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Personal Guarantees – Up Close and Personal

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Discussing bank loans backed by personal guarantees is a conversation I’ve had many times with founders and financial partners since personal guarantees are a very common form of security used in non-dilutive debt financing for early-stage companies by banks in Canada1. I’ve seen loans backed by personal guarantees used very successfully to access non-dilutive capital to fund incredible growth in tech companies at both competitive rates and favourable terms. I’ve also met startups where this type of security is not a fit at all and talked with founders that refuse to use them and decide to look for alternatives instead.

When I was researching this post I found it shocking how little is actually written on this topic. It may be that no one wants to touch on a topic that has legal implications, or maybe that it’s not very well understood. Whichever reason it is, both seem like great reasons to write this post and open a discussion on one of the most controversial topics in technology finance, loans backed by personal guarantees.

Since this can be a bit of a heavy topic, let’s start off with one of my favourite “dad” jokes about banking:

A Frog & Collateral

One day a frog goes into a bank looking to get a loan. He approaches the bank teller and asks her name. “I’m Mrs. Paddywack” she replies.

“I would like to apply for a loan” the frog says.

“Great you came to the right place! Do you have any collateral?” says Mrs. Paddywack.

The frog thinks for a moment and then digs in his pockets but can’t find anything except a small knickknack that he has been carrying around. “How about this knickknack?” he asks.

“I’m not sure if that will work but let me go check with my manager,” she says.

She goes to her manager and explains the situation and that she is not sure if the item will work as collateral.

“Do you think we can lend to this nice Frog?” she asks her manager.

The bank manager thinks about it for a second, jumps up from his seat and says: “Yes, of course, we can. It’s a Knickknack Paddywack give the frog a loan!”

Now imagine that the frog has a high-growth tech startup but no knickknacks. The author of this joke didn’t really clarify whether or not the knickknack was a personal asset or a corporate asset but either way, it’s a reminder that most banks are looking for tangible collateral for loans. Most tech companies don’t normally have the traditional forms of security on their balance sheet: real estate, equipment, or the physical knickknacks that typically secure loans. There is another way that they can offer security and that is with a Personal Guarantee.

What is a Personal Guarantee?

A bit about Personal Gurantees:

For anyone unfamiliar with what a Personal Guarantee is, it is a security document that banks and lenders will often request as part of their loan that has the majority owner(s) guarantee the loan.

A personal guarantee is an individual’s legal promise to repay credit issued to a business for which they serve as an executive or partner.  Source: Investopedia

Loans that are backed by only a personal guarantee are actually considered to be non-collateralized loans. While a personal guarantee is technically a type of collateral, this description is used because a specific asset has not been pledged to support the loan but rather a general agreement between the individual and the lender. These loans are also heavily dependent on the borrower having a good credit score/history.

A personal guarantee would normally not be registered anywhere unless there is a default or collection situation. I would suggest you clarify if this is the case with your lender or lawyer because it is important to know. I have seen comments and posts online with statements like “you can’t get a mortgage if you sign a personal guarantee”. I assume they are talking about going through a default situation and not coming to an agreement with your lender for repayment first – knowing this before you sign is important. Alternatively, a collateralized loan would have a specific asset pledged to secure the loan.

Why are banks asking for a Personal Guarantee?

There are many reasons why a bank may ask for a personal guarantee to support a loan. Here are a few of them.

  • They help to mitigate Key-Person Risk. This refers to the risk that is associated with a business being dependent on a single executive (or key group of executives). In a startup, or really in any owner-operated business, the owner-operator in an absolutely essential piece of the business’s success and can even be part of the companies competitive advantage. This is why you might see Key-Person insurance2 required as a condition to a loan as well. A personal guarantee is an easy way for a risk department to mitigate the risk of a key person leaving the business. The guarantee in this scenarios is not seen as a pure asset play but also a form of key person insurance.
  • The phone calls get answered when things go wrong. This may come as a surprise to some outside of banking, but there is significant evidence that when things go south on loans supported by personal guarantees, the owners are more willing to work though restructuring and working out a plan for repayment.
  • In early-stage businesses, the founder’s personal assets are usually used to start and back the business: Lenders add personal guarantee to serve as a reminder and incentive to the owners to continue to financially back the business. This is more common in small businesses but is still relevant for an early-stage tech startup.
  • Betting on yourself (again). If the terms of the proposed loan are fair, and repayment shouldn’t be an issue, then a personal guarantee can be a lender asking the owners to make that bet one more time. This concept can be really contentious for business owners because they have already bet on themselves so many times. Still, banks are asking the question if owners were willing to bet on themselves before then why not this time? Sometimes denying a personal guarantee can suggest or signal that the company is not sure if they can repay at the time of signing the loan. This brings the question of why the company is taking a loan without complete confidence that they can repay it.

Financing Technology Startups with Personal Guarantees

From Brick-and-Mortar to Tech Lending

So why is this form of security being used in tech now? Since it has always been used in Small and Medium Business lending (especially the early-stage companies), once banks started lending to tech startups, it has made its way over to tech lending as well.

Something that is often left out of the conversation on Personal Guarantees is the fact that they are actually an extremely common form of security in Brick-and-Mortar3 businesses. Although, there is likely no owner anywhere that likes the idea of providing a personal guarantee. However, the owners of these businesses are generally less resistant to offering them as security. There are a couple of reasons for this. First of all, when there are physical assets in the business, usually the business owners understand the value of their own assets even better than the bank would.

A calculation might go like this for example: if a company has $2MM in equipment on the balance sheet, the bank might underwrite that collateral value as 2MM x 65%4 = 1.3MM in Collateral Value. So if they are borrowing $2MM from the bank, the bank might suggest that they need a Personal Guarantee to get the deal done. The business owner themselves might know clearly that the equipment is worth more than that – let’s assume the owners believe the equipment to be worth $2.2MM in a liquidation sale scenario (they may have contacts or sold pieces of equipment before that give this confidence). In the end, the founders may not like the idea of the guarantee but also might trust the other forms of security offered. They may also negotiate the personal guarantee, but I’ll go into this negotiation process with some tips a bit further down.

This is a bit different from a distressed loan situation in a technology business where it could be challenging to sell a startup’s accumulated assets to repay a loan.

Personal Guarantees and Startups

So how do personal guarantees work for financing startups?

In addition to not having the physical assets that a brick-and-mortar business would have, there is also the challenge that comes from the underlying assumption that most startups fail.

In 2019, the failure rate of startups was around 90%. The research concludes 21.5% of startups fail in the first year, 30% in the second year, 50% in the fifth year, and 70% in their 10th year. Source Investopedia

I would caution that these numbers include all startups, not just the ones that would qualify for bank loans. These stats include companies that never generate revenue or move beyond the idea stage (which has a high death rate). There are metrics and milestones to qualify for a loan (such as minimum revenue amounts) that separate some of the bank-financed companies from the ones that fail in these numbers. I wrote more about timing and metrics for term loans in Financing a Tech Company’s growth with Term Loans – It’s all about Timing

Put the lack of assets and the fact that a significant amount of startups fail together into one scenario, and you can see why lenders are requesting additional security for their loans. It’s actually also why founders could be reluctant to give it.

