Return of the Jedi grossed $572 million in revenue, claims $0 in profit.
Harry Potter, and the Order of the Phoenix grossed $938 million in revenue, claimed a $167 million loss.
My Big Fat Greek Wedding grossed $370 million in revenue, claimed a big fat $20 million loss.
Apart from an expert lesson in bluffing, the accounting games played in the film industry teach us the risk in predicting the net profitability of a venture versus its revenue potential.
Which is easier to predict: profit or revenue?
The Obvious Answer
Revenue is always easier to predict. Management risk represents the distance between revenue and profitability of a venture.
As a financial backer who is not also a manager of the venture, it is easier to speculate on the revenue potential and performance of a venture than it is to speculate on its profitability.
Smart managers who drive down the cost of doing business can still make out like bandits in a royalty situation. But because profitability will always correlate with revenue, there is never a conflict of interest with increasing revenue.
Being the Owner sucks. Being the Bank rocks.
Royalties, when executed fairly and efficiently, give the capital managers an advantage in predicting success. And predicting success is the first thing in the game of risk capital.
For managers of the venture, a royalty payment must be accounted for in addition to regular costs of doing business. This can be a problem if the venture hits a rough patch and that royalty payment is the difference between lights on and off. Maybe a good royalty arrangement needs to account for that too.
Being an owner brings with it the reward of running the business well—and it carries with it the spectre of being the last paid or being the captain going down with the sinking ship. Managers of a business must be rewarded handsomely for success because they take the most risk.
By decoupling management risk from growth risk, the capital manager can focus on the right risk for their role. For the multitude of capital purveyors who don’t care about the benefits that come with ownership investments, like control of the business or a wider menu of vengeful lawsuits, it’s a better arrangement. Their business is to move and manage capital, and a royalty only on revenue might allow them to actually “mind their own business” while the manager minds his!
We believe in the scalable potential of simplified venture investing.
If the masses will ever successfully engage in backing higher risk ventures, some variables in the equation have got to go. That’s why our bet is on royalty-on-revenue and not on equity: easier to predict success, leave management risk to the managers, less legal hassle for lower transaction costs.
For all the aspiring actors following along, just remember to get gross points when you can.
This week, Chris Yeh in his Mashable Op-Ed article Why Valuations Are Getting to High for Seed Stage Investors outlined the circumstances leading to inflated seed stage valuations and the problem that presents for angel investors.
Chris points out that angel investors have the most to lose with these high valuations. And entrepreneurs should be concerned because they will miss out on the expertise of good angels if they are not also financially incentivized as investors.
Reward Investors for their Expertise
Revenue Trades has a new way to reward angels for their expertise and can leverage funding from the public. An angel investor with a complementary background for the current needs of a business can bring extra value to a deal and rally public support.
In many large angel groups, the member with the most relevant industry experience typically leads the round of funding and encourages other members to participate. However, the lead angels providing the most non-monetary value do not get special deal terms compared to the rest of the group.
Preferential Treatment for the Value Added to the Investment
Revenue Trades emphasizes the value provided by Experts to Businesses. When that match is made, the deal has higher potential and sets the stage for additional funding parties to enter the round.
We think pre-seed and seed stage investors should offer expertise and funding together. Moreover, our Expert-based system rewards those investors that not only fund Businesses, but also bring additional value to the deal. We accomplish this without adjusting the deal terms, instead, we compensate the lead angels that help businesses achieve actionable goals by rewarding the lead with a portion of the surplus returns delivered to follow on funders.
It’s scary to think that a person’s career earnings may be capped before they turn 18.
In the current system, undergraduate professors evaluate their students based on how they performed in accordance with their standardized grade scale. Unfortunately, if students deviate from the path designed by their undergraduate professors, they lower their chances at future employment through that school’s connections into the corporate world.
It’s also prevalent for big service firm human resources to not accept candidates for higher paying entry levels jobs if they did not graduate from a certain tier school with a GPA hurdle being met.
But, hey, that’s where entrepreneurship can change things - the undergraduate education ecosystem just needs to get with it and realize the trouble it is currently propagating.
While I was in college (2004-2008), my professors were complaining that undergraduates were a burden. They whined that they needed more time to produce research on over studied topics, so that other professors would cite them.
For example, my senior thesis proposal was shot down by a professor more interested in his own pursuits than on supporting an innovative idea suggested by another of his “undergraduate burdens”. Shortly after being rejected, I posted the concept on the most popular digital media venture capital blog at the time:
joeter, back in NY
For my economics senior seminar I wanted to build a model on this. I was trying to figure out more about the attention economy. I felt labor economics was the best place to start and used the basic labor-leisure trade off.
I made the assumption that users were a cost of input just like factory workers since in web 2.0 sites the users add a large portion of the value (or at least keep the site functional).
Y-axis: value of service (insert your marketing effort here)
X-axis: trade off between ‘rent on privacy’ and ‘$ cost of service’ (i used a percent scale since I didn’t fully figure out a way to have them expressed in the same unit)
The constraint I called the convenience rate, which then allowed for different indifference curves to be drawn tangent to it depending on user preferences. The multiple business models on the web would fit in between the x-axis scale.
The model is basic and there’s a lot more I can flesh out, but that’s because it’s still in infancy; for a poor reason. Unfortunately, my proposal was turned down. My professor told me to try another topic he knew more about – like sports betting.
Conclusions to be drawn:
It’s apparent that there’s a giant structural problem with the current system. Students aren’t encouraged to take risks in college to explore unique ideas, since they do not want to jeopardize meeting the criteria of their “professor to HR connection”.
