Entrepreneurs who build businesses in smaller cities and in low-income communities often lack the personal credit profile or assets to access the capital they need from banks and investment firms to grow their companies.
Revenue-based financing — where investors provide capital in exchange for a percentage of revenue — has become a solution recommended by foundations and social impact investment firms as an affordable option for underserved U.S. business owners. It’s an approach that can create a partnership between the business receiving funding and its investors, because both do better when the company does better.
Revenue-linked investing is also more favorable to entrepreneurs, giving them “an opportunity to get financing without having to give up ownership,” which can happen with private equity or venture financing, says Chat Reinders. CEO of Reynders, McVeigh Capital Management, a Boston-based wealth management firm.
About four years ago, Reynders McVeigh began advising Founders First Capital Partners—an income-based lender and advisory firm—on a fund that would allow individual investors, family offices and foundations to provide income-based financing in exchange for annual return of 7%.
Founders First’s financial arm (it also runs a nonprofit small business growth accelerator) has already proven the concept in a fund it launched in 2016 with some smaller foundations and family offices, says Kim Folsom, founder, chairman and CEO of the San Diego-based firm and an entrepreneur herself who has launched seven companies.
Folsom’s goal at Founders First, she told Reinders, “is to become the Goldman Sachs for different companies” by backing “different entrepreneurs [to] develop successful mid-sized businesses that create jobs and wealth in communities that are often left behind.” At the same time, Folsom said, the firm can provide “attractive returns for mission-minded investors.”
Penta recently spoke with Reynders and Folsom about revenue-based financing as a long-standing but revolutionary approach to investing and how it can create social and economic justice.
Creating a partnership
Revenue-based financing was attractive to Reynders, who manages about $100 million in investments for clients, as a mechanism to channel money into “funding deserts” around the country “where there are BIPOC and women owners who just don’t have access to capital and have no real leverage,” Reinders says.
For entrepreneurs who don’t work in New York or San Francisco, accessing venture funding can be very difficult, for example. “We thought it was important to find ways to fund and nurture some of these businesses in a way that worked for them,” he says.
Revenue-based financing gives entrepreneurs more flexibility than a standard bank loan and is better than equity financing from a venture capital fund – if it is even possible to get it – because a venture capital or private equity investor would expect the owner sell the company or eventually go public, an event that ultimately pulls local capital away from cities that need it, Reinders says.
For investors, revenue-based financing “allows you to be a financing partner with these businesses because it takes into account the reality of the markets,” he says. “There will be higher revenue quarters and lower revenue quarters, and if you can manage that with the developer you’re working with, it creates a good solution for your clients if they understand that’s what they’re investing in and create a great opportunity for the entrepreneur who is suddenly out of line.”
The Catalyst of Change Fund
The businesses that Folsom underwrites for the funds are “asset light” with a minimum of five years of revenue and a gross profit margin of at least 40%. Companies in the fund must also be “geographically challenged” (meaning not in New York or San Francisco), run by diverse owners and successful with “small capital,” she says.
Several of the companies in which the fund invests provide solutions for large companies. Examples include Onshore Technology Group in Chicago, a black women-owned business that provides compliance services for major pharmaceutical companies such as Pfizer and Moderna. Another, a 3PO in Jersey City, New Jersey, provides treasury management services.
Reinders says the firm worked with Folsom to develop a funding mechanism that would allow individuals, family offices and foundations to get a reasonable return for the risk they take, while providing “real social value” to entrepreneurs who don’t have where to turn for capital.
The seven-year fund, which will eventually total $30 million, today includes about $5 million from investors who are clients of Reynders McVeigh and who have each invested about $250,000. Investors have the opportunity to invest in the fund every quarter during its first three years. They pay no management fees to invest and earn an annual return of 7%. In the second half of the fund’s life, the internal rate of return can be higher because the principal is also being repaid, Reinders says.
The firm’s investors like the steady yield of an investment that’s a little riskier than a normal bond, he says. A seven-year U.S. Treasury, for example, currently pays about 3.1%.
The Change Catalyst fund can provide stable returns because Founders First assumes the risk that the revenue streams of the underlying companies will fluctuate. The fund manages this by bringing together a diverse portfolio of about 35 businesses, some of which have reduced earnings, Folsom says. This allows for more consistent revenue and therefore consistent returns.
Founders First currently operates in five regions (California, Illinois, Texas, New Jersey and Pennsylvania), but plans to expand to 10 over the next five years.
It will also create more Change Catalyst funds that will target investors with increasingly large asset pools. The second fund, which will be between $50 million and $75 million, will target institutional investors, including impact investing funds and registered investment advisers.
A third fund, which will be at least US$100 million, will target large corporations and pension funds that seek to invest for social impact.
The social impact this funding can achieve will be significant, Folsom argues. A generation ago, high-street retailers and hotel chains and other non-tech businesses fundamental to the economy grew to become among the largest companies in the US and to contribute significantly to the US economy.
“The funding we’re providing these diverse businesses in the form of six- and seven-figure capital infusions puts them on track to be the next high street businesses that are in the generation of $20-50 million to $100 million businesses that can to sustain this level of growth,” she says.