While personal guarantees are an extremely common lending tool for growing small businesses, in the startup world when companies have the ability to sell equity a great question to ask is whether this form of security is necessary to give. Why not ride investor capital and leave all the risk in the business? This is definitely an option so let’s look into it.

What do Investors think?

Despite its undeniable popularity, some investors still don’t like the use of Venture Debt at all. Layer on the fact that some lending requires Personal Guarantees and you could lose them completely. So why don’t investors like it? There are a few reasons, but it mostly comes down to the fact that debt in startups will amplify both the risks and the returns of an investment. If a startup is already risky, does it need leverage to amplify this risk? I wrote about this in more detail in this post: What is Venture debt.

Venture debt in some situations is a competitor to venture capital and in others, a compliment to it – but it makes their deals a bit more challenging. Investors want companies to shoot for the moon (providing >10x return). An extremely relevant argument to consider is that financing with a personal guarantee-backed loan could cause founders to be a bit more cautious and conservative rather than aim for hyper-growth that Venture Capital aspires for.

Most hyper-growth startups are completely focused on equity financing or raising capital. This model of financing has de-risked founders from personal liability if the business fails. Founders take substantial risks with their careers, time, and opportunity, and equity-financing has created the idea that a company can potentially go from raising Pre-seed, Seed and Series A,B,C – all the way to IPO5 without a founder ever risking their personal financial situation. This can be an exceptional way to build a company.

So why doesn’t every company do it this way? In addition to the obvious downside of ownership dilution with each raise, is the fact that even exceptional startups might not attract investment capital at the time that they need it most. The chart below shows that most financing for startups doesn’t actually come from investors. Here are the results of decade-long research identified from the 5,000+ entrepreneurs interviewed by the Kaufman Foundation which shows where their funding came from.

Source: The Washington Post

With Bank and other Loans accounting for 34.9% of funding, it’s clear why personal guarantees come into play so often. Considering that founders’ personal savings makeup 30% also increases the relevance of personal guarantees. This is because a personally guaranteed loan can offer an alternative to directly financing the business by using personal assets (ie: cash injections into the company). Notice that Venture Capital only accounts for 4.4% of all funding here.

Taking a loan with a personal guarantee does not exclude companies from taking investor capital either. I have seen loans with personal guarantees taken by companies backed by Venture Capital and also used to grow an early-stage company’s revenue to then qualify for Venture Capital. Keep in mind that if a company wants to go to a full equity model of financing, they can always pay back a loan and have the security released. Really, there is more than one way to finance growth and using a mix of financing options is becoming more and more popular at various stages. I went into the benefits and downfalls of various options in more detail in the post: Pros and Cons of Tech Financing Options – Debt, Equity and Bootstrapping.

Alternatives when a Personal Guarantee is not an Option

So what if a personal guarantee is off the table? Well, there are still some great alternative financing options available. The major caveat (and one that is really not clear to most borrowers) is that these options are going to either have short-term repayment periods or be more expensive than a bank loan would be – or both.

There are also many great venture debt lenders6 that will fund later-stage companies without guarantees. These companies will usually have crossed a minimum threshold of 250K Monthly Recurring Revenue or 3MM Annual Revenues. Since this post is more focused on early-stage companies, I won’t go into too much detail on these companies here and will save this for another post.

Not requiring a Personal Guarantee can be a strong differentiator for private lenders compared to banks. This makes it a great marketing tool for lenders that don’t require it. This is where Merchant Cash Advances are taking off. Companies like Clearco, Shopify Capital, and Stripe all offer them (I wrote about Merchant Cash Advances in detail here).

So what’s the catch?

  • These alternatives can come with a large price difference from those that use personal guarantees. Annual Percentage Rate7 on these products can range from 15%-30% (or even higher) depending on repayment terms. Keep in mind that the fee or discount rate is not the annual interest rate (ie: a 6% fee repaid in 3 months is actually a 24% APR).
  • Something that is actually much more important to consider than just the annual rate, is that the repayment period is usually on a very short term (usually within 1 year). Although the APR for alternatives is still technically cheaper than equity (assuming the company is a high-growth startup), short repayment periods can be very hard on cash flow if your company is not growing rapidly. Bank loans will have longer terms like 48-60 months and could include interest only periods.

Another exciting new company, Pipe, has an offering where you trade your Recurring revenue for an upfront payment at a discounted rate. This has similarities to how a factoring company works, where companies would sell their Account Receivables. In Pipe’s model, you can sell your Monthly or Annual Recurring Revenue at a discounted rate to have the funds available upfront and pay it back over the year. I’m planning on doing a deep dive into Pipe in a future post, but here are some great resources in the meantime8.

These alternative models of financing can be extremely helpful for immediate financing needs and fund growth that increases both a company’s valuation and gets them to the next stage of their business. The simplicity of using the tech-enabled platforms and the lack of personal guarantee make them very enticing options for the right companies.

If the option of providing a personal guarantee seems worth pursuing, you may have or be able to build some negotiating leverage. Here is how to do it.

How to Negotiate a Personal Guarantee

Understand the types of Personal Guarantees

All Personal Guarantees are not made equal and understanding the different types of Personal Guarantees can help this discussion. I would also strongly recommend hiring a lawyer to review all your security documents since even a single word like “unlimited” on a Personal Guarantee can change the meaning of what you are committing to9. Here are a few types to know about.

  • Limited: This means that the guarantee is limited to a certain amount that is predetermined and outlined in the security agreement.
    • Limited to a percentage: This means that your exposure would be limited to a percentage of the loan. This percentage could be to the amount initially borrowed or to the balance outstanding. These are common when there are multiple owners that are guaranteeing their ownership portion of the loan.
    • Limited to a dollar amount: This means that the guarantee is limited to a specific dollar amount that is determined in the agreement.
  • Unlimited: Unlimited guarantees are usually taken in lending when there is an expectation or potential that the borrowing amount could increase with the lender. The security is already in place for this increase.

Questions to Ask your Lender

  1. Find out if the Personal Guarantee is a deal-breaker. Are there other forms of security that could be offered? If it is a requirement and you are not willing to sign one, it doesn’t make sense to continue the conversation much futher -it could save time not to continue if its a non-starter. Although personally, I would suggest understanding the full offer before shutting down a conversation based on this one piece of security. If you receive a term sheet from your lender I wrote a guide here for Reviewing a Debt Term Sheet.
  2. Understand which type of Personal Guarantee you are being asked to provide and whether you are comfortable with that type – Limited/Unlimited and Limited to a percentage of the Loan or a set dollar amount. Does the guarantee decrease with repayment of the loan or is it a fixed amount?
  3. Discuss performance metrics that could be met to achieve a reduction or release of a guarantee. It’s great to know what a lender sees as strong performance from the company at the start of the relationship. Keep in mind that if a release of a guarantee is the goal, it could also signal to a lender that the plan is to take the loan and repay it rather than increase borrowing as your needs increase.

