The Unbundling of “Growth” Equity
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Money has product-market fit, but not all capital is born equal. At General Catalyst, we are creating novel financial solutions to help the next generation of entrepreneurs build enduring businesses.
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.
Disclaimer
GC is an investment adviser registered with the Securities and Exchange Commission. Registration as an investment adviser does not imply any special skill or training. The contents on this website are not directed to any investors or potential investors, and do not constitute an offer to sell — or a solicitation of an offer to buy — any securities, or any financial instrument or property, and may not be used or relied upon in evaluating the merits of any investment.
The contents in here — and available on any associated distribution platforms and any public GC online blogs, social media accounts, platforms, and sites (collectively, “content distribution outlets”) — should not be construed as or relied upon in any manner as investment, legal, tax, or other advice. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment. Any projections, estimates, forecasts, targets, prospects, or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Any charts or figures provided here or on GC content distribution outlets are for informational purposes only, and should not be relied upon when making any investment decision. Certain information contained in the content has been obtained from third-party sources. While taken from sources believed to be reliable, GC has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. In addition, content may include third-party advertisements or links to websites not associated with GC in any way; GC has not reviewed such advertisements or websites and does not endorse any content contained therein. All content speaks only as of the date indicated and is subject to change at any time.
Under no circumstances should any posts or other information provided on this website — or on associated content distribution outlets — be construed as an offer soliciting the purchase or sale of any security or interest in any pooled investment vehicle sponsored, discussed, or mentioned by GC personnel. Nor should it be construed as an offer to provide investment advisory services; an offer to invest in an GC-managed pooled investment vehicle will be made separately and only by means of the confidential offering documents of the specific pooled investment vehicles — which should be read in their entirety, and only to those who, among other requirements, meet certain qualifications under federal securities laws. Such investors, defined as accredited investors and qualified purchasers, are generally deemed capable of evaluating the merits and risks of prospective investments and financial matters.
An offering to invest in a GC fund or similar entity will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety. Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by GC, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
There can be no assurances that GC-managed investment vehicle’s objectives will be achieved or investment strategies will be successful. Any investment in a vehicle managed by GC involves a high degree of risk including the risk that the entire amount invested is lost. Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by GC and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results. A list of investments made by funds managed by GC is available here: https://www.generalcatalyst.com/portfolio/. Past results of GC’s investments, pooled investment vehicles, or investment strategies are not necessarily indicative of future results. Excluded from this list are investments (and certain cryptocurrencies or digital assets) for which the issuer has not provided permission for GC to disclose publicly.
For other GC site terms of use, please go to https://www.generalcatalyst.com/terms-of-use/. Additional important information about GC, including our Form ADV Part 2A Brochure, is available at the SEC’s website: http://www.adviserinfo.sec.gov.
Money has product-market fit, but not all capital is born equal. At General Catalyst, we are creating novel financial solutions to help the next generation of entrepreneurs build enduring businesses.
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.
Disclaimer
GC is an investment adviser registered with the Securities and Exchange Commission. Registration as an investment adviser does not imply any special skill or training. The contents on this website are not directed to any investors or potential investors, and do not constitute an offer to sell — or a solicitation of an offer to buy — any securities, or any financial instrument or property, and may not be used or relied upon in evaluating the merits of any investment.
The contents in here — and available on any associated distribution platforms and any public GC online blogs, social media accounts, platforms, and sites (collectively, “content distribution outlets”) — should not be construed as or relied upon in any manner as investment, legal, tax, or other advice. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment. Any projections, estimates, forecasts, targets, prospects, or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Any charts or figures provided here or on GC content distribution outlets are for informational purposes only, and should not be relied upon when making any investment decision. Certain information contained in the content has been obtained from third-party sources. While taken from sources believed to be reliable, GC has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. In addition, content may include third-party advertisements or links to websites not associated with GC in any way; GC has not reviewed such advertisements or websites and does not endorse any content contained therein. All content speaks only as of the date indicated and is subject to change at any time.
Under no circumstances should any posts or other information provided on this website — or on associated content distribution outlets — be construed as an offer soliciting the purchase or sale of any security or interest in any pooled investment vehicle sponsored, discussed, or mentioned by GC personnel. Nor should it be construed as an offer to provide investment advisory services; an offer to invest in an GC-managed pooled investment vehicle will be made separately and only by means of the confidential offering documents of the specific pooled investment vehicles — which should be read in their entirety, and only to those who, among other requirements, meet certain qualifications under federal securities laws. Such investors, defined as accredited investors and qualified purchasers, are generally deemed capable of evaluating the merits and risks of prospective investments and financial matters.
An offering to invest in a GC fund or similar entity will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety. Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by GC, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
There can be no assurances that GC-managed investment vehicle’s objectives will be achieved or investment strategies will be successful. Any investment in a vehicle managed by GC involves a high degree of risk including the risk that the entire amount invested is lost. Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by GC and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results. A list of investments made by funds managed by GC is available here: https://www.generalcatalyst.com/portfolio/. Past results of GC’s investments, pooled investment vehicles, or investment strategies are not necessarily indicative of future results. Excluded from this list are investments (and certain cryptocurrencies or digital assets) for which the issuer has not provided permission for GC to disclose publicly.
For other GC site terms of use, please go to https://www.generalcatalyst.com/terms-of-use/. Additional important information about GC, including our Form ADV Part 2A Brochure, is available at the SEC’s website: http://www.adviserinfo.sec.gov.
