ImpactAlpha, July 28 – The national focus on racial justice has expanded to include equity in finance and investing. Implicit bias in venture capital and structural discrimination in lending have left many women founders and founders of color without access to capital.
Entrepreneur-turned-investor Kim Folsom last year raised $100 million in debt capital for Founders First Capital to provide revenue-based financing and support to 500 service businesses founded by women, founders of color and military veterans. That makes Folsom one of the largest “alt-capital” providers to diverse-led businesses.
In a Q&A with ImpactAlpha, Folsom explains how investors with flexible deal structures and ecosystems of support can help diverse founders start businesses – and grow them into job engines for a diverse workforce. After expanding from San Diego to Dallas and Austin, Folsom is headed to Chicago and other cities with large, diverse populations to fill capital gaps left by legacy business financiers.
As unicorns stumble, investors warm to revenue-based financing for ‘zebras’ and ‘Clydesdales’
Folsom says overcoming businesses funding challenges facing women and founders of color is fundamental to solving underlying social and racial economic inequality. Recent research suggests equity-like and hybrid capital can boost investment in operating businesses and close capital gaps for Black and Latinx entrepreneurs.
Financing based on a share of revenues requires enterprises to have customers, rather than collateral, and lets founders retain ownership and control. Royalty distributions can alleviate the need for a sale or IPO to return investor capital.
Inclusive capital means more flexible terms and more diverse founders
“The fastest growing and largest group of diverse employers are other diverse founders,” Folsom says. “People think that we’re funding yoga shops and coffee shops. That’s not true. Our companies are essential-solution providers to mid- and large-scale businesses.”
ImpactAlpha: What challenge is Founders First solving and for what particular type of business?
Kim Folsom: I came to this with a different perspective than most money managers. I was a serial tech entrepreneur and had an opportunity to be funded by some significant institutional VCs and had participated in over 12 accelerators. The environment and the support that’s provided to tech companies is not just providing them capital. There’re so many wraparound services on the other side: social capital, ecosystems. If you are 1) not part of that or your company is not a tech company; or 2), you don’t have experience; or 3), you don’t happen to be in one or two primary cities, where most of the capital is, it really makes it quite difficult for you to grow a substantial company.
Most business founders don’t qualify for traditional debt or equity capital. For businesses led by diverse founders, it’s only getting worse, especially with COVID-19. Ninety-five percent of them overall did not participate in PPP – and that’s just accessing capital. There’s more that has to be done to support them. When I founded Founders First in 2017, I recognized that there’s support that needs to be had at the beginning. It’s recognizing the contributions that they can make with the right support. We have a pre-funding accelerator on the one side through our nonprofit. And then on the other side, through the for-profit, we provide direct funding. Not traditional debt, which also is not right for a lot of these companies that don’t have the credit or personal collateral to get access to six figures of capital. It’s much more of a shared opportunity and that’s the opportunity you have with revenue-based funding. After we fund them, we provide advisory support to help them grow.
ImpactAlpha: How can revenue-based finance meet the needs of founders of color better than traditional debt and equity?
Folsom: We work with service based companies, and most service based businesses don’t have a whole lot of assets that you can pledge against to get a substantial loan. Companies with less than $5 million in revenues, without the appropriate support for their model, may not have the predictability of the revenue streams that are required for traditional debt.
A lot of banks today that do traditional business loans, their model is based on businesses paying fixed amounts, regardless of whether or not their revenues continuously substantiate that. And that’s hard on most businesses. The risk model is such that you’re going to have three other sources to back it up. You’re going to have your business revenues, you’re going to have some personal assets, and you’re going to have real estate.
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Revenue-based financing is an interest in the business revenues. We take a royalty percentage of the revenues, and because it’s a royalty percentage, it can fluctuate with the monthly revenues of the company. The business owner and the investor of revenue-based investment are aligned. As the company grows, you increase the percentage associated with the royalty. There’s not a requirement that there has to be a big liquidation event in order to get the returns. You’re actually doing little monthly liquidation events with regards to that royalty distribution. You basically can help build the business without an exit and founders don’t have to give up control of the company in order to get access to capital and the investor doesn’t have to wait five or 10 years to get their returns.
