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It's not debt, it's better: An interview with Harry Hurst of Pipe
Two Truths and a Take, Season 2 Episode 26
Six months ago I wrote a post in the newsletter called Debt is Coming, about the all-equity model of funding startups finally coming to the end. It ran away to become the most widely-read thing I’ve ever written, ever. (Read it first, if you haven’t yet.) Since then, I’ve had a blast getting to meet all sorts of interesting founders, operators and investors who are thinking about the future of financing recurring revenue software businesses.
Harry is one of those people. A short two weeks after Debt is Coming got published, Pipe launched with an investment from David Sacks’ firm Craft Ventures, and since then they’ve gone on to scale up their business with help from our good friends at Tribe Capital.
It’s been awesome to see this story come together. Last year when I interviewed Jonathan Hsu from Tribe for this newsletter he shared a great preview of what’s since begun to materialize:
“When you acquire some customers and they start yielding revenue that behaviour sounds an awful lot like buying a fixed income instrument and there is a lot of sophistication around how to value those cash flows. In some sense, what we’ve seen over the last decade is that software enables a whole new business model – recurring revenue – which is both good for customers and is good for investors. It’s good for investors because it becomes more “predictable” in the sense that it starts to look more like a fixed income yielding asset and thus more amenable to traditional financial techniques and thus potentially “in scope” for a wider set of investors.”
Pipe is this thesis, made real.
Up until now, founders have only two things to sell as they raise capital to fund their business: they can sell equity, and take expensive dilution, or they can sell debt, and take on covenants and other handcuffs. Pipe creates a new asset class to sell: the software subscription. Founders can now sell the recurring revenue from a cohort of software customers, as an easily tradable asset, and fund their growth without taking dilution. There’s enormous demand for those kinds of cash flows, but up until today, founders haven’t been able to hook up to that demand. Now they can, and the early results sound like they’ve been spectacular.
So I’m really excited to share this interview with Harry. Enjoy.
AD: Narrative matters a lot. I’m curious to know how other founders, VCs, and other people in the community are thinking and describing revenue financing to each other. What are the recurring themes you hear, both helpful and not, when other people describe your business?
HH: I think the recurring theme is equity vs. alternatives and the upsides/downsides of each. As you grow your company, equity can actually become harder to raise. I always tell founders that I mentor, that in most cases it’s a lot easier to sell what could be than what is, so enjoy that early stage while it lasts! At the later stages, the idea of funding your subscription-based software business leveraging alternative options becomes more attractive for a number of reasons which we can explore, so I think the conversation around revenue financing is becoming more and more relevant and prevalent.
There’s a broad spectrum of VCs and founders, the latter of whom possess differing levels of capability to maintain high growth and continually raise equity dollars at inflated valuations. For example, there are many companies who raise an angel/seed round, then a Series A, spend most of it on customer acquisition which flows right into FB and Google, which drives a ton of traffic to sustain high levels of growth. However, these channels aren’t always optimal or relevant for companies. Some are better suited to channels that are lower CAC but aren’t as scalable (more akin to how normal, non-venture backed businesses grow). For these companies where growth is slower but compounding, there should be more options for how they fund this growth that don’t include taking massive dilution at the hands of flat or down rounds.
This is where Pipe comes in for software companies with highly predictable recurring revenues by creating a tradable asset class out of the underlying software subscription, the asset that actually drives the equity value in the first place.
While Pipe isn’t a debt or revenue share financing product, generally speaking I think VCs at later stages may see alternative financing as a whole as a competitive model but in reality, the two can co-exist in harmony and actually benefit each other. I’m of the strong opinion that at the earliest stages of company building (pre-product market fit), the market-clearing price for a pre-seed or seed round is massively in the founder’s favor, especially if they are repeat founders.
