VCs Watch Out. Disruption is Coming For You Next.
Oh, how the tables turn.
Venture capital has long been the capital that powers disruptors - but that journey is coming full circle. While many VCs may suffer from the coming wave of disruption, the ones who can survive will likely produce better results than ever before (I'll explain more about that next week).
There are 3 key disruptors to the “old VC model”.
Each step poses a different threat to the industry - but for the VCs that understand and embrace these changes - their returns could even rise despite a market flush with cash chasing deals.?
What’s the safest way to ski? Don’t go skiing.
The same is true for a young company. What’s the best way to need to raise less? Spend less. (Yes the quote is a reference from the office.)
In this day and age, it is easier and more cost-effective than ever before to test, launch and scale an idea.
Let’s say you have an idea for a new consumer product. You aren’t sure if people will actually be interested in it or how much it will cost to create. What do you do?
For less than $1,000 (even less if you have large organic reach) you can design a website/landing page (no-code), get a freelancer to design visuals for your product idea, launch ads, and accept pre-orders - all easily within a week (personally I've done this process for $250). You don’t need funding to develop a prototype, travel to coordinate manufacturing, legal fees, etc.?
The same is true for most technology businesses. You can develop and deploy your code without needing to invest in expensive servers or hardware.?
Without this need for initial capital, significantly more ideas are able to test the waters of the market and start generating revenue - and as the revenue for a business increases the demand for dilutive external capital decreases. And yes - it is easier to collect revenue from a global base of customers than ever before.
Technology and globalization will continue to drive down the costs to get started with a business and will increase the ability of entrepreneurs to bootstrap their ideas - leaving traditional angels and VCs out of the picture until later stages of growth - or in some cases leaving them out of the picture entirely.?
2. Crowdsourcing?
Equity and debt crowdfunding is still a relatively small part of raising money for a new business. In the United States which is arguably the most developed market for equity crowdfunding, the market has only existed for non-accredited investors since 2016.
Technology has made it easier than ever before to manage the regulations required to raise from large groups of people. Most equity crowdfunding deals can avoid the cap table complexities of multiple tables by simply designating one individual in advance who will handle any voting or regulatory matters on behalf of the whole group.?
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Crowdfunding is not going to be the right fit for many types of startups. Given the very consumer-focused nature of equity crowdfunding, many of the most successful raising companies have very consumer-focused applications. But equity crowdfunding isn’t just for cool gadgets and sexy-sounding companies. The second featured listing when I was checking https://wefunder.com/explore - was a legal services marketplace that has raised over $2.5M.?
Equity crowdfunding alone will likely have a minimal impact on VCs in the short run. The model can be cost-ineffective for founders (it can require a significant advertising budget), it can also be time-consuming depending on the speed at which funds do or don’t come through, all of that can create a big distraction for founders with all of the associated issues that can cause. Then there are fees that can either reduce the amount received by companies, increase the amount investors must pay, or a combination of both. Not to mention for later-stage companies there may simply not be enough capital available from crowdfunding sources.
But there are distinct pros over the traditional VC model as well. Firstly the designated proxy who can make decisions for the group can be someone pre-vetted so founders can avoid ending up with dud board members or unresponsive share/noteholders. Traditional VC can be a lot more time-consuming involving multiple rounds of outreach and meetings before getting checks (although good VCs can make a yes or no very quickly). The traditional VC model is also heavy on relationships which can cause founders from diverse backgrounds to have a more difficult time raising funds.?
All of this only scratches the surface of the crowdfunding model. Debt crowdfunding, product presales and simply asking for donations are all further methods used to raise funds for a startup - all with the added benefit of not diluting existing shareholders.
3. Revenue Based Financing?
This is likely the most disruptive threat to the traditional VC model. Companies like Clearco were started because growing companies spent up to half of every VC dollar on ads (https://techstartups.com/2019/10/26/startups-spend-almost-50-percent-investments-facebook-google-ads/) - there is a clear problem for growing companies and with the way most modern revenue is processed, there is also a fairly clear solution.
Revenue-based financing takes advantage of the fact that most revenues these days are easily tracked through payment processing systems like Stripe (who also do financing), or sales data from platforms like Shopify. This gives lenders a reliable way to gauge both the current unit economics of the business as well as the growth trajectory making it very easy to underwrite loans based on revenue.
While this model won’t make sense for pre-revenue nuclear fission or genetic engineering firms - for countless consumer and SaaS businesses it’s the perfect solution.
Rather than permanently having to give away 20% of your business for $1M (assuming $1M in ARR and a 5x multiple on that revenue), you could receive $1M with a fixed repayment of $1.08M. Simply pay back a percentage of your revenue on each sale. Once that loan is paid and as revenues continue to grow you can continue to take on new financing to continue to grow the business all without diluting equity stakes for any of the existing owners.
As the business grows other types of debt financing will also become available like factoring of receivables (https://pipe.com/), operating lines of credit, and secured loans for fixed assets. Longer-term I also predict that IP secured financing will become a growing industry for IP heavy but cash flow light companies (early-stage biotech, hardware, infrastructure, etc) allowing companies to leverage their assets without having to sell portions of the company.?
Debt when used responsibly can be a magical tool to improve shareholder returns. Thanks to this disruptive application of payment processing technology providing access to leverage to earlier stage companies is easier than ever before.
Key Takeaways:
The key implication here is that with the supply of funds being higher than before, entrepreneurs will get to be choosier about their sources of funding. VCs will have to prove why they are more valuable than any of the above alternatives.
Next Time:
I'll do a deep dive into how VCs can "pivot" to make sure they stay relevant in the rapidly evolving world of raising capital for startups.