ImpactAlpha: Why else is equity financing not meeting the needs of founders or color?
Folsom: With growth equity financing, the investor is looking for five, ten-times or more returns. A service-based business may not have that 10X return for them. The other side of it is you don’t have to give up substantial ownership in your company in order to get access to capital. There definitely has to be a liquidity event. You don’t have to give up a board seat. And you can still get access to smart institutional money to help you grow without having to give up those components.
ImpactAlpha: How many more moderate growth businesses are there in the economy then tech-based companies with 10X, unicorn potential?
Folsom: There’s a lot more. All of this hype around tech businesses – they’re a small percentage of businesses. And only a small fraction of those will mature to 10X. If you look at the way that VC funds work, they may do 10 or so deals. And of those 10 deals, one or two are going to mature 10X or more. What we’re doing with revenue-based funding is a way more efficient opportunity. We get to fund more companies. Our check size is six figures. Out of our $100 million, we’re going to fund 500 companies.
There’s way more diverse founders that are founding service-based businesses than there are tech businesses. There are a lot of people who want to start tech businesses that have no background in technology. They don’t have any background as a technologist but they think that running a tech business is going to be the way for them to get access to capital so they spend a lot of time chasing something that they’re not a fit for.
ImpactAlpha: On your site you say that these are “high-yield investments for fund limited partners (LPs) that perform like bonds but generate returns on par with equity investments.” Can you unpack that?
Folsom: For our LPs, we provide an income stream. Because we take revenue distributions from our businesses on a monthly basis, we’re able to provide quarterly distributions to our LPs.
ImpactAlpha: How many companies have gone through your support services? How many have gotten funded?
Folsom: We’ve supported over 300 companies. This year we will fund about 10 companies. Our average funding is $250,000. We do follow-on as well. Our goal is to be like an institutional fund. It’s not just an initial funding. We can fund them up to $1 million.
ImpactAlpha: Can you describe the types of companies that you’re funding?
Folsom: They are generally solution providers: Information technology services, compliance services, training-related services. They are enterprise platforms that are sold to slower paced industries, could be health care, government, educational markets. They have contracted revenues. We help them with establishing recurring revenue with some tech enablement. People think that we’re funding yoga shops and coffee shops. That’s not true. Our companies are essential-solution providers to mid and large-scale businesses. The challenge is, they may be half a million to less than $5 million in revenues. And that’s not a target that banks are looking to fund. They may not have a significant amount of collateral to pledge in order to get a good, six figure financing.
ImpactAlpha: Why isn’t there more revenue-based financing available?
Folsom: Revenue-based financing isn’t new. It’s been applied to other industries. In the entertainment industry, for example, revenue-based financing has been around for quite some time. If you look at Broadway shows and movies and those types of things use that method of financing. It’s a proven model that we, Founders First, are applying to the market that we are going after. Why hasn’t it been applied here? I don’t know. There is a perception that there’s an inability of the market we serve to deliver value and provide returns. However, there has been consistent research that shows that diverse organizations with the appropriate resources and support perform at or better than homogeneous organizations.
The other thing that’s unique for us is that I’ve been on the other side of the table. I was truly blessed to have founded, grown and raised $30 million in equity financing for my prior six companies. I know the grind that it takes to do this. My prior companies, I’ve grown them to be mid-market companies. Most of the people that have gone after funding this market have not been in the same shoes as the people that were seeking the funds. My mission is to help address this gap in economic inequality, as far as being able to grow these businesses to be employer-based businesses.