Though I’m in awe of founders who bootstrap to scale, to me personally, it makes a lot of sense to figure out GTM and product-market fit using some equity dollars. However, once you’ve got product-market fit with a rinse and repeatable growth strategy, spend is going to shift toward S&M away from R&D and raising equity to plug the CAC to payback gap in cash flow seems like an incredibly expensive way of achieving this when alternatives like Pipe exist. I think VCs that invested at the earlier stages are very aligned here, as they don’t want to take dilution alongside the founders as they scale, or have to deploy more capital into the company to maintain their stake via pro rata, when they could be investing those dollars into other opportunities.
AD: That last point you made is really interesting. To reiterate: once a startup reaches product market fit and starts to scale, early stage investors have to sweat about their pro rata commitments if they want to defend their ownership stake. And the more capital-hungry the business becomes, the more money the investor will have to fork in order to just defend where they are. Angel investors certainly can’t afford that. Series A investors probably can, and it’s an important component of their fund structure, but imagine if they didn’t have to! It’s like hitting green energy targets by just insulating your house better, rather than putting up money for new clean power.
Have you worked out something like, for every X dollars of Pipe financing a business raises at say, series C, that translates to Y dollars worth of additional deals that their Series A VCs can do? That would be really interesting.
HH: I haven’t actually done that equation because we’ve been squarely focused on building the value prop for the sell-side and buy-side of our platform, not for VC’s specifically. I guess it depends on a number of factors which makes it quite hard to quantify, such as ‘how early did the VC invest?’, which usually translates into ‘how much of the company do they own?’, which directly translates into ‘how expensive is it for them to maintain their ownership via pro rata?’. The qualitative answer is, assuming you’re a lead investor that wrote an early check: a lot of deals.
With that being said, the majority of (smaller) investors on a cap table don’t tend to have the luxury of pro rata rights along the way and it’s from these investors that we see so many customer intros coming to us as they try to help their early bets navigate the fundraising game, or avoid playing it all together through the use of the Pipe platform.
AD: If you could change the narrative around Pipe in any way, how would you?
HH: I’d love for everyone I speak with to understand right off the bat that Pipe doesn’t offer equity or debt financing, rather it provides the platform to trade a new asset class - the software subscription. But that’s the gift and the curse of being the first to do something new I guess.
Pipe is the trading venue of a new asset class. Analogous to what the NASDAQ did for technology stocks in 1971, though unlike a stock exchange, it’s not equity in the company that’s being traded, it’s the underlying asset that drives the value of that equity - the software subscription.
The narrative has resonated extremely well with the buy-side, we’re working with the largest banks, investment managers, hedge funds, family offices and pension plans in the world - all very excited to trade this new asset class with initial commitments to the tune of tens of billions of dollars of liquidity. For them, it provides the perfect hedge against the volatility in the equity markets, and for the sell-side (software companies), it provides the perfect way to grow without taking on debt or giving up equity. A true win-win.
AD: One of my hypotheses here, which I didn’t spell out explicitly in Debt is Coming but many readers independently concluded, is that founders’ adopting debt or other forms of financing will be heavily influenced by mimetic pressure from other founders. If you raise a Series B that’s 70% equity but, say, 30% something debt-like on attractive terms, that sends a really strong signal about confidence in your business, and your refusal to take dilution. If The Outsiders becomes fashionable reading, and founders start referring to themselves as “capital allocators”, then I could imagine a lot of social pressure among their peer set to show strength, and be more aggressive with new kinds of funding. What do you think?
HH: I have pretty unique insight here given we currently get anywhere from 30-50 software companies applying to trade on the Pipe platform every day. Based on the fact that most founders are builders, not CFOs, it’s a fair assumption that most founders aren’t naturally skilled capital allocators and so aren’t aware of all of the alternative methods large companies utilize to finance their businesses. What I see happening in B2B fintech is a sort of ‘consumerization’ of these previously unknown and unavailable methods of financing to the benefit of all founders, at all stages.
