Archive for October, 2013


Convertible royalties: An alternative to the equity model for accelerators

Posted on 02. Oct, 2013 by in Coworking, Local News, San Francisco, Startups, venture capital

Written By: Alexander Torrenegra

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Instead of earning equity from the businesses they accelerate, accelerators could earn royalties from the revenues of such businesses. This could enable accelerators to help entrepreneurs grow and bootstrap their business instead of forcing them to raise capital.


My wife and I co-founded the Voice123 brand ten years ago. Today, it’s a successful business with 30 employees. Its success didn’t depend on angels, accelerators, or venture capitalists (VCs). In fact, had we listened to any of them, Voice123 would not exist today. There are thousands, maybe millions, of entrepreneurs like us out there. The current model made popular by Silicon Valley is suffocating many of them and killing startups that could also become successful. This article explains how and offers an alternative.

v123The current Silicon Valley model has one major flaw – it creates an ecosystem that asks entrepreneurs to shoot for the moon rather than build a sustainable business. VCs won’t waste time working with companies that are likely to sell for less than $50 million (I don’t blame them as their business model needs such scale). Angels and accelerators exist because VCs exist. They work as a bridge between the startup and the VC. Although some angels prefer capital efficient businesses that don’t need much VC to avoid dilution, many angels won’t invest in startups that aren’t likely to scale to the $50 million valuation level because they’re afraid VCs won’t invest. Given that most accelerators follow the angel/VC/exit model too and measure their success based on the level of funding startups get, many entrepreneurs with great ideas and companies are being told to pivot to try “bigger ideas”. In fact, they don’t even consider bootstrapping, which actually works! Unfortunately, forcing first-time entrepreneurs to “dream big” and execute on $50 million ideas is no different than asking a first-time driver to compete in a Formula 1 race. It is very risky, to say the least. The concept of “Go Big or Go Home” may work for some, but it should not be a rigid mantra, especially in emerging economies.

I (and many of my colleagues) am fatigued from “demo days,” that, judging by recent trends, should be renamed “PowerPoint Days,” where panelists, primarily made up of investors, tell entrepreneurs that their companies are “not good enough” simply because their firms wouldn’t invest in them. I’m tired of VCs dismissing entrepreneurs because their startup is a “lifestyle business” (as if being a VC isn’t a lifestyle business!). I don’t want to continue seeing emerging economies trying and failing to copy the Silicon Valley model, teaching entrepreneurs how to raise angel capital when there are still few successful exits, if any (I’m looking at you, Colombia).

This should change. Entrepreneurs with good ideas, even if they are “not-so-big” ideas, should feel comfortable building “not-so-big” companies. This is especially relevant for first time entrepreneurs. It’s okay to build a bootstrapped company that “only” sells $1m per year and grows 20% year-to-year. Sure, no VC will get rich with them, but the founders will be happy and they can have a significant social impact.

Can angels and accelerators help? Unfortunately, their current business model depends on VCs. If a company they fund is not backed by a VC, it’s going to be very unlikely for the angel and/or the accelerator to get their money back. The solution? There could be many, but the one I’ve been thinking about for a few weeks:convertible royalties.

When an accelerator or an angel invests in a company (whether it’s cash or, more importantly, mentoring), they could start getting a small part of the company’s revenue as a royalty. Of course, the revenue may be insignificant initially, but after a couple of years and some growth, the revenue may be high enough to justify the original investment. As with convertible notes, convertible royalties could become equity upon the occurrence of certain performance or time-based milestones. For example, hitting a certain level of aggregate sales, receiving a certain amount of funding, or getting acquired.

I’m calling it convertible royalties because of its similarities with convertible notes. Unlike convertible notes, though, the business model of accelerators and angels wouldn’t depend on the company getting acquired to be viable. In fact, convertible royalties may open the door for accelerators to promote bootstrapping. The convertible royalties idea may allow accelerators and angels to invest in companies that nowadays are not even considered for acceleration: bootstrapped companies, companies that don’t need additional capital, service companies, non-for-profits, etc. It may even allow services like Kickstarter and Indiegogo to start offering some kind of return to crowdfunders. I dream of the day when accelerators stop forcing entrepreneurs to improve their pitch for investors, and instead help them improve their pitch for clients and sell more.

Some are experimenting with related concepts. Adobe Capital, a social venture fund in Mexico, uses subordinated debt that is repaid by collecting a percentage of sales. Some call this model “revenue capital”. Nevertheless, many entrepreneurs don’t need venture capital. They need education, mentoring, connections, and strategy.

Of course, the convertible royalty model won’t be perfect and may not work for every situation. For example, the royalties may need to be different for different companies depending on their business model. Royalty payments may need to be postponed initially to allow all company revenues to be reinvested into the growth of the business. Also, if royalties do get paid out, the equity or the potential conversion to equity, may need to be reduced so that the entrepreneur doesn’t need to “pay twice”.

What do you think? What drawbacks do you think the model could have? If you’re an entrepreneur would you be willing to pay 0.5% in royalties instead of giving the traditional 5% equity to accelerators? If you’re an accelerator, would you consider using the model? Will it work in emerging economies? Will it work in Silicon Valley? Should the convertible royalty agreement have a deadline? Will this model encourage accelerators to push entrepreneurs to increase sales in the short term while sacrificing long-term strategy? Let’s start a conversation.

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P.S. Wondering what makes me a qualified person to talk about this topic? To be honest, I don’t know if I’m experienced or articulate enough. Some may call me ignorant or wishful. They may be right. Nevertheless, here’s a little about me: I started my first business in Colombia when I was 14 and bootstrapped it to 25 employees. I moved to the US in 1998 and since, I’ve co-founded multiple companies here, including an incubator. We bootstrapped some of them. We raised angel capital for some. We raised venture capital for some. Some failed; some are successful. I’ve invested as an angel in several startups, as well. I’m co-founder of HubBog, the largest campus for startups in Bogotá, as well as co-founder of the two largest tech meetups of Latin America. I mentor many startups through several accelerators. I am the CEO of Bunny Inc (owner of Voice123, VoiceBunny, and BunnyCast), a successful bootstrapped company with 35 team members in Bogotá and San Francisco that is doubling sales this year. I never had an eight-digit exit, yet I am a happy entrepreneur.

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Thanks to Leonardo Suárez, Shaun Young, Patrick McGinnis, Dan Gertsacov, Dan Green, and Tara Tyler for reading and commenting on drafts of this article.

 


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