Know when to Negotiate

Another key is knowing when to negotiate. There are three things that will give you the most negotiating power with a personal guarantee.

  1. A strong balance sheet – Lenders like to give loans when the balance sheet is strong and there is equity in the company. This is why with venture debt its common to see a loan given right after a capital raise or at the same time as a raise – the incoming cash strengthens the company’s balance sheet.
  2. History with your lender – A longer-term existing relationship leads to more negotiation power.
  3. After a financial year-end with a strong financial performance – After a strong growth year is a great time to discuss your situation with your lender. You may want to ask about the security or consider requesting an increase to your loan amount to continue growing with more capital.

How about when not to negotiate a personal guarantee? After a year with low or no growth is likely a time to avoid this discussion. This can be a negative signal to your lender that you are not confident in the companies future and could cause more issues.

Summary

  • Personal Guarantees are a form of security that are commonly used in small and medium business lending that can give startups access to non-dilutive capital.
  • Not using a Personal Guarantee can mean using an alternative with a higher annual interest rate and lower amortization.
  • Personal guarantees can cause founders to act more conservatively which might not be what investors want to see.
  • Understanding the banks motivations for taking personal guarantees can help in negotiations.
  • It’s worth considering if this type of loan is a fit for your business.

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Footnotes

(1) The Business Development Bank of Canada has over $3B in loans and investments to over 3,000+ companies

(2) Key person insurance is a life insurance policy that a company purchases on the life of an owner, a top executive, or another individual considered critical to the business.

(3) Brick-and-Mortar businesses is a term that refers to companies that have physical locations and assets. Examples are manufacturing businesses or restaurants.

(4) In this case, 65% would represent the bank’s margin amount or Loss Given Default amount that they expect to be able to recover in liquidation.

(5) An IPO is an initial public offering. In an IPO, a privately owned company lists its shares on a stock exchange, making them available for purchase by the general public.

(6) This includes CIBC Innovation Banking, Silicon Valley Bank, TIMIA Capital, Flow Capital, and many more. For earlier stage SaaS companies Lighter Capital is also an option.

(7) Annual Percentage Rate is the annual amount paid for a loan. The calculation is as follows: Add total interest paid and fees over the duration of the loan. Divide by the amount of the loan. Divide by the total number of days in the loan term. Multiply by 365 to find the annual rate. Multiply by 100 to convert the annual rate into a percentage.

(8) Articles on Pipe: by founder Harry Hurst here, and Packy McCormick here. I will write my own soon.

(9) Nothing in this post is legal advice. I am not a lawyer. You should have one though.

Reviewing a Debt Term Sheet

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Term sheets are a common part of the financing process for tech companies, whether they are raising equity or taking on debt. Many tech startups are familiar with the vocabulary used on an equity term sheet (from a VC or Angel) but debt term sheets will have some terms that may not be familiar.

In this post, I’ll go over some of the basic terms in a debt term sheet that you likely won’t see on an equity term sheet. Before deciding on financing with debt, I would also recommend considering all of the Pros and Cons of Debt, Equity and Bootstrapping to ensure that debt financing is the right fit for the company.

Why Term Sheets?

In Venture Deals by Brad Feld and Jason Mendelson, they point out that Term sheets are not actually a legal requirement. They are more or less a tool for negotiations, to focus discussions and to outline an offer. From Venture Deals: “Nothing requires a term sheet to be used. Our favourite negotiations with entrepreneurs have been ones where we’ve literally shaken hands and agreed on valuation, board structure, and option pool size verbally or over email“. Even with this in mind, term sheets provide value by aligning borrowers and lenders/investors early in the process. They point out later that “Usually, the term sheet will be the first real negotiated document in a relationship”.1

Term sheets have, at times, been used to simply get a companies attention and both investors and lenders develop a reputation on whether on not they close their term sheets. Siri Srinivas’s tweet mocks this practice beautifully. 2

Term Sheets are simply a tool for outlining in writing the terms and conditions being discussed. I have personally worked on deals with and without term sheets, but when using debt financing (rather than equity) it is extremely common to use a term sheet. This is because a term sheet can clearly outline to a borrower the general terms and conditions of an offer before being presented to a credit department or committee for approval.

With this in mind it’s important to understand where in the lending process the term sheet fits in.

Term Sheets vs Letters of Offer

Although term sheets are technically non-binding offers (sometimes even called “Discussion Papers” or “Letters of Intent“) they still form a great outline of what will be offered and are generally not presented unless the lender has a strong opinion that they would like to finance the company. Once a term sheet is presented, a lender will then underwrite the file and present it for review by a credit department (or committee), to be followed up by a binding Letter of Offer.

First Things First

Some of the vocabulary used in a debt term sheet is different from what many founders are familiar with on an equity term sheet. Here are some examples.

Amortization

  • Amortization is a concept that will be different from an equity term sheet along with the interest rate. The loan will have to be payed back. The amortization is the length of the term that the loan can be payed back over. Amortizations may be as short as a few months (ei: Bridge Financing) or as long as 30 years (ei: for Real Estate Financing). Most amortizations for term loans will be 1-7 years.
Here is an Amortization Table template:Download

Interest Rate

A major difference from an equity Term Sheet is that the financing will have an interest rate and requires repayment. The interest rate may be a Fixed Rate or a Floating Rate.

  • Fixed-Rate: A fixed-rate will have a set interest and principal repayment amount each month. The downside is that it often comes with additional breakage fees, less flexibility, and if the banks prime rate drops the borrower does not benefit from this adjustment.
  • Floating Rate: A floating rate will have a “Base Rate” that follows either the Bank of Canada’s Prime Rate, LIBOR (London Inter-Bank Offered Rate), or the lender’s own internal base rate. It will also have a “variance” which represents the lender’s spread (mark-up). It is important to understand which rate you are tracking too if you are on a floating rate. For floating rates, the principle is charged based on the amortization amount and the interest amount varies month to month.
Bank of Canada Historical Prime Rate
This chart shows the historical Floating Prime rates from 2000 to 2021. Prime is currently at 2.45% as of April 1st, 2021. 3

Security

  • When raising equity a portion of the company’s ownership is exchanged for the funds. Loans take no ownership but need to be secured.
  • Types of security can include General Security Agreements (GSAs), registrations against specific Intellectual Property, Postponements of Claim, and Personal Guarantees. (I’ll go over the different types of security that can be offered or requested for debt term sheets in another post and what they each mean.)

Conditions Precedent

  • These are conditions that will need to be met prior to the loan advancing. Examples may be a specific request additional due diligence – for example, an accountant prepared year-end financial statement or execution of a legal agreement (like an offer to purchase) that would have to precede the loan advancing.
  • Another common condition precedent may be that a certain amount of equity is raised prior to the loan advancing. This condition might require the funds to either be deposited into the companies bank account first or proof that the funds are committed by the investor.

