Pipe: the most interesting fintech in new asset class investing
In my last article Open Finance, I talked about the rise of new asset class, alternative investing, and some of the related companies and their products. I mentioned that a number of companies are worth a deep dive, and today we will look into the one I am most excited about: Pipe
Disclaimer: I not being paid to write about this company, just excited when I find interesting fintech start-ups!
The overall environment:
A quick recap, there are 3 factors at play that’s giving rise to alternative investing:
- More people are investing due to excess cash.
The excess cash comes from 1. stimulus from governments 2. and more importantly since we are trapped inside and working from home, there is a lot less spending.
2. 0 to Low interest environment.
Money in the bank is not earning any yield. So people are looking for other alternatives.
3. Potential erosion of value of dollars.
In addition to money in the bank not generating any yield, it’s likely losing value due to inflation. Simple economics, our government dumped $6 trillion into our economy during the pandemic, yet our GDP (good produced) stayed relative the same during the same period (graph below), what should happen to the price those goods produced?
Note that asset inflation (like real estate or stocks) is also a form of inflation. This means that your money sitting at the banking earing 0 yield is just losing purchasing power.
Excess cash, 0 yield environment, and inflation drive up the demand for safe, and easy to understand place for better yield; hence the rise of alternative investment.
Why Pipe
Pipe is a platform for investors to get yield backed by a company’s recurring revenue, and for companies to access to funding without diluting equity. Currently, it’s limited to recurring revenue for SaaS companies. Pipe is basically a form of RBF/MCA (revenue backed financing / merchant cash advance), but does not require any warrants or lien and offers the cheapest such solution for companies. For investors, the value proposition is opportunity to invest in low risk (similar to first lien debt), but higher than expected return product.
I list my top 3 reasons why I like Pipe most out of all other alternative investment products (talked about in my last article), and they are all great companies by the way.
1. New asset with better return / risk profile
Pipe has created a new asset class that has better return over risk profile than incumbent investment products. This is an amazing innovation.
Private equity investor Robert Smith said it well:
“Software contracts are better than first-lien debt. You realize a company will not pay the interest payment on their first lien until after they pay their software maintenance or subscription fee. We get paid our money first. Who has the better credit? He can’t run his business without our software”
Pseudonymous business analyst John Street Capital has put this asset’s return and risk into perspective:
I think part of the reason SaaS based recurring revenue deserve such a low risk profile has to do with the fact that “America basically runs on Cloud /SaaS now”. Credit to the Pipe’s team for targeting so precisely.
America used to run on oil. John D Rockefeller was world’s first billionaire and Exxon Mobile was one time the most valuable company on the S&P. As Marc Andreessen has so presciently pointed out in 2011 in WSJ Why Software is Eating the Would, American basically now runs on Cloud / SaaS. Exxon Mobile has dropped to 43rd on S&P by its latest valuation, and the Nasdaq 5 (FAANG: Facebook, Apple, Amazon, Netflix, and Google) accounts for like 15% of S&P 500 by market cap.
While return on most other sectors are mediocre, SaaS based index outshines the rest. The BVP Emerging Cloud Index is +72.8% YTD vs. the NASDAQ +27.5%, the S&P 500 +5.7% and the Dow Jones (-3.5%).
2. Business-funding fit
Patrick McCormick wrote an excellent analysis on Pipe. He is spot on when he coined term “business-funding fit” for Pipe. It’s definitely worth the read, but I will boil it down:
- Basically the idea is that there are different best ways for companies to fund themselves during different phase of the company.
- For example, during the initial ideation “installment phase”, where product is being developed and tested, due to the unpredictable and speculative nature, VC capital using equity may be the only option.
- As the company gained traction and enters the growth phase, it becomes possible to predict growth (user, revenue, other measures), companies should start to add debt to its capital structure as a source of funding.
- A better way to finance than debt is through recurring revenue, and Pipe is the platform to do so.
