Debt Financing

What is Venture Debt? A Misused or Evolving term.

February 8, 2021 by Kaylan Pepin 2 Comments

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:

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.
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:

Venture debt is like a delicious sandwich that only costs ten cents, but occasionally explodes in your face.

If I were running a startup, I don't think I'd ever take it.
— Paul Graham (@paulg) February 7, 2020

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)

January 18, 2021 by Kaylan Pepin 3 Comments

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

December 28, 2020 by Kaylan Pepin 5 Comments

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

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.
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

First 5 Books to Read for Financing Tech Startups

December 16, 2020 by Kaylan Pepin 2 Comments

This is a list of the first five books that I recommend to anyone interested in learning about Financing Technology Startups. These are the books that were first recommended to me when I started financing tech companies.

Here they are in no particular order.

1) Zero to One

by Peter Thiel

This book is a must-read for understanding the psychology behind startups. It is a staple book in the startup community written by one of the Pay Pal Mafia’s original member’s Peter Theil (1). After PayPal, his top investments include Facebook, Palantir and SpaceX.

This book was born from a course he taught at Standford University on entrepreneurship (2). The concept of 0 to 1 is about how to build companies that create new things. The concept starts with the key questions: “What important truth do very few people agree with you on?” and “What valuable company is nobody building?”.

This book is not only for tech finance, it’s also essential reading for anyone involved in startups.

2) The Lean Startup

by Eric Reis

This book is an excellent read and a great way to get introduced to essential concepts in tech, including creating a Minimal Viable Product (MVP), Pivoting to find Product-Market Fit and Iterating continuously to grow a product off of user feedback.

These concepts have helped start many companies and launch products without the need to amass a ton of resources before getting started. I expected this book to hang out around the perimeter on a lot of these concepts but was really impressed with how deep and specific some of the advice is.

The book is a great manual for all aspiring entrepreneurs and tech founders and a great intro for language and concepts required to finance technology startups.

3) Venture Deals

by Brad Feld and Jason Mendelson

This book has basically become the textbook for understanding venture capital. It’s a deep dive into term sheets, cap tables, and raising venture capital. The Authors, Brad Feld (Co-founder of TechStars and Foundry Group) and Jason Mendelson (Managing Director and General Counsel for Mobius Venture Capital, now Co-founder of Foundry Group) go deep into the details and terminology involved.

The updated version also features a section on Venture debt added by Silicon Valley Bank. I wrote about the Pros and Cons of Equity, Debt and Bootstrapping here and have a post on venture debt coming up that will dig into more of the concepts from this chapter (3).

The book is a must read for companies that are on the venture capital route or that plan to raise capital and create a venture scale company.

4) Disrupted

by Dan Lyons

This is an amazing read on a writers “misadventures” joining a tech startup, Hubspot (4). The amount of irony in it is exceptional. I still can’t decide if the irony was intentional or not. The most amazing part of this book is that the author throughout the entire book seems to lack the self-awareness to realize that he is not actually the protagonist of his own story. If anything, a flawed main character actually added greatly to the read and a window into a hyper-growth tech startup.

The window into the startup world is enjoyable and reading it from a perspective without rose coloured glasses on is valuable. It’s also not something you get to hear or read about often. As Dan Lyons points out there are a ton of people invested, usually quite literally (ie: financially), in promoting only the good of tech companies. The book looks at a lot of really great points that are not talked about enough at tech startups. Especially the pains that come with scaling quickly, having workforces skewed strongly towards specific demographics, and the chaos that comes from venture scaling a company.

It’s very readable, flows well and keeps you interested with great storytelling. At times it feels like a conversation where a friend is telling you about their crazy experience at their last job over coffee. You sip your coffee and do your best not to judge the company, the industry or your friend too harshly as they speak but are entranced right until the end.

While not directly a tech finance book, understanding the impact of venture capital and the window into a successful venture scaling company is worth the read.

5) The 4-Hour Workweek

by Timothy Ferris

Traditionally seen and marketed as a self-help/productivity book, I’ve included it in this list because it introduces the idea of the Lifestyle Business. A lifestyle business in tech is one that is not typically going to reach venture scale but has automated numerous processes and has achieved profitability that supports its owners’ lifestyles.

