True, Venture Debt is often the funding vehicle of last resort. When the Board is tapped out and a bigger fool cannot be brought into the venture, all eyes turn towards debt.
But wait, debt can be your friend… if deployed wisely.
When does venture debt make sense? To answer this question, let’s analyze a real-world example.
Mr. Mojo Rising
During the Summer of 2006, I joined MojoBlue (not the company’s real name) as an Advisor. I also participated in a small convertible debt funding round. The terms of the deal offered the investors (technically we were ‘creditors’) the opportunity to earn a healthy interest rate, as well as a decent multiple in the event the company was sold. The investors also had the ability to convert their debt into equity at a discount to the value established in a subsequent venture round; otherwise known as ‘convertible debt’.
MojoBlue’s CEO orchestrated the venture debt round masterfully. Equity funding would have diluted the Founders while simultaneously complicating the company’s equity structure, thus making a potential sale of the company more cumbersome. In addition, if VC funding were secured, the Company’s ability to control the scope, nature and timing of its exit would have been greatly reduced.
In general, institutional equity investors generally do not invest in quick flips. Thus, if a venture capitalist had invested in MojoBlue, it is likely they would have encouraged the CEO to grow the company in order to enhance the return on their investment. Conversely, they may have discouraged and possibly even blocked the sale of the Company until such time that they felt their return was maximized. Although a sale of the company would have netted the venture capitalist a small return, institutional investors generally seek deals with a potential return in the range of 6x – 10x of their initial investment, not the 1x – 3x return they would have gotten with a quick flip of MojoBlue.
Accepting equity funding and growing MojoBlue might have proven to be a sound strategy, but it would have forced the CEO and the rest of the Core Team (as described in The Tribe) to increase the overall value of the Company considerably, just to recoup the impact of the dilution that would have resulted from the equity investment. For instance, if the Founders relinquished 33% of the Company to equity investors, they would then have to increase the overall valuation of the company by one third, just to recoup their relative equity ownership immediately prior to the funding round.
Although equity funding was seriously contemplated, the CEO ultimately sustained MojoBlue’s operations via debt funding. The Company took on several hundred thousand dollars in venture debt, which proved to be highly advantageous when the Company was eventually sold to a Fortune 1000 software company in a low eight-figure deal. The sale resulted in a nice return for the Founders and employees. We were also pleased as creditors, as we received a premium return on our capital.
The Debt Bridge
MojoBlue’s use of debt as a bridge to a liquidity event is a typical example of when the use of venture debt makes sense. Venture debt can also work to a company’s advantage in its early stages. Rather than seeking Angel or venture capital funds, a company might be well served to initially raise a convertible debt round. These debt funds can be used to prove the company’s business model, finish a prototype, close the first customers, etc. Achieving one or more of these key milestones will increase the company’s value, lower its risk profile and thus make it a more qualified candidate for equity funding. You can also reduce the dilutive impact on the founding shareholders by using venture debt to enhance your adVenture’s valuation prior to taking on equity funding.
Equity is similar to family members – love them or hate them, you generally cannot readily rid yourself of them. In contrast, debt is more akin to a friend, with whom you can easily part ways. The degree to which debt offers you greater flexibility than equity is based upon your wherewithal to pay the ongoing interest and ultimately repay the debt. If you are leveraging debt as a last resort, then expect it to greatly limit your flexibility. However, if consistent cash flows are not an issue, then debt may afford you more flexibility than equity.
In order to further enhance your flexibility; be sure to retain the right to repay the debt at any time, with no prepayment penalty. Also, ensure that the convertibility feature is at your option and not at the behest of the lenders.
A fair discount off a future equity round generally ranges from 20% - 30%, depending on:
- Length of time before the equity round is estimated to close - the longer the time, the higher the discount
- Relative probability of closing an equity round - the higher the probability, the lower the discount
- Overall risk profile of the company - the higher the risk profile, the higher the discount
Factor the Math
Another form of debt that may make sense at some point in your adVenture’s life is to factor your receivables, especially if you have contracts with large corporations and / or government agencies that have solid credit ratings but pay their bills at a glacial pace. Like venture debt, factoring is all too often erroneously associated with a company’s dying gasps.
Factoring is simply selling your accounts receivables for upfront cash as a means of speeding up the collection of the receivables. For instance, if you have high-quality accounts receivables totaling $100,000, you should be able to generate $80,000 - $85,000 of near-term cash, less certain fees, interest, etc. The primary issue which dictates the discount factor is the probability that the receivables will be collected. Thus, the payee’s credit rating and the number of days the receivables have been outstanding will both impact the discount factor. Distressed receivables which have a low likelihood of collection are more difficult to factor and will result in a much higher discount (as high as 90%, depending on the expected collection rate) and thus you will net you significantly less near-term cash.
Do the math. Does it make economic sense to receive the money sooner, versus the cost associated with factoring? If so, factoring might be an economical tactic to forestall, a bridge loan and / or equity funding.
Forcing Your Investors’ Hands
As an entrepreneur on The Fringe, your overriding responsibility is to ensure that your adVenture remains solvent, as described further in Frugal Is As Frugal Does. As such, you may be forced to seek venture debt in the event your current investors are not willing or able to put additional funds into your company.
Venture debt can often act as a triggering mechanism to spur your current or prospective investors into action. Current investors will often prefer to commit additional funds, rather than see their investment subordinated and the company’s assets secured by debt.
Investors know that they will be subordinated to any venture debt (i.e., all debt holders will be paid before any equity holders if an exit occurs). As such, the equity investors may prefer to stay at the front of the line with respect to receiving any proceeds from an exit. The investors may also be motivated to put forth their own funds as an additional equity investment, in order to help the company avoid the fees, loan interest and other costs associated with venture debt.
Debt Downside
The obvious downside of debt is that, unlike equity, you actually HAVE to pay the money back. Thus, at the end of the day, do not enter into debt transactions lightly. Even though venture debt offers you more flexibility than an asset-backed loan granted by a traditional lending institution, such as a bank, you will still have to pledge the company’s assets to collateralize the debt, including your intellectual property, Accounts Receivable and even control over your bank account (yes, in some cases, the lender can sweep all the money from your bank account if you fail to cooperate with them). In addition, be prepared to have someone with deep pockets personally guarantee the debt, although you may be able to avoid this particularly onerous step if the company’s assets offer adequate collateral to fully secure the loan.
If your venture debt is only secured by your company’s assets (and does not involve any personal guarantees) then the end result of defaulting on the debt is not much different than when a company becomes insolvent with no debt on its Balance Sheet. In both cases, the Founders and employees usually lose everything and the Preferred shareholders share whatever crumbs may be left, after the vendors’ trade payables are satisfied.
The next time you contemplate an equity round, give venture debt its due consideration. If you play your cards right, you might be able to leverage convertible debt to jumpstart your business, pay back your lenders and retain the lion’s share of the equity ownership in the adVenture. If you do, you will join an elite club, right alongside companies on The Fringe, like MojoBlue.
