Diversifying your private market portfolio

Many signposts track the maturing of a startup ecosystem, but one of the most prominent is the emergence of new classes of capital for startups. Equity funding in young, pre-revenue startups may seem run-of-the-mill now in India, but it was not terribly common even 10 years ago. At its simplest, in startup financing, equity funding confers ownership to the investor to the extent of his or her shareholding. This translates to high risk and high reward—if the startup doesn’t work out, an investor might not get even his capital back, but there is potential for a multi-bagger if the startup becomes a spectacular success. The recent DoorDash and Airbnb IPOs are great examples of the latter, with multiple venture capital investors seeing stellar returns and exits. Sequoia, for instance, invested about $280 million over multiple rounds in Airbnb and its stake on the company’s listing was valued at an impressive $12 billion. In India, the Happiest Minds IPO also provided a stellar 40%-plus IRR in five years for investor JPMorgan when the company went public in 2020.

Traditional debt, on the other hand, is low-risk-low-reward and does not provide ownership for the capital provider. The startup entrepreneur needs to pay back this debt with a pre-fixed interest in a set period of time. If the startup does not work out, debt takes precedence over equity in terms of returning the capital.

For entrepreneurs looking to raise debt without diluting too much of their equity, venture debt is a good source too, but venture debt is available only to startups that have already raised at least one round of venture capital and it is a medium-term loan with fixed interest rates with monthly repayments. In a way, venture debt is an extension of equity funding. Significantly, there is no typical collateral backing the debt; instead, the company’s warrants are used, with the option to convert the warrants into equity over a period of time.

Revenue-based financing (RBF) is a new form of capital that is gaining popularity in mature ecosystems like the U.S. but is a pioneering asset class in India with investors beginning to test the waters only now. So, what really is RBF? I would classify RBF as a hybrid product with medium risk and better-than-debt returns.

Here are some key points:

1) It is a debt given to the startup, but not structured as a loan.

2) Like its name suggests, investors get a fixed percentage share of the business’ revenues each month. So if a company has higher revenue one month, the investor gets a greater share back. This repayment covers the principal plus a return that is decided at the time of investment.

3) This is typically meant to meet working capital requirements. The founders do not have to dilute equity, which makes it attractive for them, and hence, a ready market is available to interested lenders.

4) There is no hard collateral or guarantees backing the financing, so it is at higher risk compared to secured loans for investors/lenders.

RBF picking up steam

For companies that can reliably predict their revenue flow, this type of alternative financing is a highly attractive prospect. This is why globally, online businesses and SaaS companies particularly are increasingly opting for RBF. These startups, while not necessarily profitable, do have a regular revenue stream.

For the entrepreneur, the advantages are clear: they do not need to dilute their equity and there is no collateral involved. Further, since the payment is linked to revenue, repayment does not become a strain.

What’s in it for investors?

Investors typically have a clear asset allocation across public markets, private equity, debt, and alternative assets. But within the private market or startup investing the only option available to ultra-high-net-worth individuals (UHNIs) and family offices so far has been equity based (either into VC funds or directly into startups); but now with some RBF funds available, this option can be explored to diversify or balance the portfolio.

With RBF, the core premise of the product is the strength of revenue and quality of revenue of the startup you are providing funds to. Secondly, as an investor, your return is directly linked to a company’s revenues over the next two to four years. This is in contrast to equity investments in startups, where the return horizon is typically eight to 10 years.

Apart from this, only a handful of companies raise venture capital funding and of these only a few will bring that 50x return that makes for a blockbuster exit. The wider universe of revenue-earning startups is much bigger. Not all of them are attractive from a VC point of view, but are great from an investment perspective.

Views are personal. The author is president, LetsVenture Plus.