Photo: Wally Gobetz

Yesterday I explained the pitfalls of too much venture funding. Whenever posting about a problem I will always attempt to follow up the next day with a potential solution. My idea is a Venture Capital funded bank account to be used by the startup where every X dollars spent translates into a percentage point of equity. The beauty in this model is that the startup receives the funding they need, but are incentivized to keeps their costs under control and become profitable in a hurry.

Let’s imagine a fictitious hot new internet startup looking for series B funding to take them to the next level. The offer they receive from KPCB is $10 million in exchange for a 40% in the company. Sounds great right: a ton of money from one of the best venture firms at what the founders feel is a generous valuation. Wrong! Take that same valuation but avoid the trap of taking more money than you need. Here is a potential counter offer:

• $2 million immediately for an 8% stake
  • This amount will certainly be needed before becoming profitable.
• The VC firm opens a bank account / line of credit for up to $8 million more where every $25k is 0.1% of equity
  • Forces the startup to watch their expenses rather than quickly burning through money without consequences
  • Protects startup from equity dilution (an excellent explanation) by only granting equity to the VC for funding used

If things start to go downhill for the startup there must be some protection from the VCs simply closing the account. Here are some potential rules:

• Account must be open for a minimum 2 years or when all $8 million is spent.
  • In the event that the VC wishes to close the account after two years they are responsible for 3 months at the current burn rate (the monthly rate they are losing money: expenses – income).
  • Here is an example. At the end of the two years the VC firm notifies the startup that they wish to cut funding. The startup has spent 5 of the original 8 million and their current monthly burn rate is $200k. With this rule the VC firm must leave $600k (3 months multiplied by $200k a month) in the account to get the startup through the next 3 months while they search for additional financing, miraculously reach profitability, or prepare for their grave. The good news is that the VC fund lost $2.4 million less than they would have with their initial offer ($2 million immediately + $5 million for the first two years + $600k for the final three months)

If things go well for the startup the VCs must be protected against outside investments:

• No additional funding to the startup is allowed unless all $8 million is exchanged for equity
  • 1 year in if the valuation of the startup skyrocketed this would prevent them from taking funding at the new valuation that has much better terms.

This deal should be attractive to VCs because they originally wanted to invest at the given valuation, although they are only getting a smaller portion of guaranteed equity. An extra benefit is that if things do go well they get to continually invest at the old valuation – a year later if the valuation of the startup is $100 million they still get to invest at the original $22 million valuation. This certainly sounds attractive.

But this idea could be made even more complicated. Why have a linear relation between the funding taken and equity provided? As the 2 year deadline draws near it should be much more “expensive” for the startup to burn through funding (because they should be profitable at this point and if they aren’t it is highly risky) – potentially $10k for 0.1%. A function for the change in payout vs. time could be negotiated.

I don’t know if Venture Capital firms would go for this model but it is worth a try. I know if I ever find myself in the position with a VC offer I will counter with this complex scheme.