Covenants

  • Covenants are one way a lender tracks a company’s performance. Some covenants can scare companies away if they are too restrictive. The goal of a well-determined covenant is that the borrower and the lender agree that it is both attainable enough to be met consistently and flexible enough to exist without impeding growth. It’s important to understand the covenants on any agreement and borrowers should feel free to ask a lender why they have chosen a specific covenant.
  • There are three types of covenants, Positive, Negative, and Financial Covenants.
  • Positive Covenants (or Affirmative covenant) is a promise to do or maintain. An example would be to maintain a certain level of working capital in the company.
  • Negative Covenants are covenants to prevent a certain activity. An example of this might be a No Dividends or Withdrawals covenant for the term of the loan. This could be put in place to clarify that all of a loans funds are to stay in the company. There are many different types of covenants and they vary substantially.
  • Financial Covenants reference maintaining a performance ratio like a Debt to Equity Ratio or a Debt Servicing Ratio (less common in tech) and is set to be met to help maintain the financial health of a company.

Reporting Requirements

  • Loans are reviewed regularly with financial information provided by the company. This can be done annually, quarterly, or even on a monthly basis depending on the size of the loan and the complexity of the agreement.
  • These reporting requirements would be listed on the Term Sheet or on the final Letter of Offer.

Prepayment Indemnity

A Prepayment Indemnity is a penalty for paying back the loan before the end of the amortization term.

It can show up in different ways but common types are:

  • Months of Interest: in this method, a prepayment may carry a fee that is equal to a certain number of months interest on either the remaining balance or the drawn amount. These can vary from 3 months to 12 months or even higher.
  • IRR Calculation: Lenders may have a set IRR (Internal Rate of Return) on their loans. If a loan is paid back early there may be a required return that is paid out calculated from the date of the loan’s advance to the date of the repayment. An example of this would be a 15% IRR requirement.

Participating in the Upside

There is a saying that goes “Equity owns the upside of a Deal and Debt owns the downside.”

What this means is that equity investing is highly focused on the success and growth of a company while lenders are highly focused on mitigating the downside risk – simply put, avoiding default situations. There are a few tools that can change this for a lender. These tools are Royalties, Warrants and Bonus/Kickers.

  1. Royalties: Royalties are a payment that is paid as a percentage of sales. They can be collected monthly, quarterly or annually. Sales growth is aligned between the lender and the company.
  2. Warrants: Warrants give the lender the option to buy shares at an agreed price on or before a specified date. The company and the lender are aligned in increasing valuation. 5
  3. Bonus (or Kicker): This is a one-time payment that is made at the end of the term. It is often used when the lender has taken a longer interest-only period. The company and lender are aligned for the full term of the loan for the bonus to be paid at maturity.

Using any of these tools, means that a lender is not just underwriting and trying to mitigate the risk of default, but is also lending to the company on the basis that they believe strongly in the companies success. These options can really align both the lender and the founder’s motivations to have the company succeed.

Summary

  • There are different terms and meanings used on a debt financing term sheet vs. an equity financing term sheet.
  • Ask your lender for clarifications and check if there are definitions in an appendix to the contract.4
  • Understand terms that help lenders participate in the “upside” of a deal (Royalties, Warrants and Bonus/Kickers).
  • Considering the Pros and Cons of Debt and Equity when looking at financing options.

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Footnotes

(1) Venture Deals by Brad Feld and Jason Mendelson – Page 253. Its also one of the First 5 books I recommend for learning about Tech Finance.

(2) Siri Srinivas is an early stage investor at @drapervc

(3) Graph from Credit Genius Article

(4) I will elaborate on these specific options in a future post. In the meantime, here is a great article on Warrants by K. Reilly of Fuse Capital

(5) Also please keep in mind that this is a guide and the specific terms may be defined in an appendix to your offer

(6) Here is another great guide to some of the more complex terms that will show up on a Debt term sheet. A guide to important terms in a debt term sheet by Rohit Mittal

What is Venture Debt? A Misused or Evolving term.

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On Definitions and Language

The Oxford English Dictionary defines the term Venture debt as… just kidding. I promise to never write an introduction like that. The Oxford English Dictionary doesn’t actually have a definition for “Venture Debt” so my gripping introduction would have been ruined anyway. I do want to talk about the Oxford English Dictionary though because definitions and language have an impact on this post and for answering the question “What is Venture Debt?”.

A fascinating aspect of language is that the words and terms we use change and evolve as we use them and new ones are created. Between 400-1250 terms are added each quarter by Lexigraphers (dictionary editors). In 2020, some of the term additions to the dictionary included Zoom, GOAT and Cookie Monster. “Arr” was also added to the dictionary in 2020, but it has been clearly defined as a pirates figure of speech and not ARR (Annual Recurring Revenue). I’m not kidding. 1

I remember when the word “Skype” was frequently used as a verb for a video call, so it will be interesting to see if the addition of the word “Zoom” can stand the test of time. Fortunately for Skype, words are actually rarely removed from the dictionary. They are just re-indexed with a label added that says “archaic” or “obsolete”. I doubt Microsoft wants to hear Skype referred to in either of those ways. Luckily for them, their word is still active without this official label, even if it has been replaced in most conversations.

Knowing that definitions change and words evolve helps to understand some of the confusion that exists today around the definition of “Venture Debt”.

What is Venture Debt?

In this post, I will look into answering the questions “What is Venture Debt?” and “What it is for?”. (I’ll go into the specifics of various terms, warrants, and pricing in a follow-up post).

Venture Debt is a term that is thrown around quite a bit, but actually causes a lot of confusion in technology finance, since it is not properly defined. Since the meaning of a word can evolve into however it is most commonly used, it’s also possible that we just haven’t finished deciding what exactly it means.

Venture Debt is sometimes used to describe any type of lending to a tech company (or “venture”), and other times it is used to describe a specific type of lending to a startup that is backed by Venture Capital. A company that has Venture Capital backing is sometimes referred to as being “sponsored”. With the term Venture Debt gaining popularity internationally, the same issue of it having different meanings is showing up in international announcements and marketing.

These are two commonly used definitions of Venture Debt:

  1. Venture Debt: as a specific financial instrument created for financing Venture Capital backed companies only. This type of venture debt is marketed as a complement to a recent or ongoing equity raise.
  2. Venture Debt: as any form of lending to a technology startup. This method is often presented as an alternative to funding with Venture Capital. This type of debt will typically be marketed as looking at both VC and non-VC backed companies. It can also be marketed along the lines of “Consider raising Venture Capital Debt as an alternative financing option!”

Let’s look at each of the two definitions:

Venture Debt – The Financial Instrument for VC backed Companies:

Venture Debt has traditionally been a specific type of lending product for Venture Capital backed companies within the broader category of Technology Lending. There are many other types of lending to tech companies too other than just Venture Debt. Other examples of products include Merchant Cash Advances (MCA), Factoring, Term Loans, Recurring Revenue Lending, and many more.

Runway

The most common and traditional use of Venture Debt to a Venture Capital-backed company is to increase a company’s runway until its next capital raise. By adding venture debt and extending a company’s runway, the company has a longer timeframe to increase its valuation before the next raise. While this is not the only use for venture debt (equipment, servers, acquisitions are other examples) it is the most commonly thought of when lending to Venture Capital-backed ventures.