The productivity tips include the Pareto Principle (80/20 rule) for focusing on your most valuable tasks, clients, activities and D.E.A.L. (Definition, Automating, Eliminating, Liberating) which looks at how to identify and redistribute tasks to liberate yourself or your company. (5)

Since Venture Capital and rapid growth is not the only way build a successful company, I’ve included this book to highlight the concept of a Lifestyle business. Tim has a great blog and postcast too.

Summary

The list again:

Zero to One by Peter Thiel
The Lean Startup by Eric Ries
Disrupted by Dan Lyons
Venture Deals by Brad Feld and Jason Mendelson
The 4-Hour Workweek by Timothy Ferris

These were the first 5 books that I read when I started in tech finance and have shaped how I look at deals and tech companies that I work with.

Have I missed any other good ones?

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Footnotes

(1) The “PayPal Mafia” is a group of former PayPal founders/employees that went on to found technology starups including Tesla, Inc., LinkedIn, SpaceX, YouTube, Yelp, and Yammer. This was the original photo and article from the November 27 2007 Issue of Forbes.

(2) Competition is for Losers is a YouTube video that gives a great intro into some of the concepts explored in Peter Thiel’s booked from a lecture at Stanford University

(3) A section on Venture debt has recently been added by Silicon Valley Bank. Here is a sample.

(4) While writing this review in 2020, Hubspot is still a top employer and is now worth ~10x what it was at IPO ($HUBS). The owners and investors have all made money and this book is used as a recruitment tool. Dan Lyons has a best-selling book and has worked on an incredible HBO show Silicon Valley for several seasons. Seems everyone made off pretty well.

(5) Pareto Principle is the concept that for many outcomes roughly 80% of more of consequences come from 20% of the causes. It is also called the 80/20 rule.

Pros and Cons of Tech Financing Options – Debt, Equity and Bootstrapping

December 6, 2020 by Kaylan Pepin 9 Comments

Teammates not competitors

This conversation is often explored as a “Debt versus Equity” debate. I’m not a fan of this debate. I find that the “versus” really misses the point. Equity and debt financing methods are not at odds with each other, they are different financial tools that can be leveraged in different ways and at different times. The same way a hammer and a screwdriver are not at odds with each other.

There is a right times and place for each method of financing. They can even be leveraged together or in various combinations throughout the lifecycle of a venture. In this post, I will look at benefits and setbacks for consideration that come with each financing source.

I’ve made a point of including Bootstrapping in this conversation too, which is not discussed often. The virtues of bootstrapping are well known and (rightfully) celebrated but it is important to discuss and consider the constraints associated with this method of financing a tech company too.

Financing by Raising Equity

Equity is the most well-known way to finance a tech company by far. It includes fundraising from Family and Friends, Crowdsourcing, Angel Investors and Venture Capital.

Pros

Patient Capital: Equity investments are incentivized by large exits or liquidity events. When things don’t go according to plan in the short term but the long term vision is still attainable, equity is patient with the company. It can continue to support a company while the company pivots or through difficult economic periods.
Early Investment: Equity raises are available to early-stage companies starting with pre-seed Angels, VC’s and family and friends fundraising rounds. It can be used to start the company and to build and create products that cannot be financed in any other way.
No Negative Impact on Cash Flow: Equity investors will assume a portion of ownership and are in turn compensated by the companies growth and increasing valuation. There are no payments that take from cash flows.
Access to Network and Expertise to Scale fast: Equity investors will often come to the table with additional resources, bring additional expertise to the table or have industry connections that can benefit the company. This is possible from both angel and venture capital investors.

Cons

Ownership dilution: Taking on an investor by raising equity requires that a portion of the company is sold which leaves the founders with less of their company.
New Partners Opinions may not match Founders: When a new investor is taken on, they may require a board seat to monitor their investment. The new investor’s opinions for the company may not always match those of the founders.
Higher overall cost than debt: If the company is growing quickly then the cost of equity is actually much higher than the interest rate on a loan (I’ll explore this cost of capital in detail in a future post).

Financing with Debt

While debt financing is becoming more and more popular (1) it is still considered to be the new kid on the block. Lenders include Banks, Credit Unions, Private Lenders, and more.

