Alternative Startup Financing Schemes

I’ve seen a number of posts lately discussing the ‘changing face of venture capital’. Paul Graham talks about the change in dynamics caused by the low capital requirements of technology startups. Fred Wilson discusses the need for a market for privately held common stock. There seems to be a general consensus about the growing role angels play in the startup ecosystem, and sadly there also seems to be a general consensus indicating that angels should basically write off their investments the moment they make them.

This last point rings true for me. Before coming to India I made a number of investments in tech companies. During my chapter in Los Angeles I also put money into a couple of independent films and a big event with uniformly poor results.

“family, friends, fools & freeman” – Joke by John Mullins at the Venture Capitalist development program at ISB.

While the returns on these investments were uniformly bad, the journey the ventures took was not. One tech company has seven figure annual revenues which support the two founders in adequate if not lavish lifestyles. The founders / promoters in each case saw money on the way. Little made it back to the investors.

In iAccelerator.org we’re fortunate to have a team as advanced as HashCube.com. They are profitable with a proven record of developing and deploying casual puzzle games for social networks and mobile devices. Recently MySpace opened up its platform to developers and HashCube has done well as an early provider of games for it. They see an opportunity to scale – more games, more platforms, more promotion, more revenues .. more investment required.

Even if HashCube can reliably replicate the success they’ve had with their initial games, the question of whether their success can translate into a meaningful exit for its equity investors remains uncertain. What if it is simply a profitable business heavily dependent on the founders? Far from being an aberration, this maybe the common case for technology companies. 37Signals.com promoter David H. Hansson argues that creating small (compared to Facebook) profitable companies which serve the needs of real customers is a far more reliable path to startup success, than the traditional Venture backed Big-Bang approach.

To address this scenario, I had the thought that HashCube could offer investors the right to invest in a pack of games taking a % of the revenue generated by those games until achieving a certain IRR. The goal being to produce an automated mechanism in which investors get paid as a normal part of the company operations rather than being dependent on an exit event. 

<p>Chetan Pungaliya spent some time here in Ahmedabad mentoring our companies, and had some interesting observations on this. He didn’t like the idea of selling the game pack as the founders needed the flexibility to apply both, the money and their time, where it would do the most good. This may be promoting the existing games rather than building new ones. For the same reason, he was resistant to carving revenues out for the investors early as he believed that HashCube could be ‘big’, and may need to reinvest all revenue back into the company to fully realize their potential. He suggested an alternative financing scheme as a compromise between the game pack based revenue share approach and the traditional equity model. His idea was to allow founders to reinvest all the revenue for the first few (say 3) years, but to cap founder compensation during this time. At the end of three years the rev share kicks in. This provides the founders with full flexibility to grow the business quickly during the initial period, and provides a clear path for investors to recoup their money if an exit isn’t apparent and the founders are taking the startup along a ‘lifestyle’ business route. Presumably, if the company raises a significant venture round angels at this stage would either be bought out, or would convert to shares on similar terms to those of the VC.

I’d be curious to hear from other potential angels about whether this kind of structure would make it more likely for them to invest in very early stage tech ventures.

7 Responses to “Alternative Startup Financing Schemes”

  1. On lifestyle business vs. hypergrowth and turning cash-flow positive early on:

    There is a huge risk of startups turning into a ‘lifestyle business’ for the founders instead of a potential hyper-growth for the investors/employees/etc.

    In American parlance, a lifestyle business is one where the company is cash flow positive and sustains itself for number of years without any outside money

    How can something like this potentially happen? a) Lack of access to capital in late stages and/or b) Too much focus on attaining cash-flow positive at the expense of growth c) Non-existence M&A market for good growth plays (Haven’t we heard of the big guys saying that we’ll DIY and clone you by putting 10 engineers?)

    Being cash-flow positive is good when you have very little or no capital. Something which makes enough money to cover your ‘cost of goods’ and potentially ‘cost of sales’.

    When a company goes lifestyle — everybody loses a) investors can’t exit b) employees can’t cash their ESOPs c) the company may not attract rockstar talent. The winner may be the corporation in itself which may survive for a long time.

  2. Vardaan says:

    An interesting view however the problem lies in (specifically for Indian arena) – those 3 initial years and getting venture rounds in those initial period.

    And talking about technology startups, funding at early stage is still a big overhead for founders even when open source technologies are being used by them the other factors that Chetan mentioned is obviously the Time and inturn Money which are interrelated to each other.

    Being part of one of web startup in India, we faced much constraints once product is live. Once its Live and you have Less Money and The Time is running, Here what you need the manipulation to bring the revenue in and this is those initial 3 period !

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