While I can’t confirm whether the key driving factor is mimetic pressure, I can confirm that almost every company from startups all the way to pre-IPO unicorns with $500MM in ARR are absolutely thinking about alternative ways to finance their businesses now that the conversation has started, thanks in large part to your Debt Is Coming post which made waves across the industry.
I think ultimately what it comes down to is that once founders have confidence around the predictability of their cash flows, they start to get turned off by the idea of bridging the cash flow gap by giving someone more equity in their company. We wouldn’t want to give our bank equity upside in our homes if we needed financing for home improvements, assuming we’ve been paying our mortgage on time for 5 years, would we?
AD: On a related note, what founder(s) do you think are the best capital allocators in software today, and why? And you can’t say the Collisons.
HH: Ah man, I was absolutely going to say the Collisons. Those guys have built something incredibly special and done so in a seemingly capital-efficient way. In lieu of Stripe, I’d have to say Jeff Bezos leveraging the free cash flow thrown off their AWS business unit to fund the growth of their other business units is genius and although he is generally admired by the tech community, I don’t actually think he gets enough credit for the way he’s allocated capital along the way to grow Amazon into the behemoth it is.
AD: When you think about financing high-growth software companies, the large growth equity rounds seem like the peak for “this is the wrong bet for the founder to make.” If things go great, then you’ve sold equity that turned out to be really expensive. If things go badly, then you get wiped out by liquidation preferences. It’s like the founder is optimizing their regret minimization framework for a moderate success, rather than for the big outcome. (In contrast to the VC / growth equity investor, who’s made a great set of bets.) What gives?
HH: I like to call it the alphabet game. Relationships are built across each letter of the alphabet typically from A through to F (I actually heard about a Series J recently), and when money is offered to you at these later stages it feels easy, and also feels market. There are of course moonshot bets that require you to play the alphabet game, however, we’re building Pipe on the premise that software companies with highly predictable recurring revenues should not need to raise large, dilutive rounds as soon as they’ve reached the point where they know that if they invest a dollar, they’re going to get more than a dollar back over a period of time. There had to be a more efficient way, so we created it.
AD: There’s an implicit thesis, baked into the Pipe narrative, that founders are getting better at building certain types of companies. Creating a tradable asset out of software subscriptions implies a pretty high degree of confidence that shared process knowledge among founders has exceeded some critical threshold. So on the one hand, Pipe is a bet on that process knowledge. But it also seeks to disrupt a little bit of that process knowledge. This is new stuff for founders to understand! Do you worry about this at all?
HH: This is a really good question. Our initial thesis was based on a more qualitative view and a bunch of assumptions, as most ideas in early stage startups are. What we’ve built, and the key to our success thus far, is an underwriting engine that dispels any of the potential human biases in assessing the quality of the assets of a business. In doing so, what we’ve created is effectively part exchange (think NASDAQ) and part ratings agency (think Moody’s) - relied upon by the buy-side in their decisioning to participate in the trading of the software subscription assets.
By taking a truly quantitative approach and with the average tenor of a single traded asset being just one year at a time, we don’t have to worry as much about the process knowledge that goes into building great companies as it relates to the performance of the assets. However, we do think deeply about building tools to help founders acquire the process knowledge to build better, more sustainable businesses - which creates a win-win for both sides of the marketplace. More to come on this soon!
AD: Let’s talk for a minute about the “Silicon Valley honour system”. One of the great advantages that the Bay Area startup ecosystem has over anywhere else in the world is how quickly deals can get done, largely because of the rich social ties and the strong social contract in place between investors and founders. The best case I can make for “equity supremacy” in startup funding is almost like, for the social contract to work, it has to be equity. What do you think about this?
HH: I’m an equity investor myself and think that equity most definitely has its place. I’m by no means anti-venture capital or anti-equity investing. Though, I do believe that the market-clearing price for equity is more firmly in the founder’s favor at pre-seed/seed stage and assuming the investor has a broad enough portfolio (and a bit of luck), the most outsized returns are made at this stage.
