The Rise of Alternative Venture Capital

March
24, 2020

12 min read

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Once upon a time, there was a very clear definition of venture capital. It was used to fund many of the largest technology companies you know, like Facebook, Twitter and LinkedIn, which received funding from venture capital firms by the names of Sequoia Capital, Accel Partners and Benchmark Capital. These firms put in millions of dollars in supergiant rounds for a percentage of equity and got up to 1,000 times returns with an IPO that occurred in less than 10 years. If these venture capitalists (commonly called VCs) got lucky, they would have one, two or three of these moonshot successes in their fund portfolio. This would then give them the return on investment they needed to fall in line with their investors’ expectations. That’s it. That is how VC evolved until today, when the startup explosion.

The startup explosion in the last decade changed the trajectory of venture capital. Although big, successful deals in companies like Airbnb, Lyft and Uber still happened, there was a major increase in the number of startups being created around the U.S. and the world. In particular, there was a huge influx of startups in San Francisco and Silicon Valley. That’s where the majority of risk-taking VCs were, after all.

Often in the last decade, you could try to raise funding as a startup founder anywhere else and run into risk-averse investors who were yet to understand the open-eyed model of venture capital. These investors wanted to see more revenue and startup investments heavily derisked in order to understand and evaluate them. It used to feel like as soon as you left California and went east, your investment terms gradually got worse from New York to London to Europe. In many places, it was nearly impossible to raise any funding at all with the same model that worked in Silicon Valley. That’s why it has the reputation it does today.

The heyday of venture capital

Silicon Valley is still known for innovation, but San Francisco has become the hotbed of startups and venture capitalists.Many VCs kept their offices or homes in Silicon Valley cornerstones on Sandhill Road in Menlo Park or Palo Alto or Mountain View but opened up hip new offices in the city to show face to the changing tide. Twitter, Uber, and Lyft decided to keep their offices in the city instead of moving to the valley like Facebook and Google. Coupled with the increase of startups moving to San Francisco from around the world, the spike in technology jobs, and a huge swath of new VC funds entering the fray, the model, and the city, started to change.

Startups now could get funding more easily. The supply of capital was high. There were a plethora of new investors, including accelerators, incubators, angels, angel networks, dumb money, old money and more VCs than you could count. In many ways, this accelerated new technology services and products. It also started the rise of San Francisco becoming a cost-prohibitive place for many people and businesses, including many startup founders. But startup founders, being the entrepreneurs they are, found a way, whether that was funding or couch surfing.

There was such a huge increase in funding mechanisms for startups, in fact, that many companies got funding that might not have otherwise. Diligence on startups in Northern California at this time was not intense like it still was in markets nearby on the East Coast or Southern California. Usually, just a pitch deck, a well-explained plan, novel technology, experienced founders, or a signaling investor could raise a $1 million seed round. No problem.

The first evolution

Amid all the startup world hullabaloo, the venture capital model started to take on different faces. AngelList and FundersClub saw the structure of a venture fund as an opportunity. A fund is made up of investors with a general partner who raises the money and does the due diligence on the startups in order for an investment to be made. Angel networks had already formed around this structure without forming VC funds, so it made natural entrepreneurial sense to simplify the fund creation process. These were the first online equity-based fundraising platforms.

At the time, raising funding for a private company publicly still had its legal restrictions. Without the right permit, it was illegal to fundraise online for equity. Kickstarter made its way around that by calling the investment donations and rewarding donors with gifts, but no equity traded hands. AngelList called their first online investment vehicle appropriately Invest Online. Then later, Syndicates. Syndicates exploded in number as the startup world had for venture funds and tech companies.

This was a huge breakthrough, and democratization of startup investing occurred. Almost anyone could not only invest,but form a syndicate of investors that looked to them to bring interesting deals. The FCC still required accreditation by investors, but enforcement online was a different story. 

In 2019, AngelList reached nearly $1.8 billion in assets under management, which is on par with most major VC funds. The venture capital scene would never be the same. Even though AngelList and other equity crowdfunding platforms improved on the fluidity of the model, the model was still mostly the same — an investor needs a big exit in order to return their fund. This left the door open to new styles of funding startups, and not just different size funds like Nano or Micro VCs. The excitement in startups was still rising, and so was the funding.

At the same time, many startup founders had been sucked in and chewed up in the traditional venture capital model. If their company wasn’t on a trajectory of rocketship growth, often founders were forgotten by their investors. Their VCs had to focus on the top 1 percent of the portfolio that they needed to scale and bring the multiples for their fund. The startup that was pushed to scale so fast it broke was left behind. Thus began a revolt.

The revolution begins

The revolt began slowly and quietly. It started with startup founders who had moved to San Francisco and become disenchanted or disenfranchised, leaving the city or becoming tired of the traditional VC model. Many of these entrepreneurs had raised early-stage funding and burned out on growing at a rate that is extremely hard to maintain. Often the push to grow the company that fast would kill the company outright.

Some founders started different types of businesses in the Bay Area or back in their home city or country. Some built investment models to support their homegrown founder friends. Some looked to cryptocurrency and ICOs. Some might even have started revenue-stable lifestyle businesses, a type of business not favored in San Francisco until more recently. Venture capital had become a stamp of approval. Your funding amount was your success. How could it be any other way?

