RBF Learnings: Lessons from 3 Funds

What building a revenue-based venture capital firm has taught us about structure, psychology, and the surprising math of small wins.

When we formed Sage Growth Capital in 2019, we had a hypothesis, a small circle of angel investors willing to go along with our latest endeavor, and some idea of how much we didn't know. Now that we’re three funds in, we've been reflecting on what we have learned about fund structure, investor psychology, deal flow, and just exactly how much we didn’t know.

Start small, fail cheap

Fund I was deliberately modest. We kept it within our personal networks and treated it as a proof of concept. We knew we were going to make mistakes and we wanted to make them with people who would forgive us.

And we did make mistakes! We experimented with the fee structure: adding a one-time expense contribution on top of capital commitments, offering first-close discounts, and forgoing a management fee in favor of a distribution fee paid only when capital was returned. In theory, it aligned incentives. In practice, it created unexpected tax consequences for the fund and left the partners personally carrying expenses for the first two years, until the portfolio grew large enough to generate meaningful distributions.

We learned our lesson: it's hard enough to innovate on the funding model, don't reinvent management compensation at the same time. For Funds II and III, we adopted the standard 2/20 structure which was one less thing to explain to investors, and one less variable to complicate our tax returns.

The power of recycling

Fund I also taught us that quarterly distributions early in the fund’s life when there's a very small portfolio create a lot of administrative work for very small returns. Our investors asked why we didn't simply hold proceeds until we could distribute something meaningful.

So in Fund II, we reinvested all proceeds for the first 24 months after final close (which stretched to 30 months, since we were investing while fundraising). The results were impressive:

• $1.75M+ Capital recycled

• 22% Increase in capital accounts without additional investor dollars

• 6 Additional investments funded 

  
  

Recycling also gave us a buffer. When one Fund II company underperformed, the gains from reinvested capital helped absorb the impact. 

The IRR perception problem

When we started raising Fund III, response from investors was tepid, which took us by surprise. Our fund was outperforming our VC peers in the metrics that are measurable and meaningful (see our blog post on this subject), and yet our investors seemed underwhelmed. This is one hazard of having angels as our investors: we are conditioned to celebrate our Big Exits and forget about our Big Losses (which in angel investing is more common than not - the data shows that angels will lose everything in roughly 7 out of 10 deals).

There is an interesting psychology to this that is hard to overcome: in the world of angels, a one-time payout of a deal that pays 3x after 8 years is reason to celebrate, but a 2x payout paid back in smaller increments over 3 years is ho-hum. An interesting dichotomy: a 3x return in 8 years equals roughly a 14% IRR, while a 2x return distributed quarterly over 3 years works out to closer to 20% IRR. The second scenario (what Sage investors see regularly) is meaningfully better by any financial measure, and yet it's the 3x scenario that gets celebrated at dinner parties.

Why? Feedback from our investors provided one clue: quarterly distributions of smaller amounts are easy to lose track of. They get directly deposited into a bank account and disappear. A single large exit, by contrast, is rare enough to be memorable.

We're still working on solutions. In addition to increasing the frequency and methods of reporting to our investors, we have seriously entertained the idea of replacing direct deposits with oversized paper checks, signed in gold ink! But the deeper issue is a real one for any fund that generates consistent cash returns rather than lottery-ticket exits: steady returns are genuinely less sexy than a headline multiple.

Angels as a source of deal flow

We realized in Fund I that our best deals came from referrals from our angel colleagues. Angels are typically very active in their local ecosystem or within their chosen area of investment. This often takes the form of mentoring or supporting young companies in addition to investing in them. 

Our hypothesis for Fund II was that angels would make better fund investors precisely because of this: they would bring us proprietary deal flow. That hypothesis has been validated more thoroughly than we expected: of the 29 companies we have invested in, 27 were introduced to us by someone in our angel network. 

Angels don't just provide capital, they provide context, relationships, and access to deals that never make it in front of an angel group. Many of our portfolio companies have since gone on to raise equity rounds from angels and VCs, and we're proud of the role our funds played in getting them ready for that next chapter.

What we'd tell our 2019 selves

Keep the structure simple: experiment with the model, not the mechanics. Reinvest early returns rather than distributing tiny checks that are more annoying than useful. Build your investor base from people who are themselves active in the ecosystem. And don't underestimate how much the narrative around returns matters, even when the math is clearly on your side.

About Sage Growth Capital

Sage Growth Capital makes revenue-based investments in companies at any stage who need growth capital. It is our mission to provide a more flexible, non-dilutive funding option to growing companies who do not fit traditional equity or lending models. To learn more about Sage Growth Capital or to apply for funding visit: www.sagegrowthcapital.com.

About Revenue-Based Financing

Revenue-based financing (RBF), also referred to as royalty financing, revenue share or revenue-financed capital (RFC), is a non-dilutive form of growth capital where investors receive a percentage of monthly revenues until a set amount has been paid. RBF differs from equity financing as the investor does not obtain ownership of the company and it differs from debt financing as there is no collateral required and payments are variable. RBF is designed to empower entrepreneurs to grow their businesses with non-dilutive capital that aligns with their sales cycles.