Runway is the companies time, usually represented in months, before the cash available to pay monthly expenses will run out. The calculation is very simple: cash in the bank (plus any available credit facility) divided by monthly net loss (which is described as burn) equals runway. So if the company has 2MM in the bank and a 1MM Venture debt loan and is burning 300K a month, they have 10 months of runway. By adding Venture Debt, the amount of cash available is increased and this runway is extended. This is shown in the diagram below.

This Diagram from Silicon Valley Bank shows an extension of a companies runway by taking on Venture debt shortly after an equity raise (can also be done at the same time as an equity raise). The additional capital added runway extension so that a larger valuation milestone could be reached at the next raise.

So what do Venture Capital firms think about this kind of debt being used?

Airbnb and Venture Debt

Something interesting to note in the rise of venture debt’s popularity is that it has not always been looked upon favorably (and still has its doubters). Paul Graham tweeted this about it:

For anyone unfamiliar with Paul Graham, he is an icon in the tech industry and one of the founding members of Y combinator, an incubator that has launched over 2,000 companies. So when Paul Graham shares his opinion on this, many founders will listen.2

There are pros and cons to using both debt and equity as a startup that should be considered by founders for each method of financing. Taking on debt is referred to as leveraging, and simply put, leverage is an amplifier. Both the returns and risks of an investment are amplified with debt. Since startups are already generally considered extremely risky (which is why Venture Capital and Angels are funding them), it’s an extremely relevant question to ask whether or not there needs to be even more risk added on to the business.

I understand where Paul Graham is coming from here. This is especially relevant for companies and investors that are based in Silicon Valley where there is a ton of equity and capital available in the market. Adding an amplifier of leverage can seem like an unnecessary addition.

Another argument against venture debt is that founders often don’t understand it or know how to use it (especially for earlier stage founders that don’t have a CFO in place yet). Although this could be a valid concern, I find it underestimates founders’ abilities to learn about financing tools and apply this knowledge. When we consider that founders have learned how to use financing instruments like SAFE’s, Equity raises, and many more complicated tools than loans, this concern seems less relevant.

An interesting progression in this story is that a few months after this tweet, Airbnb, a company that Y Combinator invested in, used venture debt to extend its runway during Covid which led up to an extremely successful IPO. I can’t help but wonder if someone has asked Paul Graham about this and if he has circled back to this tweet.

Something fascinating about the AirBnB Venture debt is that the founder revealed that the venture debt underwriting had valued the shares at $30 each at the time of the debt offering. They IPO’d months later at $68 per share, and actually opened on the first day at $146.3

I can’t help but wonder if the lesson here is that the founders hold the final decision making power or that there is a time and a place for both debt and equity financing.

Impact on Valuation

Airbnb’s use of Venture debt is a textbook example for the following diagram. By extending their runway with debt they were able to delay the timing of their valuation which led to a much higher valuation.

Venture Debt: A Capital Idea for Startups - Kauffman Fellows
This diagram from Kaufman Fellows shows very simply and clearly why founders chose to use venture debt. With a combination of debt and equity, you have a longer runway and the ability to achieve a higher valuation. This translates into less dilution or a larger amount of funds for the next raise.

The blue line shows the company extending their runway to continue for a longer time before their next raise and achieving a higher valuation compared to the black line which is an equity-only model.

Another benefit to this is that outside of Silicon Valley, raising capital can take a long time to close (sometimes months) and VC/Angel capital can be much harder to access, so additional runway could make a huge difference to a scaling startup.

The Rise in Popularity of Venture Debt

The graph below shows a clear trend in the increasing popularity of venture debt as a financing tool with 3,066 deals completed in 2019 for almost $30B in funding. Conveniently the timing of this graphs publishing also matches up very closely with Paul Graham’s tweet.

Chart from Pitchbook with Venture deals reported as of April 21st 2020.

Many top companies have taken on venture debt too. Here is a short list of some top companies that have used Venture debt:

  • Facebook (used for Servers)
  • Justin.tv (now called Twitch)
  • Airbnb (during Covid)
  • Brex – 300MM
  • Eventbrite- 225MM
  • Robinhood – Currently raising $1 Billion 4

Venture Debt – The “Alternative”

It’s becoming more and more common to see private lenders use and market around the term Venture Debt as simply meaning an alternative to venture capital rather than just a complement to it. Since most founders are familiar with the concept of raising Venture Capital, marketing the term “Venture Debt” as a debt alternative to raising venture capital may continue.

Here are some examples of Venture Debt being referred to in a context of not requiring Venture Capital backing:

  • Flow Capital: ” Venture Debt: Complement or alternative to equity financing”
  • Firepower Capital: “Venture debt is a type of debt financing provided to businesses by non-bank lenders to fund growth, i.e. working capital or capital expenses. Venture debt typically complements a VC investment, but in some cases, can also be deployed without a VC sponsor”
  • Tech Crunch: “Venture debt, in various forms, is a type of capital provided to startups that may or may not have raised equity-based funds, like venture capital”
  • FindVentureDebt.com: “We continue to use “venture debt” as an umbrella term for a broad range of non-dilutive and minimally-dilutive funding since it’s more commonly recognized”

The argument for this definition is that the term Venture Debt is actually relating to the fact that a company is a “venture” that is taking debt. If capital is provided by equity it’s Venture Capital, so if debt is provided to the venture then it can be called “Venture Debt”.

The spin-off may have also started as more and more companies have decided not to raise Venture Capital. Many of these companies are still strong candidates for lending. A great example of this would be companies with very strong recurring revenues. Many lenders feel a strong level of comfort lending to a more mature tech startup with >2MM ARR. The Tangible Addressable Market may not have fit Venture Capital standards with unicorn potential, but it was still a strong business with impressive growth metrics.

Who is Right?

So who is right? And who gets to decide? Some people may say that Silicon Valley Bank gets to make this call since they made this type of lending and the term Venture Debt popular. Other sources suggest that Venture Debt (or Venture Leasing) was first created in the 1970s while SVB was founded in 19835.

The answer to this question is actually that it will completely depend on how the terms are used by the majority. For now, there are two definitions that exist simultaneously, and knowing this can elevate a lot of confusion.

Going forward, I believe that one of two things will happen:

The ambiguity and confusion around the term Venture Debt may cause it to start being used less and less. There are numerous tech lending options available to both venture firms and non-venture backed companies now, and most of them don’t market as Venture Debt. There may be some pressure from other terms as banks start to create “Technology Industry”, “Tech Finance” or “Knowledge-Based Industry” groups. There are also many different structures available to Venture-backed companies other than just runway extension, which is the classic use. Although I doubt the term will be labelled “archaic” or “obsolete” (if it ever makes it into the dictionary), however, the use of the term could slow down.

Another option is that the meaning of the term will continue to morph and we may actually see more and more lenders start to embrace the term Venture Debt to simply refer to lending to technology startups. With this type of lending growing in popularity in the UK, India and Australia, the way the terms are used in international contexts will have a strong impact too. The simplicity of thinking that Venture Capital is equity for startups and Venture debt is debt for startups is tempting to use.

