In my last blog entry I talked about the perils and evils of debt for both the lender and debtor. Here I’d like to discuss an alternative which I believe could replace the entire concept of debt.
Revenue sharing, sometimes referred to revenue-based finance and income-contingent loans, is just recently starting to take off. The White House is making a big push for income-based repayment of student loans.* And at least two private (and highly capitalized) startups are launching soon to provide revenue-based financing options for individuals who agree to pay a portion of their future income in exchange for cash upfront.
With U.S. consumer debt topping $2.5 Trillion and student loans now totaling over $1 Trillion, it’s no wonder that there’s a lot of interest in revenue-based finance. Let’s look at several common debt scenarios and see how they could be different — and better for all parties — if they were based on revenue-sharing instead.
There are many ways to structure a revenue-share contract, but let’s start by assuming a very basic model: investor pays a lump sum in cash to investee, in exchange for a fixed future return, with a minimum annual payment based on post-tax income/revenue.
Instead of Student Loans
Let’s say you have $100K in student loans. Based on the 6.8% federally guaranteed annual interest rate, you’ll be able to pay it off in 10 years, but only if you can afford the $14K per year starting when you graduate. If you are one of the lucky American college graduates to find full-time employment you’ll make an average annual salary of $27K. You can expect to pay $5K of that in taxes, leaving you with just $8K to live on for the entire year, once you meet your student loan obligation. You can get your annual loan repayment to under $8k, but only if you want to be saddled with debt for the next 30 years. And by the end you will have payed $135K in interest on that $100K loan.
Now consider that you find an investor who wants to give you $100K revenue share contract instead. In exchange you agree to share 33% of your post-tax income up to a total of $150K. Instead of paying $14K of your $22K post-tax annual salary, you’re paying about $7K (lower than you cold have gotten with a student loan). But, where it gets really interesting is looking at two extreme scenarios:
- You defer college and agree to work for a startup for three years without a salary, living off the $100K. Because you are saving your company valuable seed capital, they give you a large chunk of equity. Two potential outcomes:
- You cash out, and 33% of your post-tax income exceeds $150K. You’re investor has just made the equivalent of 15% interest compounded annually, and is fully cashed out in 3 years instead of 30.
- You have to get a “real job” in three years, but now you are a hot commodity because of your experience, and you’re earning $130K a year. You’re sharing $25K annually with your investor, which means that they are made whole 9 years after they invested in you. While their effective ROI is 4.7% annually compounded, they don’t have to wait 30 years. Plus they have a “free shot” at doing better, assuming you will get raises and bonuses along the way.
- You go to college, find your calling, and decide you want to work in the non-profit sector for the rest of your life. While your starting salary is only $25K, you make an average of $70K per year over the course of 30 years. Your average revenue share is $15K annually, and you’re contract is complete in 10 years. Very similar to the 6.8% student loan over the same period, but you are not being squeezed by large payments in lean years — remember, you only pay based on what you actually take home as income. And rather than paying more than 100% in total interest, you are capped at the pre-agreed upon ROI (in this case 50%). Finally, you have the flexibility to take a different path at any time without worrying about the debt spiral of compounding interest.
From the investor’s standpoint, the risk of losing their investment is lower with a revenue share contract than a loan. After all, they have no collateral in either case. And and if you declare bankruptcy — or even threaten to — they are likely to lose some or all of their investment. With a loan, you pay the same regardless of what you earn. But with revenue share, your payments are tied to what you can actually afford. Less likelihood of bankruptcy means lower risk for your investor.
As for ROI, the investor has traded lower total return on investment for a higher rate of return and a shorter time to liquidity. This is valuable because there is a cost (the so-called time premium) associated with having your money locked up over a long period of time. To understand this concept, consider the following choice: would you rather have $10,000 in cash now $12,000 in two years?
Finally, the sooner the investor is made whole, the more money they can earn by reinvesting with someone else, or in an unexpected opportunity. If you are waiting for someone to repay a loan, you can’t use that money to invest in that foreclosure down the street.
Real Estate Financing
Speaking of which, let’s say you are looking to purchase a home using a standard mortgage. It might be a good financial investment, but only if you are willing and able to sell it at a loss when the market (and your finances) dictate.
If you use a revenue share contract instead, you are aligning your investor with your total earning potential rather than just the value of your equity in the house. That total earning potential includes the scenario where you sell your house for a profit, but it also includes your other sources of income, like your salary.
But the real value to both you and your investor is that you are never forced to sell at a loss, and the investor is not forced to foreclose. You are partners in the success of the home-as-investment, and you are partners in your overall financial success.
The situation is even brighter for someone who is in the business of real estate development. In my previous blog post I discussed the insidiousness of debt financing for real estate projects. Let’s look at what happens with revenue share, using the a familiar example: you need $300K to purchase land and build a house on it. This should take you a year to complete, after which you hope to sell it for $400K, yielding $100K in gross profit.