“Founder friendly” was starting to be heard on the streets of San Francisco more. Y-Combinator and 500 Startups launched new convertible notes for early-stage investing called the SAFE and KISS respectively to give better terms to founders. Stripe built Stripe Atlas to help founders with the legal and financial requirements of starting a business. Financial institutions that had built their profits in different ways decided to be more helpful to the lucrative startup scene. So it began.

Many founders who wanted to still build successful tech companies in and outside of San Francisco demanded new terms, or flat-out avoided traditional venture capital. They wanted to build healthy revenues naturally. They wanted to maintain ownership and not give up 20-25 percent of their company for a seed round. They wanted acquisition optionality and to not be forced to only sell or IPO at a $1 billion valuation. They wanted flexibility and fairness most of all.

Then the stories of companies doing this started to become public. Tuft and Needle was a big one. It had considered venture capital but ended up building a smart, profitable business that sold for around $450 million with the founders still owning most of the company. Buffer was another sweetheart of the no- or low-funding company crowd who grew to 82 employees, is profitable and serves 75,000 customers. Countless other startups started to take notice, and so did the investors.

The funders become the innovators

The culmination of this pushback from founders was to create more solutions for the 99 percent of entrepreneurs. The unicorn outliers were too rare of a case study. There was a missed opportunity here.

One of the first innovators on the venture capital model was Indie.vc. Known by its burning unicorn image, Indie.vc has tested multiple versions of its fund with three different investment models. Currently, it’s a 12-month program that supports entrepreneurs on a path to profitability. It invests between $100,000 and $1 million and always takes an equity stake. In addition, it takes a percentage of gross revenue. Indie.vc Founder Bryce Roberts calls their model Permissionless Entrepreneurship.

Another early innovator with a similar model is Earnest Capital, which created the Shared Earning Agreement. Also, called an SEA or SEAL (for cuteness’ sake), a venture investor model built upon a combination of equity and annual cash payments.

“Shared Earnings is equity-like,” explains Earnest Capital founder Tyler Tringa, “and only a percentage of ‘profits’ (technically ‘Founder Earnings’) is paid to the investor after everybody, including the founders, are compensated.”

In between Earnest Capital and Indie.vc you have TinySeed, which describes itself as “the first startup accelerator designed for bootstrappers.” The program is a 1-year, remote accelerator with 10-15 companies going through it at the same time. It based its terms on how Rand Fishkin raised venture capital for his company SparkToro: a 10 to 12 percent equity stake with a cut of dividends. For that, TinySeed invests $120,000 for the first founder and $60,000 per additional founder.

Alternative VC models are even expanding internationally, where these models are needed the most, with one of the first examples being Pick & Shovel Ventures in Australia, which sets an up-front multiple with the founder and takes 5 percent of monthly recurring revenue (MRR) after a 12-month holiday period. The founder then pays back the venture funding either through revenue or an exit.

“It’s all about optionality,” explains Pick & Shovel Ventures Founder Matt Allen. “Our business model works for profitable companies, companies that choose to raise and companies that exit early and create a windfall for the founders. I really want the founder to do what they feel is right and will support them in all aspects of that.”

The thought behind these new forms of venture capital is that they can attract revenue-generating startups with interesting technology or a novel product with founders who want to continue thoughtfully growing their company while maintaining ownership.

That doesn’t mean the company won’t be a $1 billion unicorn in Silicon Valley’s eyes, but it does mean that their investor’s venture capital model doesn’t require them to be in order to make a return on investment that’s favorable to all involved. It’s still an experiment.

Another experiment is AI-backed investment firms like CircleUp. CircleUp uses proprietary algorithms to evaluate and identify consumer startups to which it should offer equity investments and working capital loans, typically to companies with $1 million to $15 million in revenue.

Corl is another example that uses an artificially-intelligent platform to finance businesses in the digital economy and shares in their future revenue. Their pitch is a no-brainer: “30 percent of businesses don’t have the assets necessary for debt financing and 98 percent don’t meet the venture requirements for equity financing. This has led to a $3 trillion global funding deficit.” The model they use is RBF or revenue-based financing.

Revenue-based financing firms have also sprinted onto the scene in order to give other non-dilutive alternatives to startups. Most of these firms focus on earning commissions on revenues, so the startups they fund need to have a minimum level of annual revenue somewhere between $100,000 and $10,000,000. Not surprisingly, this is often ARR, or annual recurring revenue, that comes via predictable-revenue SaaS businesses. Although this suits a portion of the underserved startup scene, it doesn’t address the majority of it and is one of many solutions a founder can choose from.

The future is flexible

In all senses of the word, alternative venture capital is flourishing. 2020 will be a year of major expansion. New methods and models are already launching in startup ecosystems across the globe in the footsteps of the first movers. These new founder-investor relationships seem to already be in a more empathetic, stable and healthy place than they often were before.

As the model continues to evolve, the important thing to remember is that businesses can be built in many different ways. A founder’s appetite for scaling culture can vary widely from high-growth blitzscaling to lifestyle living to slow-build big business. It’s up to the founder and investor to strike a deal that supports the true mentality, cultural values and mission for both.