I’m looking forward to coming back to this post in few years to see how the term is being used or if a new term has emerged to replace it, but for now, knowing both uses of the term can hopefully alleviate some of the confusion when you see or hear it used.

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Footnotes

(1) Additions to the dictionary and the Oxford Definition of ARR

(2) Paul Graham Essays Link – Paul Graham has an excellent set of Essays. Reading them was a partial inspiration for starting my own blog and using footnotes in a similar way.

(3) AirBnB IPO and IPO video discussing debt financing at $30 share price:

(4) Robinhood article about raising 1 Billion in debt

(5) History of Venture Debt by Espresso Capital

Arming the Rebels – Financing E-Commerce with Merchant Cash Advances (MCA)

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The Retail Apocalypse

I am old enough to remember when the Retail Apocalypse was being discussed in banking. Spoiler: It actually wasn’t that long ago. The bankruptcies for big box stores were pilling up. One of the biggest and most memorable to me was when SEARS applied for creditor protection. This moment stood out because SEARS’s downfall was defined by its inability to recognize this shift and pivot early to e-commerce. (1,2)

The craziest thing about the SEARS situation was that they had basically invented e-commerce before it even existed, they just didn’t realize it! The SEARS catalogue was a game-changer in the history of retail. They had catalogued and indexed all of their inventory, presented the catalogue directly to their buyers, the buyers selected items and could order them by mail. Sound familiar? Put the catalogue online and have the ordering processed by email and you have the future of retail: e-commerce.

It was right there, the execution just wasn’t.

Arming the Rebels

The tools to execute in e-commerce are here and they are easier than ever to set up and use. This is true for small retailers and big-box stores.

One of the most epic quotes from a tech community of the last decade had to be from Tobi, the founder of Shopify, when he was asked if he was competing with Amazon. I’ll never forget this answer:

Amazon is building an empire, and Shopify is trying to arm the rebels.”

Tobi Lütke, Shopify Founder and CEO

Since then, Shopify ($SHOP) has become the most valuable company on the TSX surpassing the Royal Bank of Canada ($RBC) for the top spot (5).

Grow your own TAM (Tangible Addressable Market)

Something I will always find amazing about Shopify is that they not only support existing businesses, they are actually actively growing and creating their market by how easy their platform is to use. What I mean by this is that I have met entrepreneurs that have started their e-commerce businesses because Shopify exists not just taking an existing business online with it. That is an exceptional impact. That’s not even including the number of tech companies that are creating apps and add-ons built to service the Shopify marketplace/platform.

I’m obviously a little bit biased because I love the Canadian success story too.

War Profiteering

Tech Blogger, Packy McCormick, has an interesting post where he disagrees that Shopify is actually arming the rebels. He compares it more to war-profiteering with the argument that when everyone is armed then no one is really benefiting, except those doing the arming.

I disagree with this assessment. The main issues brought up seem to be that Direct-to-Consumer (DTC) brands are all “armed” and therefore no one can actually win. I think the unfortunate part is that, first of all, the assessment of winning or losing seems to be based on whether a company can reach venture scale. This metric for winning is wrong and one that I will talk about frequently in this blog. I’m not a fan of the idea that companies should only be created or considered a success if they can reach venture scale or become unicorns.

Second, The article also states that marketing is the only differentiator left which I also disagree with since I think it’s actually on the product that companies can differentiate. Regardless, it is a brilliant and informative article on e-commerce and DTC brands and the challenges they face. I’d definitely recommend the read for anyone involved in e-commerce. (6)

The incredible e-commerce tools to create an online store through Shopify are well known, but one of the ways that Shopify has decided to “arm the rebels” is with financing and Merchant Cash Advances. This type of financing is also offered by Clearbanc and Stripe (3).

Is E-commerce considered Tech Financing?

This is a debate I have been a part of many times. I see this answer as an easy yes. I understand the other side of the argument fully. It’s has a physical product. Instead of being sold in store, it’s just sold online. Yes, these things are true. But this is why it’s considered tech. The DTC Value Chain is often almost entirely managed by software.

This diagram from Packy McCormick Article is a great visual to show an example of how much of the DTC (e-commerce) value chain is managed with software and digitally. This is one of the main reasons why loans to DTC companies are considered technology financing.

This is the distribution chain that makes it a tech company from a financing perspective. There is substantial “tech risk” associated with e-commerce companies. An example of this risk is the question of whether or not the company will be able to deliver on its digital marketing and manage its digital supply chain.

Banks and eCommerce

Many banks will take a look at financing these companies and sometimes try to finance them. The main reason these discussions usually get shut down is because of the only asset in the business in inventory.

So when you look at the company from a traditional financing lens you end up with the following thought process: Revenues are growing: Check. Profitable: Check! Collateral: Consumer inventory… Oh. Then a bank starts to think, “okay, if this company with all their competitive advantages goes out of business selling this inventory, then how are we going to sell it in a liquidation scenario?”. Not to mention whether the company should even be carrying large amounts of inventory at all and is it even stored in this country? This starts to get too messy for them so we have to look at it from a tech finance perspective and that’s why MCA is so popular.

Creating a Negative Cash Conversion Cycle

The biggest cash flow problem that all DTC companies face is that they have to be able to convert their sales into cash faster than suppliers require repayment. If a company can do this, they have created a negative cash conversion cycle. This is a good thing. To understand this first let’s look at the Operating Cycle.

Cash Conversion Cycle - Overview, Example, Cash Conversion Cycle Formula
This is the Operating Cycle in it’s simplest form. Inventory becomes a Receivable which is turned to Cash to pay the bills (Payables) and to buy more inventory.

A negative cash conversion cycle means that it takes a company longer to pay suppliers/bills than it takes to both sell your inventory and collect the payments. In this situation, your suppliers are financing your operations so you don’t need substantial amounts of capital to grow.

This Cash Conversion Cycle diagram from Treasures.org shows an example of the Cash conversion cycle within the Operating Cycle. The time after the payment is made for the inventory (called “Raw Material” here) and until the payment is received in cash is the Cash Conversion Cycle.

The opposite of this is actually how most e-commerce companies operate, where payments to suppliers are required sooner than payments from customers can be collected, the result is cash flow issues. When this happens then as your sales increase, your cash flow actually decreases and you’ll need additional debt/equity to finance your growth. (I’ll dig into the specifics of these calculations and suggestions to improve the cycle in a future post).

In a traditional business like a manufacturing company, this could be solved with an operating line of credit margined against a company’s receivables. In a DTC company, a Line of credit is harder to get so MCA is one of the tools used to help finance this cycle.

Shopify and Clearbanc’s Merchant Cash Advances (MCA)

This might come as a surprise to some because of how friendly their advertising is these days, but historically Merchant Cash Advances were frowned upon as a source of financing. They were seen as very expensive loans that were distributed by Credit Card and Point of Sale (POS) companies and usually taken out in desperate situations to bridge short term cashflow issues. Earlier in my career when I would see these loans on a balance sheet it was often a red flag that the company was likely not going to be “bankable”.