Suppose you find an investor willing to give you $300K in exchange for half your post-tax income, up to a total of $600K. Now, in the desired scenario, you make $100K gross income on the initial deal, pay $50K to your investor, and have $350K in the bank to finance your next deal.
Compare this with the bank loan where you might pay off the $300K principal plus $30K in interest, and be left with only $70K in capital. But what’s even worse is that the $70K is all taxable capital gains, whereas in the revenue share scenario, $50K is your capital gain.
Again, with a revenue share contract, you and your investor are aligned as partners. So if you’ve proven yourself a good earner, they might be excited to help you earn more by helping you find more development opportunities. Plus, your investor’s risk goes down again, even compared to a loan secured against the property.
To see why, let’s consider what happens if the market tanks and the completed home is now worth $200K. If a lender forecloses, they are stuck with a $100K loss (plus they have to go through the hassle and cost of selling it themselves). But with a revenue share contract, you are taking the risk, as it should be.
The investor owns a share of your future revenue (up to the cap), no matter whether that comes from real estate or not, and no matter if it takes you a while to reach the cap. And once again, the investor has a “free shot” at doing really well, if you find yourselves in an up-market.
Beginning with the example above, let’s say you parlay your things, and after several years, your post-tax bankroll stands at $900K. You may decide to pay off your revenue share contract, netting $300K free and clear. If so, your investor has just doubled their money in several years. Compare this with the 10% loan, where the investor doesn’t double their money until at least year 7.
Financing Your Startup
An entrepreneur looking for seed financing of $50K – $100K can expect to spend 9 months full-time, without pay, to close the deal. Most never do close a dime. And after you spend that cash (which will last you 6-9 months at most), you’re in need of Series A, which can be even harder to close.
But what if you and each of your co-founders got backers to fund a year’s worth of living expenses in exchange for a piece of your upside? For the sake of comparison, let’s assume you are a sole founder and have an angel investor willing to give you $50K in exchange for 6% of your business. Instead you convince them to give you the $50K to spend as you see fit, and in exchange you agree to give them 10% of your post-tax income and 50% of your capital gains and dividends, up to a total of $500K.
Scenario A: You Cash Out
After 5 years working 70 hours a week, your hard work pays off and your company is sold for $30M. By this point you’ve been diluted to a 30% shareholder, so net after taxes and completing your revenue share contract you clear $6M personally. Your investor gets a 10 times their original investment. Had they invested in the company directly, they would have ended up with $540K, just about the same as the revenue share deal. However, if the company had run into problems along the way and had to dilute shareholders to raise more money, your investor could end up with less than if they invested in you directly.
Scenario B: You Crap Out
Let’s say you are unsuccessful in raising enough money to make a go of it and have to close the doors after a year. You are in the same position as you would have been by selling equity in your company, except now you’re still under contract for revenue sharing. This might seem like a burden, but it can also be an opportunity. Because your investor, instead of parting ways and probably never helping you again, now has a vested interest in your future success. Maybe they back your next startup directly and get the extra value of making good on their original revenue share with you. Maybe you get a job working for them to help analyze and oversee their investments. Either way, this is a much better deal for your investor than purchasing stock in your first company.
Small Business Finance
It’s not hard to see how revenue share contracts can be a good way to raise capital to expand a business with decent cashflow.
In fact, for many such businesses this is commonplace and is known as cash-flow factoring. The difference though is that factoring is really a loan based on cash flow projections, where as revenue sharing is based on actual booked revenue. And just as with any lender, a factor is not a value-aligned investor.
Revenue share contracts for businesses can be structured either based on gross revenue, net revenue, EBIT, EBITDA, or net profit, depending on how aligned the investor wants to be with the success of the business.
On the totally-aligned end of the spectrum (net profits), the investor can expect a higher ROI and a higher minimum share percentage. On the other end of the spectrum (gross revenue), the investor can still expect better ROI with lower risk than a factor could.
Impact Investing & Social Enterprise
Whether they are mission-driven and want to continue to oversee the impact of their business in the world, or whether they see the business as supporting a certain lifestyle that they don’t want to give up, more and more founders are in it for the long haul. Which presents a real challenge when raising startup capital.
The whole reason and early stage investor would want equity in a startup is because of the potential for a big score when the company sells or goes public. Once again, revenue share presents a win-win solution that has the benefits of equity and eliminates the problems with debt.
Structuring Your Revenue Share Agreement
Each situation is different, which means one size does not fit all. However, there are some overlaps and lessons to be learned from my experimentation with Personal Investment Contracts. Also, check out Upstart.com and watch this space for the announcement of another venture which aims to create a marketplace for personal equity.
If you are interested in creating your own revenue share contract now, contact Kinetic Law and ask for Orlando Medina. And post your experiences, ideas and questions below.
* It’s worth noting here that some people are calling for student loan forgiveness on a wide scale. At first this seems like an even better option than Obama’s idea of converting these loans to income-based repayment. Until you realize that it’s not the lenders, but the taxpayers, who will be footing the bill.
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