The largest wealth transfer in the history of venture?

Over the last decade, subscription and subscription-like business models have become pervasive. Business models have shifted to allow customers to grow into their lifetime value rather than commit to large upfront payments: this was manifested in the move to “pay-as-you-go” pricing structures. This includes business models as diverse as: paying one-time for DVDs to streaming on-demand; purchasing a computer game upfront to in-app purchases; perpetual licenses to SaaS; and the list goes on. This model came to dominate because it works: companies can widen their net and capture more initial customers, who over a period of time become much more valuable than the set of customers willing to engage in a lump-sum upfront purchase. Companies noticed this, as did investors. But this shift creates deferred cash flows that can inadvertently consume much more capital than before. 

In this model, the faster your business grows, the more cash it burns from S&M (Sales & Marketing): businesses effectively finance a customer's lifetime value using their own balance sheet, versus realizing it at the point of sale.  The acquisition of each customer represents a cash ‘trough’ on day one, which is only paid back in months and years to come by the lifetime value of that customer; by the time the customer acquisition spend from the past is in the positive, a fast-growing company is spending multiples more on new customer acquisition, which means companies grow faster and faster – with consistent unit economics and positive metrics – all the while continually burning cash. As a result of this cash trough, founders have grown dependent on “growth” equity capital to fund their ambitious goals. But that growth comes at a price:  dilution.  Most founders own <20% of their companies by the time of their IPO; some founders own <5%. 

For a sense of how much the goalposts have moved: the Microsoft founders owned almost four-fifths of their company at IPO. This shift in business models has caused what is arguably the single largest wealth transfer from founders to “growth” equity investors.

With the rise in interest rates, the days of free-flowing late-stage capital are gone; the cost of feeding the customer acquisition machine through repeated equity raises has become slower, more painful, and more expensive. Now, more than ever, we believe there is a need for a source of capital that is not beholden to equity valuations and allows companies to continue to invest in growth without negatively impacting their balance sheet.

‍Sources vs Uses of Capital

For many companies that have found product-market fit, their primary use of capital is to fund the burn caused by S&M spend (Sales & Marketing) or CAC (Customer Acquisition Cost). This activity is largely funded using “growth” equity today, which inadvertently turns these businesses into dilution machines and provides minimal leverage on that investment. 

Traditional debt and variations of it such as ARR financing, credit lines, or revenue based financing can be a cheaper source of capital, but are not designed to fund S&M, for the simple reason that debt has to be repaid or refinanced on a fixed schedule. The payback on S&M is variable in nature, but a company’s debt repayment is typically fixed. Using debt for S&M can create an asset-liability mismatch, which encumbers the company with downside risk (not too distinct from what we saw in the recent events with SVB). This is why debt and debt-like products have never supplanted using equity for S&M/CAC. This is not an indictment of those capital sources, which still have a place in the capital structure, but at a fundamental level, they are not risk capital, limiting how much of it can be used to fund S&M.

Because of the misalignment between variable paybacks from sales and marketing, and fixed debt repayment, almost every company funds its entire S&M budget using equity, effectively getting no leverage on that investment. 

Navigating the downturn

Many companies that achieved product-market fit in the last couple of years when access to equity capital was abundant, have had to reset their plans to manage cash to get as close to their prior valuation as possible before they have to raise their next round. This is forcing companies to grow a lot slower than they otherwise would.

As we move to an environment where capital is much more constrained, we believe equity should be preserved for what it was intended to underwrite: unstructured risk like investments in product, engineering, new markets, etc., with uncapped return. Spend $10mm on a team of engineers and designers to build a product and you might generate $0 in value – or you might create billions. Spend $10mm on sales and marketing, and once a company reaches product-market fit, you can predictably say your return will be range-bounded on a 2-3 year time horizon.

Once a business has components that are “structured”, like S&M and CAC, those components deserve a solution that is precisely matched to their output – just like a company with inventory gets financing tied to that inventory, or a company in need of a machine takes out a financing tied to the value of that machine. Using equity to fund S&M is a poor use of that capital, which is even more pronounced now given the capital constrained environment.

GC’s Customer Value strategy

GC created the Customer Value strategy to solve the issue of how to fund S&M/CAC– avoiding the endless dilution and instead providing leverage on this investment. We did this by treating S&M/CAC as though it's an asset.

With this strategy, GC pre-funds a company’s S&M budget. In return, GC is entitled only to the customer value created by that spend, and GC’s entitlement is capped at a fixed amount. After GC reaches that fixed amount, the remaining lifetime value of the customers is the company’s to keep forever.

On the flipside, if the S&M spend does not pan out as expected, GC owns the downside – GC only gets paid if and when the company gets paid. The company never comes out of pocket to pay GC back.

This strategy seeks to give the company a balance sheet to invest in growth, so it can preserve or reallocate its own capital to unstructured – and higher-expected-value – risks, such as product and engineering or just use the excess cash to build a fortress balance sheet.

Many fast growing late stage companies are already using this

Below are reactions from a few companies whose growth we have been funding:

Fivetran: “This product has had significant benefit for us by providing a dedicated way to scale our sales and marketing investments with no additional risk to the company.” - Kalor Lewis, CFO

Kandji: “The product has been critical to our growth and enabled us to further invest in our GTM engine to drive customer acquisition. The product is a great balance to our strategy and has also helped build a long term relationship with a world class partner in GC” - Danny Zorotovich, CFO

Ro: “The product provides Ro valuable access to capital to bolster our balance sheet and allows us to invest our equity cash in high-value projects. As we launch new products, this is a meaningful tool to lever up our growth spend while capping our costs.” - Aron Susman, CFO

Superplay: "This product has been incredible for our company, almost like a secret weapon. We don't see a world where we'd go back to funding our CAC the way we used to." - Gilad Almog, CEO

Travelperk: "This product has helped us scale our investment in growth, while allowing us to re-allocate our equity into product and engineering. We now have a dedicated balance sheet that scales our growth according to our unit economics vs the whims of the market" - Roy Hefer, CFO

Upside: “We leveraged this product to unlock tremendous growth with an easy to work with partner that diligently understood our business model.” - Daryl Ribeiro, CFO

Equity is and will always remain the foundational layer of risk capital and we believe it should continue to be used for unstructured risk. The Customer Value strategy is intended to provide the next layer of capital, designed for structured risk like S&M or CAC.  And then there will always still be debt providers – where the cost of funds is very cheap, because the risk is existential and not performance based. 

There are pros and cons to all kinds of capital; at a certain scale of company, founders should devote as much attention to their business’ capital structure as they put into building their product. Our goal at GC is to create innovative capital solutions in support of the next generation of enduring companies. Companies interested in our Customer Value strategy should contact us to learn more.

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