There’s so many benefits to this model working and winning, such that there are other people that are pursuing this because there is a big market. Because of what’s happened with innovation, major corporations are able to operate with significantly less workforce than they used to 10 and 20 years ago. Most diverse employees are not in leadership roles. That’s one of the issues that’s being talked about right now. What’s happening is more of these folks are going out and starting their own businesses. The current challenge has been access to resources to not start these businesses, I think we’ve done a fantastic job to help companies start businesses. There needs to be a better job of helping grow these businesses than what has happened before.
ImpactAlpha: Next Street recently identified a $146 million gap in equity capital for founders of color in Chicago and recommended equity-like capital as one solution to fill that gap. You’ve recently expanded to Chicago. Is it your strategy to move to where there’s a gap?
Folsom: Most capital, 40% or more of capital, goes to the two coasts. New York or the Bay Area. Less than 2% goes to women. Less than 1% goes to founders of color, and those are tech companies. So there are all of these gaps. Then when you go to second and third tier cities that have large, diverse populations, it’s even more so. So two years ago we expanded to Texas, for the same reasons, that there are under-capitalized, great companies in these markets that we can be a fit for. And the same is true for Chicago.
Spectrum of companies, capital and creatives aim for justice
ImpactAlpha: You recently launched the Racial and Social Economic Equality initiative. What does it involve?
Folsom: We have added components with regards to what we’re doing to more intentionally address the economic gap. Beyond the growth mindset of growing a business there’s also wealth-related issues, so we’ve added components into our program to help address those specific things because it’s way more intentional. There’s an assumption that if you start a business then automatically you’re going to become a millionaire. We’ve added components to help founders get the guidance to help achieve those wealth driving goals, be it owning a home, saving for retirement, sending their kids to college, being in position to address emergencies like right now. Those are the gaps that hurt communities of color because they don’t have the resources that majority communities have.
ImpactAlpha: The conversation about racial justice has expanded to business and financing and investments. Where does that conversation need to go?
Folsom: A lot of this is economics. The altercation with George Floyd began because he tried to pass a counterfeit $20 bill. Why would he do that? Because of economics, having sufficient capital to go about some aspects of basic life. Until we address the economic issues, unfortunately, we’re going to live in a groundhog-day type of experience.
There’s a wealth creation diagram. When you look at the growing disparity, or gap, in wealth between folks of color, specifically African Americans and Hispanics, versus, everyone else, it’s 10 to one. At the rates it’s growing, there’s a forecast that by 2035 it may be negative. Something has to be done. It used to be, “when there’s opportunity in education, they’ll be economic opportunity.” Well, there are more college graduates, women and people of color college graduates now and we’re still going through this. Look at the issue with regards to the pay gap: 80% for women, 65% for women of color, 58% for Hispanics. I mean, it’s crazy. So something has to be done.
ImpactAlpha: Is Founders First seeking to fix the underlying piping of the economic system to make it work better?
Folsom: By us helping diverse founders become employers, they have a greater diverse workforce than alternatively. Our diverse founders, 85% of their workforce is diverse as well. And one of the categories that we include in a diverse founder is military veterans. Ninety-five percent of their workforce is other military veterans. So while major corporations are dancing around the two or 4% representation of people of color, the fastest growing and largest group of diverse employers are other diverse founders. And so by us helping fund and grow diverse founder-led businesses, they can be a major workforce provider.
Corporations are making announcements and not so much outcomes. There’s a really big opportunity for them to partner with organizations like ours to help. They may not, for whatever reason, be in the position to significantly change their employee base but they can definitely add 5 to 10% of their spend with diverse founder-led businesses, thereby being able to increase employment for diverse founder-led businesses and increase in a diverse workforce.
ImpactAlpha: What’s next for Founders First?
Folsom: Executing the fund. Our mission is growing and funding diverse founders. When we started, our goal was to fund and grow 1000 diverse founder-led businesses and help them create 20 to 50 jobs. That’s a multi-billion dollar impact. We are expanding to Chicago this year but we look to expand to other, second and third tier cities and regions.
This Q&A has been edited for brevity and clarity.