The honour (loving the Canadian/British spelling here) system is, I think somewhat of a fallacy and a big part of the marketing that’s gone into making equity feel supreme at all stages. Though, it’s worth noting that assuming a clean SPA is in place with founder friendly terms, there is significantly more alignment between VCs and founders than banks and founders. The downside protections in place with traditional debt (liens, personal guarantees etc.) lead to a misalignment when things go wrong, whereas the equity investor with protections usually limited to liquidation preferences still need that liquidation event of some sort for that to matter, thus they are more incentivized to make sure that happens.
When it comes to equity, the handshake deal may be convenient but in reality, unless you have a seriously hot deal that people are begging to get into, convenient usually equals expensive for the founders, especially when things go really well. Pipe is a new option, with new sets of dynamics, where the investors into the software subscriptions do not have any lien in the business, thus they have an alignment with the founders of the company for its enduring success so the assets they’ve purchased remain assets of par value at maturity.
The Pipe platform offers a lot of the honorable benefits of an equity investment relationship, without any of the dilution, and without the misalignment created by the traditional debt products offered by banks and alternative lenders. With that said though, honour should be prevalent in every sector, no matter what the financial instrument, and I think legacy debt players could take a leaf out of the best equity players’ books to build trust around their more traditional offerings.
AD: I feel like everyone has their own thesis about what will happen to the Bay Area’s geographic network effect post-Covid. What’s yours?
HH: I moved to Los Angeles in 2014 from London. I haven’t been deeply impacted by the Bay Area network effect as a result, though I have benefited from working with some amazing investors based in SF. My thesis on this is more a viewpoint, from a ‘one ecosystem down the street’ spectators view. I think the impact of COVID on people’s desire to live in the Bay Area is a real thing. I see house prices in certain LA markets rising due to an influx of Bay Area folks jumping ship down here. I’m sure this is happening in other states (particularly those with more founder-friendly taxes), and to your beautiful country, Canada - who I think really get it right with respect to immigration and long-term investment into building a fantastic ecosystem. With that said, I think SF has such a strong brand, it will remain a hub for innovation, even if it’s derived from a more distributed workforce. There’s just too much infrastructure and capexed investment that’s been made there for it to become void.
Further, I think SF has held two uniquely special qualities vs. other ecosystems. There’s a bunch of amazing blue chip tech companies that have been built over the last couple of decades all with their operations centralized in the Bay Area. From within these blue chips have emerged thousands of incredible operators who have learned how to execute masterfully and now have the experience and network to aid smaller companies in replicating their success by joining as co-founders or early employees. This network effect is huge and I suspect won’t disappear entirely, however, as blue chip companies disperse their work force geographically, the blue chip alumnus will naturally spread geographically - laying the foundations for a more geographically diverse set of amazing companies to be built across the country. I think this will happen more slowly than some may predict, but the effect is compounding nonetheless.
The other thing in SF is the investor ecosystem that basically funds just about anything under the sun in the earliest stages. Since capital moves around easily and Zoom has made it more normal to not meet founders in person, we should expect that the SF funding ecosystem will continue to push money into other geos as it searches for founders doing great things.
The way I view the answer to your question isn’t so much around the dominance of the Bay Area’s geographic network effect, it’s more so how do we define geography in the context of centralization, or lack thereof, of an organization in a post-COVID world. I think a good example of this that we’re seeing play out in real-time is Harvard (as a business) still being able to charge $50,000 for tuition even though geography isn’t so relevant to attendance anymore, the brand and operations are still centralized around the Bostonian institution post-COVID. Will that remain true over the next decade? We shall see, but I think so for the most part.
AD: Last question: since they’re topical right now, do you think that new ways of going public (direct listing, SPACs) will have any major upstream effects on how software businesses finance their growth?
