Christian Czernich, CEO, Founder and Managing Partner of Round2 Capital Partners in an interview with Palico in february 2019. He talks about his views on Revenue-based Financing and discuss how this can provide an answer to the current challenges facing young tech companies.
What is the concept behind Round2 Capital Partners and to what extent can it support entrepreneurs in their further development?
Christian Czernich: Round2 is an innovative growth debt fund. We support young technology companies in accelerating growth by providing capital and our expertise. For this purpose, we use a for the German-speaking region new form of hybrid financing – revenue based loans. Revenue based financing offers entrepreneurs and investors a whole range of benefits and solves significant problems in the financing market for young companies. The company receives capital and in return Round2 receives a share of 2% to 5% of the monthly turnover until a pre-defined cap of 1.35x-2.15x the financing amount has been reached. There is neither a clearly defined financing duration nor a pre-defined interest rate. Both arise only at the end of the term, i.e. when the cap has been reached. For us, a typical financing horizon is 3-6 years. As we don’t need to buy shares in the company, Round2 does not require an exit, as the financing automatically expires when the cap is reached. However, if an exit takes place during the term, Round2 receives an exit fee as a bonus.
What challenges do you see for young companies and start-ups in times of digital transformation in the DACH region?
Christian Czernich: The challenges are diverse. One of the key challenges is to occupy a profitable niche in the market that is not pursued by global tech giants. Contrary to initial expectations, the internet and the cloud have strongly promoted the creation of global monopolies. This is particularly due to positive network effects and the subsequent positive feedback loops in the area of big data and AI, which provides immense benefits to large companies. A second major challenge for young tech companies is the access to talent in the tech-sector. Especially in the DACH region there is high competence in the field of mechanics. Nevertheless, the fields of electronics and software programming are still lacking behind. University education needs to be both adapted and extended rapidly. Furthermore, it is necessary to promote the immigration of talent from all over the world into Europe. Only qualified immigration can solve the talent problem in the short term. A third problem is securing the necessary funding for growth. As a result of digital transformation, corporate assets are increasingly based on intangible assets, which banks, however, are not accepting and understanding as collateral. As a result, due to structural problems, banks are unable to finance young tech companies, even if they are profitable. In a lot of cases VC firms are the only real alternative, but the funding they are providing always leads to a dilution of the founders and forces companies into extremely aggressive growth strategies that are often not viable. Here Round2 is a real alternative for young companies.
What are the benefits of revenue-based financing? Is the concept of revenue-based financings an answer to the changing assets of tech companies?
Christian Czernich: This form of funding has some important benefits for both target companies and investors. For target companies, the most significant advantages are that there is no dilution of the existing shareholders, that the repayment automatically adapts to the company’s success in the form of revenue and that the financier is not forced to urge the founders at any price into an exit, often against the interests of the founding team. Another significant advantage is that the financing process is much easier and faster than that for equity investment, for example because it is not necessary to negotiate a valuation. This leaves more time for the company’s management to take care of the company’s operational needs rather than spending too much time on fundraising. There are also significant benefits for investors in revenue-based loan funds such as Round2. In such funds, volatile cash flows from young growth companies are transformed into stable cash flows through a diversified portfolio of revenue shares. So, there is an asset transformation that significantly reduces the risk. At the same time, however, yields are achieved which are higher than those of most VC funds and there are ongoing distributions to investors.
In my view, revenue-sharing loans are the new bank loans of the digital age. Instead of hanging the collateral on the – non-existent – collateral, revenue shares use recurring revenues – as the basis of the collateral. This is possible because digital business models enable the transparent generation of recurring revenues. The pricing of revenue shares automatically adapts to the company’s performance but must always be above the pricing of traditional bank loans to meet the risk of each individual financing.
Do you think that this form of financing will increase in Europe?
Christian Czernich: Yes, I definitely think so. In the past 12 to 18 months, there has been a strong increase in interest in venture debt in the DACH region, especially in Germany. Company founders are actively seeking alternatives to VC financing that will allow them to minimize dilution. In addition, not all young companies want and can meet the often unrealistic growth expectations of VCs driven by massive burn rates. Business start-ups and self-employment are becoming a way of life for the younger generation and not every startup can lead to a new Google. Hence, financing alternatives are needed that allow the growing number of founders to develop their businesses aggressively, yet sustainably, profitably and in the long term. And exactly for this revenue-based financing is the ideal instrument.
What would banks and other traditional donors need to change to be able to close the funding gap for SMEs?
Christian Czernich: In my opinion, banks do neither have suitable instruments nor the necessary competencies to finance young and on intangible assets based tech companies on a large scale. The bank credit, developed in the age of the industrial revolution, is simply obsolete in the digital age. Hence, banks would have to develop fundamentally new financing instruments, which then would be in direct competition with their established instruments. A classic innovator`s dilemma. I doubt that they can realize this.
In addition, banks would need to hire new staff, which is not only capable of balance sheet analysis and appraisal of tangible collateral, but also of assessing the sustainability of digital business models and management. This would further lead to a massive remodeling of staff and cost structure of SME financing. One possibility, however, is the extensive automation of the financing process with the help of AI. We will see such models soon in standardized bank lending, for example in financing of real estate or consumer loans. When and if those models can be used for the non-standardized assessment of young growth companies, their management teams and their business models currently remains an open question. I doubt it can in any near future.
Two questions with open end:
Compared to the Anglo-Saxon region, the DACH region has / should have…
Christian Czernich: … a leading role in at least several technological core areas. Undoubtedly, the DACH region is currently outperformed by the Anglo-Saxon region in the core technologies AI and BigData, because the ecosystem for innovation is still underdeveloped and the technological development has largely been missed, just think of the automotive industry. Nevertheless, I believe that the DACH region can take on a global leading role, especially in the area of intelligent and connected manufacturing and infrastructure systems, keyword industry 4.0 and 3D printing, in the areas of chemistry and materials science as well as in the field of healthcare and healthtech.
2019 will be especially exciting in the field of ….
Christian Czernich: … overall economic development. While the economy will cool noticeably, I do not believe in a catastrophic scenario like in 2008. The digital transformation will constantly cause profound structural changes in all sectors but is at the same time a long-term positive growth engine that is not based on an artificial bubble.