Taking a look specifically at Venture debt activity in 2019, there was over $25 billion in lending across 3,066 companies. (1) This might seem like a lot but it is barely scratching the surface. Keep in mind this is only for Venture debt deals for Venture Capital backed companies. There is still a significant amount of loans made to angel-backed or bootstrapped companies too. Still, the trend from the graph shows the rising popularity of this method of financing.

According to Pitchbook: In the USA, 3066 Venture Debt deals were completed in 2019 for just over $25B. (1)

Pros

Non-Dilutive: This is by far the number one reason that founders chose to use debt as a tool for financing their company, the capital does not dilute their ownership percentage. (2)
Control of management decisions stays with current ownership groups: Control is a very close second reason to use debt. Many founders want to continue to grow with the current ownership group without adding additional partners and just need more capital to do it. This ownership group could already include equity investors or just the original founders.
Cheaper overall cost of capital than equity investment: If the companies valuation is increasing year over year, as most startups are, the cost of equity is usually higher than debt (I’ll do a deep dive into this in another post).
Ability to end the relationship: If for any reason, including deciding to switch to strictly equity-only financing model, a loan can be repaid. Most loans will likely have a prepayment cost to ending the relationship but it is way easier to drop a debt provider than an equity investor that is on your cap table.

Cons

Repayment can Interfere with Growth: Debt will have to be paid back. There may be a principal postponement period, but interest will likely start being paid immediately. When the payments are due the company will need to have sufficient cash flows to support the payments and continue to grow their business.
Interest Cost & Fees: Loans will often have fees for set up and security registration as well as an interest cost to be paid on a monthly basis.
Requires collateral and covenants: Loans will require security. General Security Agreements, Specific charges on Intellectual Property, Personal Guarantees, Postponements from Shareholders, and more are all potential security that could be required to secure a loan. Some lenders required covenants, which are performance metrics that are monitored.
Default Potential: If loan payments are not made, the loan goes into default. This could require credit restructuring and if no resolution is reached, the lender can collect on the security taken.

Bootstrapping

Bootstrapping is financing growth by using a founder’s own funds or reinvesting profits from previous years. Some like to refer to it as funding your company with your revenues. I love this statement because it is simple and true. Bootstrapping involves covering the expenses with the revenues and funding opportunities with what is left.

To be clear, Bootstrapping is actually a form of equity financing. It’s just that the equity is either injected by the owners or created from the profits of the company. I’ve given it its own section to separate it from raising equity as an option.

Pros

No Interest Cost: Great.
Retain Equity: Amazing.
Full decision making control: Even better!

Cons

Not always possible: Unfortunately not all companies have the ability to bootstrap. There are significant capital costs related to starting a company and building a competitive product.
Can limit Growth: Unless a company is making more money than it can spend, choosing to bootstrap can actually impair decision making by limiting opportunities to cash available.
Owners Assume all Capital Risk: The founders have assumed all the capital risk in a bootstrapped business. This risk is not shared with a bank or an equity partner when it could be.
Miss out on access to Professional Partners: This one will likely be the most disputed, but there are many examples of investors bringing connections to the table that advance a companies growth significantly. Lenders may also find potential risks in their assessments that had not been noticed. Founders could be missing out on valuable expertise and connections.
No Cushion or Insurance for challenges: Depending on how much cash is kept on hand, bootstrapped companies may not have the ability to absorb challenging periods.

Recommendation

It is important to remember that there are success stories with all three methods and with various combinations of the three. Also, each method may have a better use depending on the use of financing and growth stage of the company. For example, I have seen both: Bootstrapped -> Debt -> Venture Capital Raise and also Angel Investment -> VC -> Debt work out successfully for scaling a company (among many other combinations).

A few tips for when you are looking at each financing option:

Consider the right option for your company based on the pros and cons weighted to which one is most important to your current ownership group (3).
Make sure you use the right financial instrument at the right time and business stage.
Talk to your financial partners frequently for advice and to be prepared for opportunities.
Dig into potential investors’ or lenders’ backgrounds before making a commitment to understand the reputation of who you are about to partner with.