HH: I think SPACs, in most cases, probably lead to a suboptimal outcome for existing shareholders of the company. If the company is ready to go public ‘the traditional way’ then they should probably do that over the more convenient and seemingly cost-efficient SPAC. Conversely, at the other end of the spectrum, where a private company can afford to stay private but want to enjoy the benefits of going public (liquidity for shareholders, ability to close larger deals as trust is built in the market, getting the infamous ‘ringing of the bell’ picture to make Mom proud) the Direct Listing is a really interesting way to achieve this and save a bunch of costs and dilution.
With respect to the upstream impacts, I don’t think companies will build with getting acquired by a SPAC in mind, on the other hand, I think many founders, including myself, are building their companies to be real businesses from day one. Profitability is the new sexy and the public markets are rewarding high growth, cash flowing businesses (see $ZM), no longer are narratives around distant paths to profitability enough (in most cases). By focusing on growth and cash flow in synchrony, founders build leverage down the line at the IPO, making a direct listing with instant liquidity for shareholders, no dilution, and lower costs a totally feasible option.
If I’m realistic though, the abundance of capital available in the alphabet game for high performing companies leads me to believe that the upstream effects may not be major for Bay Area companies in the short term, though perhaps they should be. Pipe is certainly increasing the opportunity for founders in all geos to make shifts in the way they build their businesses toward much more optimal outcomes.
Thank you so much to Harry for coming on the newsletter and for taking the time to share these thoughtful answers. Can’t wait for 18 months from now when recurring revenue financing has taken over tech, and we can do another one!
If you’re running a software business and you’re thinking about your next round (and you always are), go to Pipe.com right now. I’m serious! Go right now. Then have a conversation with your existing investors about it. You can also find Harry on Twitter @harryhurst.
If you wanted to, you could get approved to sell your recurring revenue and get cash up front for it in your bank account in hours. (Don’t actually do this. Think about it for, you know, an appropriate length of time. But still, you think you can raise your Series A in a few hours? Forget it.)
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For this week’s reading, here’s a great post from Matt Ball on Nintendo, the “Nintendo is just like Disney was X years ago” thesis, and why Nintendo’s internal culture (which made it the great company that it is) prevents the Disney vision from coming true.
I especially appreciated this bit about the Nintendo Wii remote, as a representative story around the blessing and curse of Nintendo’s craft of building unique game experiences. The Wii remote was a big hit, but it was ultimately a false trail, or a local maximum, however you want to think of it. It did not launch a fundamentally new way of interacting with games, beyond the deceptively popular Wii Sports.
Speaking of Nintendo and entertainment experiences, Niantic - who you probably know from their global smash hit success Pokemon Go - has its own work cut out for it over the next decade. To me, we’ve only had one real glimpse of AR in our future to date, and that’s been Pokemon Go. (By the way, if you thought Pokemon Go was a flash in the pan that died out, think again. It’s had remarkable staying power.)
Pokemon Go, or a similar game format like it (although I have a hard time imagining what else could replicate that same magic), is to me the most likely launch pad we have to actual adoption of smart glasses, or perhaps some other hardware format, that brings AR into the world. The simple reason why is that when you wear them, you look like a total dork, unless you’re clearly having fun, in which case they become fascinating and beg further inquiry.
Anyway, I highly recommend this short but great interview with Megan Quinn, who many of you in tech know from her time running product at Square or in VC at Spark Capital. Many of you may not know that she’s actually one of the founding team members of the internal mapping experiment at Google that became Niantic. She’s one of the most remarkable people in tech, period, and when she announced she was headed back to Niantic to become COO, it made me genuinely happier than just about any other hiring move in tech I can remember. Here’s the interview:
Here’s another great post from Li Jin on the internet and the rise of micro-entrepreneurship, and the many, many opportunities to build “Shopify for X” out there. (Hopefully some of them will be us, but many more will be from other great companies!)
And finally, this week’s Tweet of the Week that made me laugh the hardest (click through to watch the video, it’s incredible)
Have a great week,