Renowned author and Harvard Business School professor, Clayton Christensen, recently sat down with Mark Suster for an interview at Startup Grind 2013. Around 19 minutes into the interview Suster brings up the topic of disruption of Venture Capital. Christensen mentions a form of investing which he believes will be “disruptive”. It is significant to understand how he uses the word disruptive, because it can be applied in various formats. Christensen developed the theory of disruptive innovation, which is the primary topic of his influential book, The Innovator’s Dilemma. According to his website, disruptive innovation “describes a process by which a product or service takes root initially in simple applications at the bottom of a market and then relentlessly moves up market, eventually displacing established competitors.” Examples are cell phones disrupting the landline market, and personal computers disrupting the original mainframe mammoth computers.
Christensen explains that he has seen a new idea surface that has the potential to disrupt traditional Venture Capital. He explains that certain situations require more creative types of capital. For instance, when there isn’t a likely liquidity event for a company, traditional Venture Capital isn’t going to be interested. He uses the designation “royalty capital” as he explains a form of investing in which capital is repaid in proportion to revenue. When a predefined cap is met, the investment cycle is complete. There is no equity dilution of the company, and there is no requirement for a liquidity event. GSD capital refers to this concept as Revenue-Based Financing (RBF). His explanation is slightly different from RBF, however the core principles remain. Christensen highlights the primary benefits of this model:
• Flexible in payment (% of monthly revenue)
• Cap on repayment
• No equity dilution
• Interest paid with pre-tax dollars
Christensen merely gives a brief overview before moving on to the next topic. Yet there is much more to RBF than what he’s described. As highlighted in a recent article by the Kauffman Foundation, Six Myths About Venture Capital Offer Dose of Reality, the VC fund structure, fund life, and economic terms have remained the same for more than 20 years. That same report also reminds us that VC financing is the exception, not the norm, for startups. Historically, less than 1% of U.S. companies have raised capital from VCs. RBF can better serve a selection of the 1% with a better aligned investment structure. RBF also offers a solution for the 99% that are struggling to find the right capital structure to meet the needs of their businesses.
The timing is right for RBF. Startups are monetizing faster than ever, the 2012 Halo Report states, “63% of 2012 angel group deals were in companies with revenue”. It’s unknown how many of those companies would better served by RBF, but I would speculate a reasonable percentage.
I appreciate Christensen bringing awareness to this investment structure. For him to propose its potential to disrupt VC lends credibility that RBF is one of the latest evolutions in venture capital.