This is Part II of a two-part series on Revenue-Financed Capital (RFC) for angels. Part I addressed the question of when RFC might be appropriate to meet some of the capital needs of angel portfolio companies. This post discusses why RFC may be appropriate for angel portfolios.
ACA member Sage Growth Capital hosted a meet-up of attendees who were interested in RFC at the recent ACA Summit in Las Vegas. On the last day of the Summit, Sage also presented a formal session on the nuts and bolts of RFC along with counsel Gary Kocher of K&L Gates and Sage investor Jb Beaird. Much to our delight (and admittedly, surprise), it was standing room only for both sessions (and that was after we were moved to a larger room – both times).
Sage launched its first fund in 2019 and has actively evangelized for the RFC model of investment in many gatherings across the country since then. We have witnessed a steady increase in individuals and angel groups who are interested, but the appetite seems to have finally taken hold. Why are so many angels expressing interest in RFC and when might RFC investments be appropriate as part of a portfolio of angel investments?
We explained RFC in our first blog post and won’t repeat that explanation here other than to say that revenue-financed capital is risk capital that is not dependent upon an exit to generate a return. Instead, RFC is a purchase of a share of revenue until an agreed-upon fixed return has been paid. While there are regular payments, those payments are variable depending upon revenue. And if the company fails, we may lose all or a portion of our investment, similar to equity investors.
Simply put, angels add RFC to their portfolio to receive equity-like returns through regular cash flow rather than by exit.
A Refresher on Angel Investment Returns
A quick shorthand for thinking about investment profits is return on investment (ROI), defined as the amount ultimately received divided by the amount invested. If an angel invests $100,000 and receives $1 million at exit, then the return is 10X ($1,000,000/$100,000) and we all celebrate.
But not all 10X returns are the same. The compounded rate of return, expressed mathematically as the internal rate of return (IRR), decreases as time increases. A 10X return over five years means we have earned about 58% per year compounded on our money. The IRR drops to about 26% if we wait 10 years for our return. All things equal, we are better off to get our returns sooner rather than later.
Of course, not all angel investments produce positive returns. We know from various studies that only one or two out of ten equity investments will produce outsized returns. Many investments will return less than invested. To maximize the probability of earning an outsized return, we must adopt a portfolio strategy of making many investments.
How Might RFC Fit into the Angel’s Portfolio Strategy?
Investing for “home run” returns with the expectation of lots of strikeouts is not the only way to generate returns from early stage investing. RFC can produce similar returns without depending upon the exit.
RFC produces a stream of cash flow over generally a three-to-five-year period, sometimes after a period where payments are not collected. (In Sage’s case, we begin to receive monthly cash payments about four months after we make the investment, and we usually target receiving our full return over about four years.) This improves our time weighted return as we are receiving our “exit” month by month beginning four months after the investment. We also have less risk of loss because, not only are we getting payback beginning a few months after investment, we also only invest in post-revenue companies with strong margins, repeatable revenue, and relatively clean balance sheets.
We expect to invest in companies who will grow their revenue over the life of our investment. This means our early payments will be smaller than our later payments. The IRR from such investments can be quite attractive on modest multiples. For example, assume we invest $100,000 and receive a total return of $200,000 (2X). And assume over four years we received annual payments at the end of each year of 10% in year 1, 20% in year 2, 30% in year 3 and 40% in year 4. The IRR on such a stream of payments would be roughly 27%, which is in line with what the ACA data shows angels may earn on a diversified portfolio of equity investments.
In fairness, we have only been investing for four years. We have made 20 investments, and had four profitable complete exits, and one partial write-off. The other 15 investments are all producing cash flow monthly.
Over the life of our funds, we believe our investors will earn similar returns to the 20-30% IRR that angel investors expect on their diversified portfolio of equity investments. And our investors will do this while enjoying regular cash flow! Consequently, angels may wish to supplement their equity portfolios with some RFC investments, thereby adding regular cash flow and a bit more certainty to their returns.
There are several downsides compared to equity investments:
1. No big exits. RFC investors do not participate in the final exit. They must accept they will have no huge exits, but of course, this is the tradeoff for regular cash flow.
2. Ordinary income. The investment returns are generally considered to be interest income. For some investors, the possibility of making high interest returns outweighs the obvious tax issues. Others invest through IRAs and other sheltered vehicles.
3. Complexity. Monthly returns mean monthly accounting. This requires a tracking system to be sure the investor is paid the correct amount every month. If the investment is made through a fund or SPV, then the manager will want to make frequent distributions of the cash flow to the investors. For example, we expect to generate approximately 4,200 transactions over about eight years in Sage’s second fund of $7.7 million. This complexity means RFC investments are probably best made by angels who can support some professional staff to maintain the records.
4. Losses: Because you aren’t going to receive any “home runs” you also must minimize your losses. This means a diligence strategy focused on the downside rather than the upside, which is different from traditional angel investing.
If you have a deal that appears appropriate for RFC and in which you would like to invest, feel free to contact us at firstname.lastname@example.org. Sage may be able to set up a syndicate where we vet the deal and serve as the lead investor, and you and other angels can participate as syndicate members.
About Sage Growth Capital
Sage Growth Capital is a venture capital firm that provides revenue-financed capital exclusively. We launched our first fund in Q4 2019 and have invested $5.6 million in 20 deals as of June 2023. We invest between $100,000 and $1 million in growing companies at any stage with “recurring-like” revenue, gross margins of at least 40% and who can demonstrate that our capital will lead to higher sales. Our limited partners are all angels and most of our deal flow comes from the angel investor community. To learn more about Sage Growth Capital or to apply for funding, visit: www.sagegrowthcapital.com.
About Revenue-Financed Capital
Revenue-financed capital (RFC), also referred to as royalty financing, revenue share or revenue-based financing, is a non-dilutive form of growth capital where investors receive a percentage of monthly revenues until a set amount has been paid. RFC 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. RFC is designed to empower entrepreneurs to grow their businesses with non-dilutive capital that aligns with their sales cycles.
About Revenue-Financed Capital for ACA members
For additional information on revenue-financed capital, ACA members may join the ACA Connect Community on Revenue-Financed Capital by going here to complete the form. This is a place where those interested in RFC can exchange information. Members may also download the slides from the Sage presentation to the 2023 Summit in Las Vegas and Sage partner Kevin Learned's white paper, Revenue-Based Investing: Another Option for Angel Investors.
1 For those interested in going further into the concept of return, the impact of time on investment returns, and the importance of building a portfolio of investments rather than depending upon a specific investment, see the work of ACA board members Rick Timmins of Central Texas Angel Network, and John Harbison of Tech Coast Angels as summarized in the Ann and Bill Payne ACA Angel University Courses Angel Returns and Portfolio Strategy. Their work and that of other researchers shows a carefully constructed portfolio of angel investments should produce an internal rate of return between 20% and 30% over a period of five to ten years.
2 There are complex ways to perhaps change RFC returns to capital gains from interest income. However, these are highly technical, and not without tax risk. At Sage we leave such methods to future fintech entrepreneurs who have the stamina and resources to test such strategies.