What a year it’s been. Last February, before joining Shopify, I wrote a post called Debt is Coming that provoked a great discussion around how fixed income is finally going to challenge the all-equity fundraising model in software startups. (It remains, by a long shot, the most widely read piece I’ve ever written.)
Maybe 24 hours after posting it, I got an email from Harry saying, “Your timing is incredible: this is exactly the bet we’re making, and exactly what we’re building.”
And so, we met.
Pipe officially launched a couple weeks later, and their momentum over the last year has been stunning. Here was a chat between Harry and I in July, that gives a little preview:
And that brings us to today.
For the time being we’re going to keep quiet about Shopify + Pipe specifically; today, I want to talk more generally about Pipe and Platforms. It’s a bigger deal than you think.
Equity Shares and the Black Box
When you buy equity in a startup, the asset that’s being exchanged is a black box. Investment goes in, something happens that you can’t quite know; and then later, profit comes out. Hopefully.
Equity shares are the atomic unit of value for growing these kinds of companies. Companies are made of people – founders, employees, investors – and their relative arrangement and motivation and ownership are all represented through the atomic unit of the equity share.
When you’re funding a Black Box company, equity shares get you, your VCs, and your employees all aligned on the same unit of ownership, even if you don’t totally know what it is you own yet.
Getting investors, employees, and founders aligned on this atomic unit of value was an important step in learning how to grow startups.
It helps you make a bet together:
“This company could change the world in an unpredictable way. We don’t know how big it could be, or what the founders will do, or how much money this will make. So let’s focus on growing the size of the black box, rather than solving for what’s inside.”
Software is well-suited to this kind of black box investment, as the market for software turned out to be bigger than we thought by a couple orders of magnitude. So venture capital and tech employment co-evolved with software companies around the atomic unit of the equity share, into a familiar and efficient process.
As you know, this came with a catch.
This model is tuned for a particular kind of bet, where you’re going after a grand slam or nothing. Pursuing anything less than a grand slam (multibillion dollar aggregator / platform opportunities) is insufficiently ambitious for the model to optimally work.
I wrote in the Debt essay:
Continuously selling equity, even at high valuations, is more expensive than the narrative suggests. It costs you optionality. The higher your equity valuation, the fewer out of all possible future trajectories for your business are acceptable.
There are some kinds of companies for which this is totally the right path to take. If you’re all-in on building a radically different future, and want to fund it entirely through printing equity shares, then you’re all set: the black box VC model is pretty optimized for you today.
But most businesses aren’t that.
When you have customers you can serve profitably today, and you want to fund yourself off of the strength of something that exists today, the all-equity funding model is not optimized for you.
You ought to ask: is there a complimentary way to fund your growth, that takes you on a different growth path?
The Opposite of the Black Box
Now, there’s an entirely different way that you can raise money to grow a company, and that’s debt. In contrast to VC or equity in general, when you loan money to a company, you do not want to think about it like a black box.
Debt serves a different purpose in the company’s capital stack than equity. It has lower cost of capital, and a tighter commitment. You’d like a claim on something as direct as possible; as close to the source of revenue as possible. You want the black box to be as small as possible.
In contrast to VC – where over the past 30 years of software, there’s been a circular “we shape our tools, and then they shape us” coevolution around how equity works – this hasn’t happened for debt yet. We haven’t figured out the right atomic unit; nor do we really understand the playing field where that atomic unit can live.
It’s funny that this hasn’t happened yet, because software can also be really interesting as a fixed income proposition. Recurring revenue is not only predictable, it’s also turned out to be lower-risk than people initially thought it was.
Vista took an early claim to this idea, with their line, “Software contracts are better than first-lien debt.”
When I was at Social Capital we looked an awful lot at businesses like Slack that knew their CAC/Payback math like clockwork, and it certainly seemed to us like Black Box Equity wasn’t the best way to keep funding growth.
But we had not yet figured out how to optimize debt for 21st century software businesses.
Part of the problem is the structure of debt itself. Debt is a claim on the entire business; not on a smaller or more granular atomic unit.
The recent fintech explosion has largely gone in the wrong direction here. To offer a more attractive cost of capital, lenders are exploring creative financing mechanisms like Whole Business Securitization, which isn’t real progress – it’s just a more severe, and more easily executable, claim on the entire business as a black box.
What we should be doing instead is trying to shrink the black box down to something smaller.
Then we can define the tradable atomic unit we can sell to fund the business, and figure out the playing field where it will live.
Photo credit: Cristian Palmer on Unsplash