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Buying a share of tomorrow - 'Seraph' deals



One of the biggest risks that young companies face is premature scaling. This seems to be the cause of death for most funded startups.

Angels see a good idea with a good team, and they are prepared to fund it with seed capital in exchange for equity (a share of the stock). The most likely way for these angels to get their money back is if the company can raise VC capital. Otherwise, their sunk capital may never be returned to them.

This means that angels will put intense pressure on the firm to scale quickly, to the point where a VC will step in. VCs in turn will, of course, put even greater pressure on growth. If Angels cannot envisage the company having a $20-50m valuation, then they cannot feel assured of getting their exit.

The problem is that as Geoffrey Moore would say, Early Adopters do not a Target Market make. The first customers may have completely different goals or requirements than those of the regular consumers. However, every founding team wants to believe (or is whipped by investors into believing) that they have found the true target market, and Product / Market fit.  This encourages scaling at the earliest possible stage, often a deadly error.

The truth is that far more in-depth customer discovery and market investigation may be necessary (in fact, it almost always is). This could take anything from 6 to 18 months to get done correctly.

Now, Angels are unlikely to permit such experimentation unless they are very experienced. They want results fast, and they want an exit. They would rather put in cash for 'faster movement', than have the patience whilst the startup sputters along safely bootstrapping, and learning. They will encourage the founders to raise big, and blow funds on a big team.

The big team is usually not necessary (only engineering and cust dev is required at this point), and if the team must expand quickly, the newbies are usually comprised of 'B' players. 'A's are rare, and take time and persuasion to recruit (they know their value). 'B' players may look good on paper, but they often need to be managed, rather than take furious initiative (as Founders would). This need for management and defined 'rules' creates additional overhead that depletes efficiency and morale within the organisation.

So, here's a modest proposal. What if instead of equity, angels took a convertible revenue stake instead? 

It's a very different paradigm than the Silicon Valley Moonshot, but it may be far more appropriate for most startups. Everyone wants to be an overnight success, but the truth is that even outright successes like Facebook etc took years of carefully nurtured growth and iterating before they got into a position for scale.

Accelerators are often judged by the amount of capital that their companies raise, which creates additional pressure to pivot to something 'bigger', and a perverse trend towards chasing vanity metrics. Bigger ideas are also a poor fit for first-time founders, who would be much better off chasing a niche somewhere, where their true passion lies. This is particularly pertinent in emerging economies, where there is a lack of follow-on funding to support big, ambitious concepts.

Where are all the sustainable businesses? Why is a slow burn-in considered a bad thing?

Consider that most funds DONT MAKE MONEY. A few do, the Sequoia's and Index's of the world. Most just about break even. Something is very broken in startup capital.

How might we fix it? Could a non-equity deal really make money? I think so.

Consider the following:

A small company of 6 people makes a product in a very specific niche, say cushions for wheelchairs. They focus on making the best damned wheelchair cushions that money can buy, and their customers love them. Now, the total addressable market may be small, but the customers are very enthusiastic for the product. Let's say that the TAM in this case is $24m and they can reach 25% of it, through careful cultivation of the right channels. This means sales of $6m per annum, with a headcount of 6... $1m per capita.

That's a very profitable company. Bootstrapping can be a 'sure bet'.

Now, in an equity deal, the company would have to expand into other markets, "make bike saddles, make gym equipment seats", investors would cry. Such expansion into bigger markets is the only way to get bigger players interested, and secure an exit. Meanwhile, the company loses its focus, and stops addressing it's niche but profitable market. 

However, if the deal was structured in a way that didn't take an equity stake per se, but rather was 'a cash in exchange for convertible revenue deal', then the company could stay in it's niche. The angel would not need to exit, instead they could enjoy a revenue stream for the effective life of the company. If the company did later get acquired, the investor would have an option to convert the rev share into equity in the new company.

This change of paradigm is very different from traditional angel deals, being somewhat of a hybrid of a convertible loan, a bond, and a rev share. Because it's different, and has a different mindset behind it (for both investor and invested-in), I think that it needs a specifc name.

Angels of a sort, but those who choose to support targeted and highly effective ventures in a long-term time orientation: Seraphs then, who burn with raw passion.

Coming from the entrepreneurial side more than the investment side, I'm very interested in feedback on the Seraph concept from current angel investors. I'm also searching for the best legal and financial structures for such deals. The devil is in the details, of course - conversion terms need to relate to business models, and royalties should be postponed until the company is stable.

Folks, let's get companies chasing sales, not pitches. Let's get bootstrapped companies the support in accelerators that they need, and deserve, and will never receive. Let's find ways to merge crowdfunding and capital, without the problems of having a yard-long cap table. Let's give FFFs a slice of the pie long-term, in exchange for their loyalty.

Where resources permit in future, I would like to find a way to offer capital on Seraph terms to the next generation of entrepreneurs.  If this idea is well-received, I may consider establishing a society to promote awareness of such deals, and distribute standard term sheets for new Seraphs. If others may wish to join forces in this, let me know.