Shopify Capital and Clearbanc have changed this perception. One reason I think this has happened is that financing for tech startups (yes- this includes e-commerce) is already generally happening at higher interest rates than traditional bank debt (5). Therefore coming in with an offering of a higher interest rate doesn’t actually raise any eyebrows.

Second, the ease of getting the loan is actually stunning. Clearbanc created the 20-minute Term Sheet and it’s probably even faster than that now. Every time I check in on Clearbanc or see an update, the max funding amounts have increased too which is also incredible. The pre-approvals and the data-based underwriting they use seems to be excellent.

I would love to have a look at this algorithm and I actually highly doubt that the default rates are substantially higher than most financial institutions on their loans. The model is probably that good. The returns from the loans will have to be higher but that’s mostly because they are funding their lending programs with equity funds so the returns need to exceed the cost of funds for profitability (8). Could they lower this cost of capital going forward? The easy answer is yes, with deposit accounts and treasury services (bank accounts and payment transfers). If they hold deposits they can make the spread in-house instead of off of equity investments. If they haven’t started to roll them out yet I would expect this is coming down the pipeline or at least being discussed.

Pros and Cons of MCA Loans

Pros

Let’s start with the positive.

  • Data based underwriting removes bias. Michelle Romanow often talks about the fact that they finance more minority-owned businesses and women-led businesses than venture capital. This is wonderful to see.
  • Simple process – Clearbanc has the 20-minute term sheet. Shopify’s process is very simple too and if they don’t have this feature already I would expect that there will be pre-approved loans pop up in the founder’s dashboards down the road.
  • No collateral required. This is music to a tech founder’s ears. Especially for earlier stage companies because there is likely none to offer.
  • No personal liability. Again music. Personal guarantees are a common form of security for bank debt. Keep in mind that loans without personal guarantees likely cost more than those with them, but to some, this is an important factor.
  • Fees instead of interest. The fees are pretty clear (other than the confusion around the annualized costs). They are upfront and they don’t fluctuate. The interest rate doesn’t compound either. Just beware of the time horizon, the annual cost of capital changes substantially if paid down early and a borrowing fee ≠ interest rate.

Cons

  • The Lender gets paid first with MCA‘s and right off of the top line. The deposit occurs and then the repayment comes right out of the revenues being deposited into your accounts. The funds are usually withdrawn as soon as the revenue deposit hits your bank account. With other types of debt, you will create your revenue, run your company and then interest and principal will be one of your monthly expenses.
  • There is typically no way to prepay or payout a contract early with any benefit. Once the money is borrowed, no matter how long it takes to pay it back it is still going to cost the same. This is referred to as a fixed borrowing cost. This can actually be a benefit to the company from a budgeting perspective too since you know what your loan is going to cost exactly to repay and there is no risk of fluctuation from the federal interest rates while being on a floating rate.
  • Cost of Capital can be very high and easily get up into the 30%+ range (or higher) on an Annual Percentage Rate (APR) basis with short term repayments and fixed fees. Make sure that you are calculating the costs of capital on an annualized basis.
  • Controlled Spend. These funds often have to be used for specific marketing expenses or are highly incentivized to be used with specific companies (eg: Facebook Ads). I do actually see this as a good thing since this is one of the things that debt should typically be used for and the controlled spend can remove the temptation to allocate debt to things that loans shouldn’t be funding (hint: Non-Revenue generating activities).
  • The loans are very short term. Shopify’s are 12-month terms and Clearbanc offers similar. Not exactly patient capital, but can be used to bridge short term cash flow issues. Unfortunately, short-term financing can put substantial pressure on the near future’s cash flows and growth.

Examining the Costs of Fees vs. Interest Rate

Something that is often missed when comparing fees to interest is that an interest rate is an annual amount. Here’s a very simple example. If you are charged a 6% fixed fee on 4 advances (one per quarter) that you pay back every 3 months, then the cost of capital is actually 24%.

A simple formula for this is (the fee percentage paid/amount of days the loan was taken out for) then multiply this number by 365. That is your APR.

Summary

  • Consider the pros and cons of MCA for your specific situation from this post.
  • Make sure to understand the true Costs of Capital associated with any fees or interest rates.
  • Look into your cash conversion cycle to see if you can improve it. (I will have a post with recommendations posted soon)
  • Consider if this is the best financing option for the company or if term loans or equity may be a better option.
  • I am a huge fan of what both Shopify and Clearbanc are building and will always be cheering for them as Canadian success stories. They are two of the top Canadian tech companies to follow and I expect more financial products to keep coming from both companies. (8)

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Footnotes

(1) Story on the Retail Apocalypse from Business Insider

(2) In finance I like making statements like this “old enough to remember” because it makes me sound like a seasoned veteran but the SEARS situation was actually in 2018

(3) Here is Shopify’s Loan details and here is Clearbanc’s Loan details.

(4) This article looks at how Sears actually didn’t succeed in their e-commerce pivot also an interesting perspective that the hedge fund that bought SEARS may have seen it as more of a real estate play.

(5) Top spot on the TSX (Toronto Stock Exchange) doesn’t guarantee you stay there. $RIM (Research in Motion/Blackberry held this spot for a while). Still, I am willing to bet on Spotify long term since their TAM is huge and they have just barely scratched the surface of it.

(6) Article by Packy McCormick on Shopify

(7) Clearbanc has also expanded in SaaS Based Recurring Revenue Financing but I will talk about that in another post.

(8) Clearbanc recently raised 300 million in equity to continue to grow their market share

External Ressources

– Jay Vasantharajah has a great post where he dissects the specific costs associated with a loan from Clearbanc.

– Patrick Coudou Tweeted a thread about his experience and opinions on MCA.

– Here is another resource on the details of the loans and specific requirement to qualifying for MCA from Finder.com.

Financing a Tech Company’s growth with Term Loans – It’s all about Timing

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Timing

This post will focus specifically on when the best time is to use term loans to finance growth. There are other times and types of debt too but this article will focus specifically on using term debt to finance growth (1).

Venture Debt is not included in this post’s analysis because it is essentially leveraging a companies venture capital investment to extend the runway to the next raise so different rules apply. Not all startups will qualify for venture capital or have venture capital firms involved (2). This post will focus on term debt and I will look into venture debt in a future post.

There are many pros and cons when using debt as a financing option that you should also consider. First, let’s talk about the best timing to qualify for a loan.

Venture Stage not Revenue Numbers

When assessing whether or not a startup can, or should, access a loan for growth capital, a common question that I hear from founders is “what revenue amount do you need to see?”. It is my own fault that I get this question because revenue targets are usually the simplest way to set the timing for this conversation. Both equity investors and debt providers will often say things like: “Let’s revisit when you are at 75K Monthly Recurring Revenue (MRR)” to founders, but revenue numbers alone are not the full picture for qualifying.

The evaluation should not just be about the companies revenue amounts but also the stage of the company. Most lenders will still want a minimum revenue amount before they open a discussion for financing so this is another reason why we give revenue targets to start a discussion.

Lifecyle of a Venture Diagram

Let’s start by getting a strong understanding of the Lifecycle of a Venture.

