Capped Return or Fallback Price?
Terms the Scale Series
Debt prices its capital. A loan will cost the principal plus interest to pay back.
Equity does not price its capital. Depending on the exit, it could pay out nothing, if the company fails, or infinite amounts in grand-slam exit.
So what should founders and investors make of the return cap in many innovative term sheets?
There could be a 1.5x, or a 3x, or even a 10x. Is this the cost of capital?
It depends.
If the investment is debt, then yes. A 2x revenue based loan will only ever cost 2x. The lender underwrote the deal to get a 2x. Some revenue based loans have lower multiples to incentivize early repayment, but by and large, the cost of capital is exactly as advertised.
If the investment is risk capital, such as redeemable equity or a convertible note paired with a revenue/profit share, then the return cap is a fallback. Why?
Risk capital is not a game of assessing risk. Risk in new markets or early stage companies is impossible to quantify and capture in a price. As a result, risk capital is not a matter of underwriting a single deal but rather bundling a batch of deals and letting the cards fall as they may. Unlike underwriting debt, the higher order task is not risk assessment or avoiding defaults at all. It is all about capturing winners in a batch.
So what is the return cap with risk capital term sheets? It is a price should a company not turn out to be an outsized winner. If the equity position is not on track to become a great multiple, the return cap offers a release valve, allowing the investor and founder to remain aligned as they shoot for a modest multiple comparatively.
It is critical for investors and founders to understand if the return cap is the price of capital (innovative debt) or is the fallback price (today’s innovative risk capital).
For founders, this mistake is a windfall at first. When cheaper debt is not available, more expensive “whatever type of capital” will do. They do not plan to take on burdensome debt, but the return cap often ends up feeling expensive. As a result, the equity has no prospects of converting or getting purchased in an exit. The revenue share kicks in and a debt-like tailspin ensues.
This is most common with equity-sensitive founders. Hoping to retain full cap table control, they raise this hybrid structure and anticipate paying it off just like a loan. When real risk wins out, they are stuck with an obligation they can’t service. The correct funding was risk capital, designed to tolerate failure.
When investors make this mistake, they fail to optimize for picking upside.
The multiple, or return cap, gets seen as a continuation of debt’s pricing. “If a bank offers 10% and a revenue based lender’s 1.5x usually nets out to 15%, I can just price my startup capital at 2x and aim for 20% IRR/interest.” The investor thinks they are tippy-toeing near the edge of what is underwritable when in fact they’re deep off the banks of making a bundle of risk capital bets. The result is a portfolio with risk capital-like failure rates and debt-like returns on the deal-level. Lacking a mechanism to capture upside and make up for the failures, the portfolio looks like the disastrous underwriting that it was.
This pricing misconception must be dispelled for innovative finance terms that scale.
At the deal level, this causes years of misaligned founder-investor partnerships. One level up, GPs end up with real risk and no upside to make up for it. At the macro level, investors see mediocre returns and head for the hills.
The key to avoiding these misconceptions is simple: ask questions. Portfolio strategy is an essential conversation in the investor-founder dating process. Funding creates obligations, so both parties should be clear about what obligations they see being created and the pressures that will come with them.
SOCAP Session Submissions That Need Your Vote (from the team at Catalyze)
💰🛫 » Funding the Runway: Addressing Cash Flow Challenges for Emerging Investment Fund Managers with Sonam Velani, David Lynn, Michael Belles & moderated by Margot Kane
🗣️🏋️ ♀ » Raising a first-time fund in 2024: Real talk for Fund Managers and Investors with Connie Bowen, Tessa Flippin, Margot Kane & moderated by Brendan Cosgrove