Venture Capital Alternatives
In 1999 I founded a company and raised $7.5 million in venture capital. Four years later, when the company was eventually sold to a public firm my final dispersement check as founder was a whopping $84.17.
That was then. This is now. And one of the things that’s different today is the number of different financing mechanisms available to startup CEO’s.
Historically, traditional venture investing was always equity-based, and outcomes were assumed to be binary: the company would either go bankrupt or hit it big. A home run or a strike out. No one cared about singles.
Many perfectly good startup companies today, of course, don’t fit that model but fortunately investors and entrepreneurs can use a variety of investment instruments to provide startup capital while keeping interests aligned.
In the early 2000’s convertible notes appeared as the seed-funding instrument of choice. Convertible notes say “let’s call it debt for now and convert it to equity later”, which defers the valuation question while assuming that a “Series A” equity round will follow and valuation can be set then.
But convertible notes can have their pitfalls as well, so Y Combinator came up with a structure they call SAFE (Simple Agreement for Future Equity) as a replacement for convertible notes, providing a more agile mechanism which keeps interests better aligned.
Now John Kohler of Santa Clara University, working with a variety of funds and institutions, has develop the demand dividend, a financing structure specifically designed for social ventures and other enterprises which are worthy of investment but aren’t a fit for traditional risk capital financings.
The central feature of the demand dividend is that it is contractual debt (not equity) and that the investor holds a claim to a share of future cash flow from operations until the debt obligation is fulfilled.
- An investment fund makes a $500,000 investment in a new social enterprise.
- For the first 12 months there is no repayment obligation, giving the enterprise a chance to put the capital to work.
- After the first 12 months the investment fund receives 30% of the enterprise’s cash flow until 1.6x the original investment is returned.
- After that the investors have no future claim to cash flow or equity.
These numbers are just examples. There are many other flavors and options out there as well. Warrants could be included in the above example, as a way providing equity upside and keeping the investors engaged after the original obligation is complete.
There are lots of options. It all depends on the company, the investors, and their mutual goals and interests. The point is we’re lucky to be running enterprises in an era when there are many different options for entrepreneurs and social entrepreneurs seeking capital on terms well-aligned with mission and goals.
Resources for additional reading:
- Sample Demand Dividend term sheet
- White paper on the Demand Dividend
Thanks to Santa Clara University and the Center for Science, Technology, and Society