Moreover, the cost for college education has been continuously rising (along with student debt), while the number of high paying jobs for young people in the USA appears to be falling.
To fix this problem, we need to increase the number of college graduates that go and create their own businesses to spur future employment. However, the change needs to be effectuated by more than just colleges.
Mentors need to be able to recognize those students who have the potential to be great entrepreneurs and these mentors must be properly incentivized to work with this talent. Experienced mentors from any industry could guide entrepreneurs, and thereby accelerate the proliferation of innovative businesses which are needed to sustain our economy.
Finally, this mentor model could also work for professionals looking to transition from a large company career path into the world of entrepreneurship.
Entry by: Joe Williams
The ROI for 39% of US angel investors is negative.1
While 39% is not a majority, it represents something bigger than a trend or coincidence of all angel investing. The bottom-line, from a pure financial perspective, is that more than one third of all angel investors are wasting their money.
That’s less than a 1x return on capital. That’s a losing proposition. And it’s down-right puzzling. After all, angel investors are all accredited investors having achieved some substantial success. Come to think of it, I have never met an angel investor who did it to get by!
There are many contributing factors to this problem, whether you consider modern angel investing practices or the current climate of early stage investing. One factor stands out to us.
WHERE IS THE MONEY?
I spent a year exchanging emails with angel investors across the world in my role as Community Manager at Angelsoft.net, the collaboration platform used by most angel investor groups. Once, a manager of a California angel group relayed his disappointment when meeting promising entrepreneurs. Even if the entrepreneur presented a strong deal to the group, many willing and interested angel investors in his group could not invest because their available capital was in ventures still far from exits.
When the recession hit, everyone was affected. My own startup raised $200k in the weeks before Lehmen Brothers fell. Our business model relied on the availability of bank financing for real estate projects. When that financial infrastructure came screeching to a halt, we closed our doors and returned the funds we raised. Thankfully, nobody got hurt and we parted on good terms.
For those angel-funded startups that survived with cash on hand, the path to a liquidity event has become a longer one. Only years later are we seeing a surge in technology IPO activity.
The recession has reduced the number of angel funded startups still in business and increased the “gestation period” for pre-recession angel investments. This is all aside from the bigger issue of how many angels lost liquidity in the recession from other investments.
RELOAD THE ARTILLERY
Angel investors risk their own cash. And when it is gone, it is gone. Unlike venture capitalists, angel investors will not raise another round to maintain their investment habit. They have to wait until a portfolio investment turns into cash to continue investing.
According to Kauffman’s eVenturing guide, “While the average time to exit was four years, the home runs took an average of 8.6 years to harvest. Lemons sour quickly but plums take longer to ripen.”2
It’s a liquidity problem, of course. It is to be expected when investing directly in an early stage company in exchange for equity in the venture. The benefit, of course, is the potential upside of the venture if it is extremely successful.
For some angel-funded or VC-funded ventures, there is an opportunity to hold on to that upside potential while returning the principal investment so that it can be reinvested in the next big thing.
ROYALTY AND EQUITY, LIKE PEANUT BUTTER AND JELLY
Revenue Trades is pioneering the process of combining equity and royalty investments. For ventures with the right margins and growth potential, royalty with equity provides benefits to entrepreneurs and investors.
A royalty investment is a promise to pay out to the investor a percentage of future revenue for capital given today.
Investors can plan on a return of their principal and even interest from the revenue of the company. And an uncapped royalty can tie the upside potential to steady liquidity. Entrepreneurs can give up less equity. After all, they expect to stay in the venture until the end!
A simplified royalty agreement consisting of a set percentage over a set period of time would not work for many typical startups. What about including a delayed period where revenue is 100% retained for a couple years? How about a variable royalty percentage tied to other growth metrics?
Getting principal back sooner from a healthy investment can be the difference between saying yes or no to that next new entrepreneur—while maintaining that portfolio of long term investments with fantastic upside potential.
Will this solve the problem of negative ROI for 39% of angel investors? Probably not. But we must all do our part to solve that problem. After all, we want to be angel investors too.
1 Page 4 of the Kauffman report, “Returns of Angel Investors in Groups”. About the study or download the full report.
2 Page 9 of the Kauffman-sponsored eVenturing guide. Download the guide.
Entry by: Israel Vicars
After an initial grinding phase to organize our business, we are finally ready to start blogging a few times per week.
Since we first started building the concept of RevenueTrades.com in September, a lot has happened in the venture business. Mark Suster does a great job explaining how the game is changing for VCs.
We do not view these changes as negative - we’ve been expecting disruption in this industry ever since the proliferation of startup accelerators (aka Ycombinator clones).
We do, however, anticipate things to get even more exciting for entrepreneurs - and we want to open up the potential returns to anyone; not just the wealthy.
To get our content rolling, here are a few trends we have been watching and will be commenting on over the next year:
1. Education and big service firm Human Resources have co-evolved to an unsustainable point
2. Apps are becoming simpler to create for even non coders and although there will be “next generation Marios”, expect most apps to have a similar half-life as hot NYC night spots
3. A person’s attention is quickly becoming their most valuable asset while discovery technologies are vastly improving and being introduced to consumers in more relevant ways
4. Web platforms are communicating more data back and forth every day
5. Privacy concerns are growing and these are not only isolated to Facebook blunders or data mining companies trying to serve you targeted ads
More to come soon, but on a final note, we have started evaluating applications from companies to be included in our first batch of businesses.
Fill out this form to start the process, and we will be in touch.
Entry by: Joe Williams
Entry by: Joe Williams
Entry by: Joe Williams
The purpose of this blog is to:
Entry by: Joe Williams