What happened at Pipe?
Revenue-based financing collides into higher interest rates
Note: There is some controversy about what events transpired to cause Pipe’s CEO to resign. A VC had posted a tweet last week detailing some troubling allegations; that tweet was subsequently deleted. Before it was deleted, I had revised this post with a link to that now-deleted tweet. I don’t know what the truth is at this point, and so am including the CEO’s recent tweet thread for reference:
My original post continues below.
Setting the scene
The co-founders of revenue-based financing startup Pipe announced this week that they’re all resigning, and that they will search for a seasoned CEO and COO to replace them. Normally, when a tech startup founder cedes the reins to an experienced scaler, the person so charged with scaling the company is hired before the resignation is announced.
So, people have questions.
I can’t tell you what prompted these resignations. But clearly something has deteriorated at the company, and I think it’s pretty easy to figure out:
Pipe’s main customer base is small SaaS companies
Small SaaS companies have been negatively affected by higher interest rates: their customers are scrutinizing expenses and cancelling unneeded subscriptions
Efforts to diversify Pipe’s revenue base have failed
The rest of this post goes into this in more detail.
OK, sounds interesting. So what is revenue-based financing?
Revenue-based financing companies provide cash to companies in exchange for a senior claim on that company’s revenues. I give you $1 million in cash right now, in exchange for, say, $1.25 million in payments over X number of months. But instead of taking that $1.25 million from your gross profits, I’m going to take it directly from your revenue. I get my hands on my cash before you pay any other expense.
One way for revenue-based financing companies to find customers is to look for companies that have recurring revenues. Recurring revenues tend to be contractually guaranteed payments, so from the perspective of a financing company that wants a claim on your revenues, companies that have recurring revenue is a pretty good bet.
In the tech space, SaaS (software-as-a-service) companies are an obvious fit. But more typical use cases are oil & gas pipeline projects, film production, etc. Pipelines generally create reliable revenues, film productions earn revenues through ticket sales, etc. Their revenues are relatively predictable, at least as compared to companies with more volatile revenue streams like, say, a retailer or real estate developer or car company.
Here’s Investopedia explaining the concept:
Revenue-based financing, also known as royalty-based financing, is a method of raising capital for a business from investors who receive a percentage of the enterprise’s ongoing gross revenues in exchange for the money they invested.
In a revenue-based financing investment, investors receive a regular share of the businesses income until a predetermined amount has been paid. Typically, this predetermined amount is a multiple of the principal investment and usually ranges between three to five times the original amount invested.
Is Pipe a revenue-based financing company?
Pipe tries to differentiate itself from traditional revenue-based financing (RBF) companies:
Because RBF providers are depending on the underlying loan (often provided by a bank) they can be limited in scope as well as in the industries they can serve. The lender dictates who can be funded and how much funding they can access. Many RBF lenders are capped at a few million dollars in funding and may only serve high-growth tech companies, SaaS, or eCommerce businesses.
As a trading platform, Pipe doesn’t try to fit your business in a box. Instead, we make your revenue streams available to institutional investors looking for a diverse mix of revenue streams. That means Pipe can be a great fit for many businesses with recurring revenue, whether they’re SaaS, D2C, service businesses, or something else entirely. With Pipe, your access to growth capital is limited only by your recurring revenue and the health of your business.
This is, of course, a distinction without a difference. Pipe may not call itself a revenue-based financing company but it is in fact offering revenue-based financing! It literally makes reference to enabling companies to use recurring revenues as a vehicle for raising cash!
Traditional revenue-based financing companies usually arrange a loan from a bank, the proceeds of which they then use to provide revenue-based financing to their customers. And that bank loan has covenants attached to it, which restrict the revenue-based financing company to specific types of opportunities: “you can only use the proceeds of this loan to finance oil & gas pipeline projects in South Dakota.” These covenants limit traditional revenue-based financing companies’ options and so their growth potential.
Pipe claims that it is different from revenue-based financing companies because it does not rely on restrictive bank loans. Maybe Pipe relies on a revolving credit facility of some sort. This can provide it with greater operational flexibility.
Maybe Pipe is able to offer better repayment terms because it does not rely on restrictive bank loans for its financing. And because Pipe is not constrained by the terms of a bank loan, it gets even better: it can package these financings and sell them to institutional investors looking to buy assets uncorrelated with the stock market. This is asset securitization, and when it works it’s a great way to remove risk from your balance sheet. So Pipe basically operates as a revenue-based financing middleman, sitting between demand (institutional investors looking to buy alternative assets) and supply (companies looking for alternative financing sources).
And being the matchmaker in a two-sided market can be a great place! Especially if you’re able to build slick-looking tech on top of what is otherwise a pretty conventional business. When supply and demand is abundant, but the market is relatively opaque, being the matchmaker in a two-sided market is a great way to capture fees from both sides of a transaction.
Enter interest rates
This entire model—capture transaction fees from companies looking for cash and from institutional investors looking to buy revenue-based financing cash flows—relies on low interest rates.
In my mental model of Pipe, the demand side is institutional investors looking to buy asset securitizations. The supply side is the companies looking to raise cash from Pipe. And both the demand and supply side are negatively affected by higher interest rates.
Let’s take the demand side first. Pipe apparently packages its financings into securitized assets that it sells to institutional investors. There’s nothing original here—asset securitizations are a pretty standard way to package a risky asset sitting on your balance sheet and sell it to a buyer who is more interested in taking on that risk in exchange for guaranteed cash payments. And in a low interest rate environment, this kind of risky, illiquid asset is attractive! The yield is above the prevailing interest rate, and institutional investors are mainly interested in capturing yield above that of the market.
But when interest rates rise, risky and illiquid investments suddenly become much less attractive. Because the prevailing interest rates have risen, the spread between that interest rate and the yield on a risky and illiquid asset, such as an asset securitization, is suddenly much smaller. And the yield spread is your compensation for taking on risk. But if that spread compresses because interest rates have risen, suddenly you’re not being compensated very well for taking on that extra risk!
This means that as interest rates rise, the demand side of Pipe falls away, and Pipe is left with risky assets (its financings to SaaS companies) sitting on its balance sheet.
On the supply side, Pipe’s customers are all reeling because their own customers are canceling subscriptions as capital becomes more scarce and more expensive in a higher interest rate environment. The SaaS companies which are faring best right now are the largest ones, and they’re not the ones that need revenue-based financing. Like all too many fintech startups as of late, Pipe’s main customer base is likely other startups. When times are good, startups can be great customers. But because their finances are so shaky, as soon as economic conditions deteriorate, startups start conserving cash.
This has the second order effect of negatively affecting Pipe.
So where does this leave Pipe?
Pipe finds itself in the difficult position of facing decreasing interest on both its supply and demand sides. And that decreasing interest is mainly a function of higher interest rates. This is a non-linear phenomenon, and a complex one at that.
Pipe needs to find a CEO who can scale a company given declining economic fundamentals. It needs a CFO who can model interest rate sensitivity in a bond portfolio.
These people exist, but they’re in super high demand and so are very expensive to hire. Pipe's founder Harry Hurst says that Pipe has five years worth of runway:
Hopefully that buys them time to find the right people to take Pipe to the next level.