- Pipe, due to its platform model, actually turns out to be the cheapest way for growth stage companies to get funding (more on that in the next section)
3. The platform model: Connect the buyers and sellers
Now, financing by recurring revenue is nothing new. Clearbanc has started way earlier than Pipe. The difference is that Clearbanc uses more of a venture capital / hedge fund model, where investors are buying into their fund, and Clearbanc uses the fund to invest in recurring revenues of SaaS or eCommerce companies. Though Clearbanc is a great company, I like the platform model offered by Pipe better due to the following:
- Platform model tends to offer the best deals for companies
- Flywheel effect
- The platform delivery model is better than the VC / HF model
Platform model offers the best deal for companies
One of the goals of platform model is bringing buyers and sellers together, removing middle man, so that both end of the trade gets better deal. Pipe’s platform offers the cheapest option for growth companies to raise fund. Let’s take a closer look. Below are options for pre-IPO companies to access capital:
- VC equity
- Debt / VC debt
- Revenue backed financing (RBF) / Merchant cash advance (MCA)
VC capital for equity is very expensive for growth companies. Pre-IPO companies are typically valued at a multiple of revenue. So, if your revenue grow by 100% the next year, which is very conservative for growth stage firms, that means the equity you just sold increased by 100% in a year. It’s like a debt with 100% APY. And the more you grow, the more APY you are paying or losing.
VC debt is also very expensive in that it typically has high interest rate (low to mid double digits) with warrants. The warrant part is very expensive that can double or triple with increasing revenue, and often becomes multiple of the original principle, so APY in the ~100% again.
RBF or MCA is also very expensive because payment often based on a % of revenue and can result in high double digit or even +100% APY especially for high growth companies where revenue can double, triple, or more.
Basically, the above option all can result in high growth companies paying APY ~100%, and sometimes even more. Then there is Pipe, which on average cost companies around 5–10%. It’s the cheapest option for growth companies with SaaS revenue, and there is no other strings attached (covenant, warrants, % of revenue,…,etc). And for investors to get that kind of return for assets with first lien risk is a double win!
I simplified the math here, but for those interested in details can checkout John Street Capital’s Recurring Revenue: The Rise of an Asset Class.
Flywheel
Since Pipe is the cheapest option to funding compared to other methods or platforms, it will attract more companies onto its platform. This gives Pipe the option to offer more choices or be more selective on the companies it accepts, and which will allow Pipe to improve its offerings (more choices / higher quality). With better offerings, Pipe will attract more investors. Thus creating the flywheel effect.
The platform delivery model is better than the VC / HF model
The platform delivery model is better than the VC / HF model because most fintech entrepreneurs are not fund managers. For one, the skillset is very different. The platform model allows the entrepreneur to focus on product-market fit and building their company. But as a fund manager, the focus is shifted to finding yield in addition to fund admin, how to scale the fund, protect downside risk, how to avoid moral hazard risks for investors,…,etc. As you can see, it’s very different and most of the entrepreneurs I know are didn’t create their visionary companies for those fund related tasks.
Looking forward
Currently, Pipe is just focused on SaaS revenues for pre-IPO companies. This makes a lot of sense given the stability of SaaS revenue and likely simplifies the underwriting process and risks, lowest hanging fruit first principle. Pipe can certainly expand horizontally and vertically. It certainly exhibit the N of 1 effect
The phrase “N-of-1” has multiple meanings for us. It refers to companies or products that are capable of becoming much larger than what people expect early on. Their level of product-market fit is so strong that it carries the business through successive orders of magnitude of scale in ways that would have been unthinkable when they were getting started.
For example Facebook. The company may have been started to look at others’ photo, but turned out to be the basis of how we social and stay connected, a much bigger market. It’s similar to what I call the eco-system effect:
Eco-system effect: A hook to lure users into the app with an enticing feature (like high yield on saving, 2 days pay early), then keeping the users inside the app by offering related services. As the user uses more of the app, the app collects more data and improve to make the user more sticky. This increases CLV (customer lifetime value), and creates a moat against competition.
Pipe can certainly turn into an eco-system as it already has the hook part figured out(low risk and high yield asset backed by SaaS recurring revenue), and can expand both vertically or horizontally to maximize CLV.
Horizontal
First, the opportunity or TAM (total addressible market) is huge. Recurring revenue based on SaaS is just a starting point. Pipe’s model can be expanded to other types of recurring revenue / subscription. For example, ISP is a $120 billion per year market.
The types of companies can also be expanded beyond growth stage start-ups, even traditional companies can consider Pipe to find the best financing options based on their needs. At the minimum, companies will have more options.
Vertical
Pipe can also expand vertically, which is likely to happen before horizontal expansion. For example, it can offer treasury management for companies that get funded. For investors, recommendations based on their past investment / trading pattern.
There are many areas for Pipe to expand like geographically, allow fractional ownership for investors…,etc. The key is that it’s just getting started in a new area, so there are lots of opportunities.
Conclusion:
Alternative investing is here to stay, and Pipe is currently my favorite company in the space. Pipe created a new asset class that has better risk adjusted return than similar incumbent product (first lien), gave companies cheaper way to fund itself (business-funding fit), and delivered through platform model. The best part is that it’s just getting started!