MSBA professors create an optimization model demonstrating that revenue-sharing contracts provide a higher net present value and a lower probability of bankruptcy.
Crowdfunding is the trending way to raise money.
This democratization of financing, enabled by sites such as Kickstarter and Indiegogo, offers small businesses a speedy alternative to cumbersome and often elusive bank loans and small investors an accessible alternative to the stock market.
Typically, online crowdfunding sites allow companies to offer rewards, early access to products or firm equity in exchange for investment.
But a new kind of crowdfunding, built around revenue-sharing contracts, may serve the interests of both businesses and investors better than the alternatives, according to research by Soraya Fatehiand Michael Wagner of the University of Washington Foster School of Business.
An optimization model created by Fatehi and Wagner demonstrates that revenue-sharing contracts provide a higher net present value and a lower probability of bankruptcy.
It also shows that these benefits are heightened for firms with uncertain cash flows.
“In practice, we’ve seen crowdfunding with revenue-sharing contracts to be very fast and successful,” says Fatehi, a doctoral student at the Foster School. “Now our analysis shows its superiority to other financing models, including equity crowdfunding and small business loans.”
Crowdfunding = Sharing fortunes
Crowdfunding sites provide an online marketplace that matches small and medium-sized firms needing to raise capital with individuals looking to invest in promising new products and services. The newest version of this model, pioneered on sites such as Bolstr, Localstake and Startwise, allows firms to repay investors a multiple of their investment set at a percentage of future revenues.
Here’s how it works, in a simplified example:
Firm A offers to reimburse investors 1.5 times their investment by paying 0.5 percent of revenues until they have paid off the multiple. Investor B “loans” Firm A $1,000 to expand its business. With the 1.5x multiple, Firm A is contracted to repay Investor B a total of $1,500. If Firm A makes $100,000 annually, on average, it would pay back its debt in three years, at a rate of $500 per year. But if Firm A only brings in $50,000 annually, it would pay Investor B $250 per year, taking six years to pay off the loan.
So the repayment time and rate of return—and effective interest rate—is variable, dependent upon the fortunes of the firm. When business is good, payback is fast and the interest rate is high. When business lags, payback is slower and the interest rate is lower.
It’s certainly a novel model of financing. But does it actually work better than other forms of crowdfunding or small business loans?
To find out, Fatehi and Wagner constructed a model using real data—investments, monthly revenues, costs, rates of return—from 56 company fund-raising campaigns on Bolstr. This model calculated the optimal outcomes of these same fund-raising efforts in the form of revenue-sharing crowdfunding contracts, equity crowdfunding contracts and small business loans.
At the bottom line of each equation was net present value (NPV), the difference between the current value of a sum of money and its future value when it has been invested at compound interest. Or, to put it another way, it’s the expression of future cash flows in today’s dollars. The best investments have the highest NPV.
“The investment structure is different in all three cases, but the objective is the same: to maximize the net present value,” says Wagner, an assistant professor of operations management and Neal and Jan Dempsey Endowed Faculty Fellow at Foster. “This allows us a true apples-to-apples comparison.”
The model revealed that revenue-sharing contracts produced the highest NPVs, on average. And it illuminated several distinct advantages to investor and investee.
“Revenue-sharing contracts intuitively align the incentives of firms and investors in a way not possible with traditional fixed-rate loans,” says Fatehi.
For firms seeking to raise capital, revenue-sharing contracts yield lower effective interest rates, on average, than small business loans, which are hard to get and take a long time to pay off. They offer a cheaper way to raise money than equity contracts. And they’re generally the quickest path to funding. But the biggest advantage is the adjustable monthly payments that reduce the pressure of meeting a fixed payment during slow times. This lowers the risk of bankruptcy for smaller—and inherently vulnerable—companies.
“This more flexible repayment agreement is linked to the financial performance of the firm,” says Wagner, “allowing variable payments and investment horizons, thus reducing financial stress on the borrower.”
For investors, revenue-sharing contracts allow a fairly low threshold for investing, compared to angel or venture-capital investing, or even entry in some high-end mutual funds. This makes for an appealing option to the stock market (for those who think it may be overpriced), and an opportunity to diversify. But perhaps the biggest advantage is in mitigating the risk of bankruptcy—increasing the chance an investor will get reimbursed.
“It’s a uniquely flexible investment that reduces the inherent risk of investing in smaller firms,” adds Wagner. “Because it doesn’t kick a firm when it’s down, you’re more likely to get paid back in full.”
Not surprisingly, the study also reveals that the benefits of revenue-sharing contracts are more significant for firms with more uncertain cash flows.
Bolstr, which brokers investments in a range of smaller companies, recently reported that an investment across its campaigns would yield a 19 percent return on investment. Not too shabby by most measures.
Wagner and Fatehi’s work can’t confirm this number, but they do find this new model of crowdfunding most promising.
And while their optimization model was built looking backward, they say it could also be valuable to firms looking forward.
For instance, a business looking to expand a product line or make a capital enhancement could enter projected costs and cash flows and calculate not only the best form of financing to pursue, but also the optimal amount, rate and repayment multiplier.
“In practice, many firms eyeball these decisions,” Wagner says. “And they’re probably sacrificing some net present value because they’re not raising capital optimally.”
He cautions that not all adjustable contracts are equal. Revenue-sharing debt is totally different than “performance-sensitive” debt which rewards a high-performing firm with a lower interest rate, but penalizes a firm doing poorly with a higher interest rate.
“It’s the complete opposite, and it has been shown to be really bad for both the firm and the investor,” Wagner says. “On the other hand, revenue-sharing crowdfunding benefits all parties.”
He adds that some universities have begun experimenting with the revenue-sharing model for student loans which link repayment to a percentage of future income.
“Crowdfunding via Revenue-Sharing Contracts” is forthcoming in the journal Manufacturing & Service Operations Management.