Lifecycle of a Venture Diagram
Full credit for this exceptional diagram to BDC’s ICE Venture fund (I first saw it in a presentation from BDC’s Industrial, Clean and Energy Technology (ICE) Venture Fund

Starting at the top we see the Development Phases of a technology venture. It’s important to note that this diagram can be stretched to adjust for time. For example, a biotech company that needs to go through FDA approval would have a much longer time in the R&D phase than say software as a service (SaaS) company which could launch at a much faster timeline and improve the product as it adds customers.

Next on the diagram is the Cumulative Cash Flow (the red line). This is where we see companies go into burn mode as they are developing their product or proving out their market. The risks in this area are highlighted with the blue arrows as two ominous Valleys of Death.

The Valleys of Death

  1. The Technological Valley of Death is the risk that the tech/innovation that is being developed is not able to be created. This could be due to running out of money or running into technological hurdles that can’t be overcome with the resources available. One of those resources could be capital.
  2. The Commercialization Valley of Death is the risk that the market rejects your product. This is commonly referred to as a “product-market fit”. Farther down the diagram you can see First Revenues followed by Product-Market Fit. These are two separate stages because unfortunately generating revenue does not necessarily mean you have reached product-market fit (I’ll write about this in another post). This is also why minimum revenue targets are often given to a client by a lender to set a timing for the next conversation. Hitting a minimum revenue target can generally mean that you are progressing well through this Commercialization Valley of Death.

A company will typically need to have made it through the Technological Valley of Death using equity financing. Loans will rarely be given to companies with unfinished tech risk (3). They should also be generating revenue and be progressing well through the Commercialization Valley of Death before debt can be considered.

The main reason why these valleys matter to founders considering taking loans is actually quite simple. It is a lot easier to pivot in these valleys on equity financing than it is on debt financing. A loan will be much less patient and forgiving. If you haven’t made it out of these valleys and the loans need to be repaid, then the company will be in a situation where not only is there going to be pressure to use cash flows to pivot, but also pressure on cash flows from loan repayments.

Lending does occur in the Commercialization Valley of Death but it should be at a point where there are stable revenues and proper sightlines to future cash flows.

Something to keep in mind with lenders is that they are not typically going to test out or validate your product. They usually won’t have the tools, resources or time to do this. They will depend on your paying clients and their commitments, to assess and prove that you have market validation. The general assumption of a lender is that if you have consistent and growing paying customers then they are validating your product and your progress through commercialization.

Equity Comes First

At the bottom of the diagram are the sources of funding and how they fit into the picture. For a discussion on debt, I would remove the pre-seed/seed/series A part of this diagram. Since the series typically refers to the amount of equity fundraising done, there isn’t really a perfect answer correlated to “series” for when debt should be accessed.

Something that should really stand out from this diagram is the bottom section where the options for financing are laid out. One of the key things to notice is that equity financing options always comes first (bottom left on the graph).

One of the most powerful ways I’ve heard this described is that debt needs equity to exist.

You may hear this from your lender too. They might ask you to raise additional equity as a condition to their financing or tell you that the MVP needs to be completed with equity. Sometimes this will be described as being over-leveraged, which means there is not enough equity to support adding debt.

Starting or building an early-stage company heavily levered on debt is not only likely impossible, because no debt providers will qualify you for a loan, but also it can trap you in one of the “valleys of death”.

Why does this timing matter?

The answer is actually quite simple. There is a type of risk that should be financed with Venture Capital funds and less risky spending that can be financed with debt.

Sales, marketing and revenue-generating expenses have much more predictable risks than the types of risk venture capital will take. VC money is also much more expensive. Yes, it really is. And it should be. (I’ll go into this in detail in another post). They are taking on more risk than debt does. In finance: higher risk = higher returns. Debt could never charge the rates to match the returns that equity could get on a successful investment (it would actually be illegal), but lenders could also not accept the failure rates. Many lenders would be fired for an 80% write off rate even if 20% of companies exited. (4)

Since the original diagram wasn’t initially meant for a discussion around debt financing, here is an edited version of the diagram for discussion around when to use debt for financing growth:

When does Debt come in?

A very simple rule of thumb that most earlier stage debt providers will use, is that you should have a path to profitability within 18 months. This will be assessed by a cash flow projection (I’ll cover how to make one in a future post). It doesn’t necessarily mean the company has to choose to head to profitability, but a clear path needs to exist. The reason for this is simple too. Lenders want to know that when repayments start, the company has the ability to repay without the need to do another equity raise.

So when should you consider term debt for growth? The best time is when this curve starts to invert and you have confidence in your future cash flows. This is marked in green. Based on the risk tolerance of your lender they may be willing to come further left of this curve to finance the company at an earlier stage.

The Checklist

Here is a quick checklist to simplify the thought process of being ready to seek out debt:

  • Minimum Viable Product (MVP) developed and in market
  • Generating revenue
  • Gaining traction and adding clients
  • Identified revenue-generating opportunities to finance (use of funds)

Growth Capital as Rocket Fuel

If a company has planned revenue-generating activities, growth capital can be extremely cheap (compared to equity) and very powerful rocket fuel to shoot up that slope. The non-dilutive capital can be a great tool to increase your valuation before your next raise and to get a company to a higher revenue amount.

What kind of company does this apply to?

The beauty of this model is that it can apply to any scaling tech company or startup. They don’t need to have raised venture capital, which is a good thing considering only a small percentage of companies qualify for it. Some estimates show that less than 1% of startups are funded by venture capital (5). If a company has raised venture capital then venture debt is another option (we’ll look into this in another post.)

You can even be fully bootstrapping off profits alone and then shift gears with some debt to launch up that slope. For the all too rare, currently profitable startup, the opportunity is to grow with leverage by using debt to take advantage of additional opportunities that the profits alone could not have made available.

Summary

  • Term debt can be an extremely powerful non-dilutive tool to help cash flow and for increasing revenues when it is used at the right time.
  • Consider which stage the company is at and how far the company has progressed through the technology and commercialization valleys of death.
  • When considering term loans, keep in mind that you will want to have a path to profitability (even if it is not followed).
  • Consider the pros and cons of debt, equity and bootstrapping to make sure this option is the right fit for the company.

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Footnotes

(1) Term debt is a loan that will have set repayment amounts that usually come after an initial interest-only period.

(2) There is often confusion around the term “Venture Debt.” The term was originally meant to be for venture backed companies that used a debt instrument alongside their raise to extend their runway. Sometimes it has been used to refer to any loan to a tech startup. In this post I’m using its original meaning of debt for venture backed startups. I will write about this in detail in another post.

(3) The exception here is, again, Bio-tech where there are times where a substantial amount of IP can be used by specialized lenders for financing in this Valley.

(4) This 80/20 split is based on the Pareto Principle which is the idea that 20% of the fund returns 80% or more of the returns. 80/20 Rule applied to VC

(5) Where Startup Funding Really Comes From by Laura Entis for Entrepreneur.com:

External Resources

Original Life Cycle of a Venture diagram created by BDC’s Industrial, Clean and Energy Technology (ICE) Venture Fund