures or parties to drive mutual growth.  It also provides corporations with strategic corporate intelligence and insights in areas of interest and concern, particularly regarding transformative, disruptive and even incremental innovations.

Corporate innovation units and CVC are important players that can be extremely valuable to startups and the startup ecosystem generally. On the other hand, these initiatives can be difficult to staff, manage and measure, which can lead to unintended consequences for startups if not structured and managed correctly.

Venture Debt and Venture Lending

Venture debt or venture lending is a type of debt financing provided to venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses, such as purchasing equipment. Unlike traditional bank lending, venture debt is available to startups and growth companies that do not have positive cash flows or significant assets to use as collateral. To compensate for the higher risk of default, venture debt and venture lending providers frequently request warrants (rights to purchase equity).  This can be a great source of capital to extend runway and finance growth while minimizing equity dilution.

Revenue-Based Financing and Royalty-Based Financing

Revenue-based financing and royalty-based financing (“RBF”) is another way for startups to attract upfront capital in exchange for a fixed percentage of ongoing gross revenues, measured as daily, monthly or quarterly revenue.  The returns to the investor usually continue until the initial capital amount, plus some multiple or “cap”, is repaid.  Note that RBF is different than “factoring”, which is another type of finance where a business sells its accounts receivable (i.e., invoices) to a third party (aka “factor”) at a discount.  In general, RBF typically does not require any collateral or personal guarantee, but in some cases may require an equity based kicker in the form of a warrant.  For startups with software as a service (“SAAS”) and other predictable recurring revenue business models, RBF is another great source of capital to extend runway and finance growth while minimizing equity dilution.

Innovations in Venture Finance - ICOs and STOs

The most interesting and most innovative form of venture finance over the last three or four years is clearly tokens. Most people know about Bitcoin. There was a bit of a mania from 2015 through the summer of 2018 in this token space, when over $20 Billion was raised through “Initial Coin Offerings” or “ICOs”.

In an ICO, a quantity of cryptocurrency is sold in the form of "tokens" ("coins") to investors in exchange for legal tender (aka “fiat currency”) or more established coins/cryptocurrencies such as Bitcoin or Ethereum.  The tokens are promoted as future functional units of currency if or when the ICO's funding goal is met and the project successfully launches.  The value to the holder of the token is generally access to some kind of benefit, such as "With this coin you can get access to cloud storage or you can get access to some other utility." These benefits are somewhat like airline points or gift cards.  In addition to the benefit/utility, the token offers potential upside in the form of token value appreciation.  Many ICOs were marketed and sold in a manner that did not comply with applicable securities laws (i.e., as “speculative investment contracts”), and there have been a number of very high profile scams and failures, not to mention hundreds of lawsuits brought by private parties and securities regulators all over the world (and especially in the USA). 

In the wake of the ICO boom and bust, since late 2018 there has been growing interest by more reputable players in “Securities Token Offerings” or “STOs”.  An STO is a type of public offering in which tokenized digital securities (i.e., “security tokens”) are sold on cryptocurrency exchanges or security token exchanges.  STOs are generally built upon a blockchain virtual ledger system to store and validate token transactions.  Such tokens can be backed by almost any type of asset.  It could be a hard asset. It could be a share certificate. It could be art. It could be real estate. There's really no end to things that could be tokenized, but in the case of a security token, it need not have any utility other than the fact that it represents an investment.  In other words, it may have a utility but that is not a requirement. 

There are many different regulatory approaches being developed and implemented globally with a view towards attracting companies and capital, and at present there is still a great deal of regulatory uncertainty surrounding ICOs, STOs and the like.  With the ICO boom and bust now almost two years in the rear view mirror, I believe the STO will continue to emerge as a safe and trusted way for innovative founders and funders to raise risk capital efficiently and at scale.  It’s definitely “one to watch” going forward.  

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Brad Furber

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About the Author

Founder of Aery Advisors Seed Investor, Company Advisor, Entrepreneur, Lawyer

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