While other VCs seek Unicorns, is all about that cashflow

By Michael Carney , written on February 17, 2015

From The News Desk

While most VCs are busy searching for Unicorns, the mythical $1 billion and up startups that can define a portfolio, there’s a group of investors in Silicon Valley looking at the opposite end of the spectrum: modest, cashflow businesses.

Bryce Roberts and his team from O'Reilly AlphaTech Ventures (OATV) have launched a new funding initiative called aimed at identifying and encouraging these businesses that may never sell or IPO, and that may never raise another dollar of outside capital. Surely there are far more businesses that fit into this category than the unicorn bucket above. But the question is, can you generate meaningful returns financing them? To be sure, is not a charitable project. The goal is back winners, albeit atypical ones.

Roberts describers as an experiment and per that classification, the details of the funding model are still emerging. Late last week he pulled back the curtain a little further, sharing the outlines of a new (and still nameless) funding instrument developed in conjunction with his law firm, Cooley. Roberts writes on his personal blog:

[It’s an] instrument that has elements of both debt and equity. Debt in that we will not be purchasing equity initially, but, unlike debt, there is no maturity date, no collateralization of assets and no recourse if it’s never paid back. The equity element will only become a factor if the participating company chooses to raise a round of financing or sell out to an acquiring company.
For the purposes of this discussion, let’s call these Cashflow Notes. At the core of the Cashflow Note model is the distribution. Essentially, asks its founders to use excess cashflow generated by a business to repay the firm’s investment. When and how much is up to the founders. But the catch is, if the founder wants to pay themselves more than 50 percent above “market salary” – a threshold that’s determined within the terms of each investment – he need to also begin making distributions to his investors.

Per the terms of its Cashflow Notes, gets 80 percent of all distributions made until its investment is repaid two-fold (2X). After that point, the firm gets 20 percent of all distributions until its investment is returned five-fold (5X). Then, that’s it. Once a loan is repaid five-fold has no more claim over the business.

If on the other hand, a business having raised a Cashflow Note decides to raise additional investment capital or to sell itself to another company,’s investment would convert into equity. In the case of an investment, would convert into preferred shares at the round’s pre-money valuation and hold a pro-rata right to invest in the round to maintain ownership. In the case of a sale, the Cashflow Notes convert into common equity at an ownership level chosen by the founders – “pay what you want” style – at the time of investment. Roberts writes:

If you make it to the final round of the application process, you’ll be given a termsheet with the equity amount intentionally left blank. You get to fill that in. Pay what you want might be a terrible idea, but we think it’s worth trying.
The model diverges from traditional venture beliefs at nearly every turn. For example, because VCs are concerned with building the biggest companies possible, the idea of removing capital, the lifeblood of any growing company, early from a winner is looked down upon. Some founders get early liquidity, but rarely do all but the smallest investors take money off the table when a company continues to grow. That said, VCs rarely invest in profitable businesses, or when that option is available based on company performance, typically advise founders to reinvest all available profits in search of greater growth., on the other hand, seeks out cashflow businesses that are unlikely to be a fit within a traditional venture portfolio. The firm describes its target audience on its homepage, writing:


Bootstrappers with ambitions that exceed their cash flow.

Creatives with side projects they’re funding through client work.

Founders that don’t want to sell out their users to attract investors or advertisers. [emphasis original] The other glaring difference between traditional a venture investment and Cashflow Notes is that has, from the outset, capped its potential return at “5X.” The mythical ”100-bagger,” meaning a company that returns an investment 100-times, is the stuff of VC lore and part and parcel to the hits-driven model that has defined Silicon Valley since its earliest days., on the other hand, eliminates any chance at such a return by absolving its founders of all responsibility beyond a (let’s admit it, not too shabby) five-times return.

The challenge with artificially limiting returns in the venture sector is that the limited partners that invest in these firms (endowments, pensions, family offices, etc.) can get modest IRRs with lower risk elsewhere, such as in the real estate or private equity sectors. These investors turn to venture and willingly accept the increased levels of risk in exchange for the potential for increased return. By capping that return, even with an equivalent reduction in risk – and potentially shorter time horizons – may unintentionally remove some of the appeal of the category. Then again, it may be creating a new category altogether.

There is precedent to suggest there are some businesses that could benefit from's less rigid approach, while still generating attractive returns for the firm. Roberts notes that his partner at both OATV and, Tim O'Reilly, bootstrapped his own business O'Reilly Media to a nine-figure success. Other examples like Zoho and AirPush suggest that it wasn't a fluke. Whether can identify other businesses like these early in their lifecycle and convince their founders to accept a few hundred thousand bucks on non-traditional terms remains to be seen.

OATV has set aside enough cash to make eight $100,000 investments under the above model, including additional reserve capital for each participating company. The firm has set a tentative application deadline of March 15th, and plans to complete its interview process and make offers by April 30, officially kicking off the program in “early May.”

Roberts has returned to the word "experiment" repeatedly in his descriptions of To be sure, the above is a radically different funding model than has been tried in the venture capital or technology sector previously. But, as he notes, many elements of the above model are familiar within other more traditional industries, such as restaurants.

The question that will seek to answer is whether such a model can support the growth of technology-driven businesses, which we’ve come to think of as capital-hungry, money losing endeavors hell-bent on achieving a maximum possible return upon a sale or an IPO. But this mentality is exactly the thing Roberts and his team of merry-contrarians are seeking to avoid. In a blog post titled “The Shareholder Trap,” he writes:

With venture money comes venture expectations around growth, margins and value at exit.

That works well for some, but not for all.

In the past not having investors and deep pockets has been seen as a huge disadvantage.

Maybe, just maybe, the underlying economics of cash efficient startups will swing to favor those who haven’t fallen into the shareholder trap.

Maybe… is a fascinating new approach to company building that challenges many of the long-held truisms of venture capital. The project is still in its embryonic phase, but the questions it’s asking and the approach it’s taking are thought provoking. Maybe there’s another way. Maybe...