If you think it's rare for a company in the U.S. to have a successful exit (i.e. get acquired or have a public offering), then imagine how unlikely an exit is for a company operating out of Nigeria or Myanmar... it's less common by an order of magnitude. However, some of the greatest investment opportunities and some of the smartest entrepreneurs in the world are coming out of these "new" markets. For investors who don't want to be left behind with the mega-trend of entrepreneurship in emerging markets, and for entrepreneurs unlikely to see an exit with their company, it's important to look into new structures of investment that don't rely on taking equity (broadly referred to here as "Quasi-Equity" structures).
Through my work at the Unreasonable Institute and Unreasonable@Sea, I've become intimately involved with over 80 companies operating in over 45 countries (mostly in emerging markets). Along the way, I've seen firsthand the difficulties of placing investments in startups operating in developing world markets. In fact, many of our Unreasonable Entrepreneurs, even when running highly profitable companies, may not even desire to have an exit. They are more attracted to saving millions of lives and running 100-year-companies. I've now had hundreds of conversations about the importance of re-assessing the "Term-Sheet" for the next-generation of entrepreneurs... this post is a highlight of the broad takeaways from these conversations.
When Equity is Smart: For most of you out there in the startup world, this is likely painfully obvious... Equity investments should only be placed in companies that have foreseeable public offering or acquisition in the cards. I won't get into my opinions on good investments vs. bad investments, and out of respect for your time I won't talk about Convertible Notes (see Seth Levine's post on this). Instead, I want to remain focused on the subject of this post. If an investment you are looking at is unlikely to exit, then the last thing you should do is invest equity. For entrepreneurs who do not desire to be acquired or to go public, then the last term-sheet you want to sign is an equity investment. Don't do it. It's that simple. In either of these circumstances though, the investment may still be highly productive and profitable. So if the investment seems like a good one, you should look into debt-financing, factoring (see Miguel Ganier's "Impact Factoring Fund"), or the world of quasi-equity structures that will allow for your dollars to become liquid in the foreseeable future.
When Quasi-Equity is Smart: Whenever an exit isn't likely or when a company doesn't desire to ever go public or be acquired. Obvious... I know. There are two common (although not common enough) forms of quasi-equity: revenue sharing agreements / royalty financing and profit sharing agreements. Personally, I find profit sharing agreements to be very dangerous as net-revenue vs. gross-revenue is always a bit tricky to calculate (ex: a company can simply increase all of its employees' salaries by 2x which would increase their costs of business and decrease net-revenue or profits and in turn decrease the amount of profits shared with an investor). Because of this, I'll focus on revenue sharing agreements or royalty financing.
The concept of royalty-based financing or revenue share financing is simple. Instead of purchasing equity in a company, an investor agrees to receive a percentage of a company's monthly or annual revenues. Typically there is a limit on this rev-share agreement that is either a multiple of the original investment amount (say 5x the principal) or the revenue share is limited by a period of time (say 10 years). Where appropriate, it can be a blend of the two.
BACKGROUND ON QUASI-EQUITY: Let me begin with a quick definition of what quasi-equity is. A lot of people have different definitions for the term (as it can take on many forms), but for the purpose of this article, quasi-equity will refer to structures of investment that take on the same win-win incentives of a normal equity investment but do not rely on "an exit" for investors to see a handsome return on their dollars.
Why Quasi-Equity Can be Awesome:
For Investors: Many investors today make claim that they cannot invest in an exciting company that is having a positive impact on the world and that they believe will be widely profitable. They can't invest because they aren't certain how a company operating in Algeria or in Northern Mali will ever get acquired or see an IPO. They may also not invest in more developed regions of the world, say Spain or Japan, because equity is a enormous commitment and they have yet to invest in that part of the world. Furthermore, oftentimes investors aren't comfortable with the commitment that equity has and the paperwork that comes along with it... I agree... it's way too complicated(especially when international)! By adopting a quasi-equity structure, you can invest in these types of companies relatively easily. Knowing the dearth of equity investment opportunities and the explosion of entrepreneurship across the developing and emerging markets, I think quasi-equity is going to become commonplace / incredibly important now and into the future.
For Entrepreneurs: If you do not desire to sell your company or to go public, and you are tired of taking on loans and asking for debt financing, using a quasi-equity structure may be a smart approach. You can have investors aligned with the health of your company (i.e. they don't get any money unless you make money because this is a revenue sharing agreement) and you can ensure a fair win-win situation between you and prospective investors without giving up your sacred equity. When you are negotiating a structure for investment or a term sheet with an investor, you may want to ask them to seriously consider this option. You will likely find that they will appreciate your ingenuity and your desire to create a mutually beneficial situation. Furthermore, if an investor takes equity in your company, they are invested in you for the life of your business and there is no getting out of it (divorce isn't an option). With a revenue-share / royalty financing structure, the investor is only with you and your company as long as the terms allow. Their need to have a board seat on your company is less and they will not take a voting control of your company (note: many times it's strategic and beneficial to the entrepreneur to have an investor on their board... just not all the time).
For the Future of Investment: More creative structures like the ones mentioned here (and many others) open up a new world of what can be considered investable. Companies that are thriving in emerging markets are just one case study. These types of structures can also be applied to revenue generating non-profit organizations and even to investments in individuals instead of in companies.
This blog post is part of a series produced by The Huffington Post and The B Team community to help articulate a Plan B for Business. To see other posts in the series, visit here. For more information about The B Team, visit here.
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