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In June, we held a CFO summit in NYC. Kevin Weinman, the EVP of Finance at Mohawk Group talked about the importance of debt to early stage startups
To see more from the summit click here.
Hi! Good morning. My name is Kevin Weinman. I’m the EVP of Finance at Mohawk Group, which is an eCommerce startup here in New York City. We’ve developed software that utilizes AI and machine learning to discover, design, and deliver the products that people are looking for online. For all the VCs, did I hit all the buzzwords? Yes? All right. Let’s move on.
So today I want to talk to you about something that not a lot of us really put into our businesses. And it’s actually the role of debt in startups. So when we’re thinking about debt, for the startup realm, there’s really two major types that we can use. So the first one is gonna be a line of credit, and the other is gonna be a term loan.
So when we’re thinking about lines of credit, there are really three major types that our businesses are gonna be able to utilize. So the first is gonna be AR factoring. The AR factoring is great for companies that have relatively high gross margins, and low turnover. The ABR revolver, which is something that my company is now using, is great for companies that have very high stocks of AR and inventory and want to be able to leverage that, tap into it, and add some liquidity from that position. And then for software companies, or asset light companies, the MLR line is gonna be great because the SAS companies are able to use the predictable monthly recurring revenue, the low return customer base, to be able to tap into that product.
On the term loan side, there are really two different types. One’s gonna be your traditional bank loan. It’s gonna be great for companies that are generating positive EBITDA, that have a relatively strong credit profile. But for probably most of the companies in this room and for mine as well, we’re looking at venture debt. Venture debt is a really really special product that’s meant specifically for VC backed companies. And the great thing about it is you could be a cash burning business and still get a loan.
So now, you’re running your company. You know, I want to bring on debt onto my books. What type of debt do I want to bring on? So the venture debt is actually, you can get a line of credit, or more commonly, you can get a term loan. So which type do you want?
Let’s talk about the advantages and disadvantages of both. Some of the advantages of the venture debt, which you’re typically gonna be using to fund your operations. Because normally you’d want to match your long term liabilities, obviously to fund your long term assets. The great part about venture debt is it’s non formulaic. You can have up to the entire sum available at closing, which allows you to deploy a tremendous amount of capital right from the get go, and juice your growth. Another big strong advantage is that there are no financial covenants. So because we’re cash burning companies, we don’t want to have the limitations that could be placed on us by some of those financial covenants.
When we’re talking about lines of credit, two of the biggest advantages there are, number one it’s gonna grow with your company. If you’re using something like an ABR revolver, as your inventory, and as your AR increases over time, you’re gonna be able to draw against those funds. So it’s great for growing along with the company. And the biggest advantage for the line of credit over the venture debt is that it’s gonna be less expensive because it’s primarily gonna come from banks.
On the disadvantages side, two things with the venture debt. Number one, there could be a relatively short drawdown period. So this is the amount of time that you have between the closing and the end of that period to draw down the total amount of funds that are being lent to you. If you don’t have a great reason to deploy all of that capital immediately, that relatively short drawdown period is not so great for you because now you’re paying interest on cash that you’re actually not using. And the second disadvantage of the term loan is that you have the amortization grade. You need to understand what does that schedule look like? Is there gonna be a bulk maturity or is it gonna be fully amortized?
On the line of credit, opposite of the venture debt, there are going to be financial covenants, so you’re probably gonna need to maintain some type of fixed charged ratio, some EBITDA margins. And then also, you may not have access to as much capital as you would like. As the company is growing, you may have five million in inventory and two million in AR. You might be able to borrow up to 85% of that AR, and maybe 50 to 65% of the balance sheet cost of that inventory. So you may not have the ability to put as much capital to work as you would like.
Something we could go through now, at 9:30 in the morning, what’s the most important thing we all have to do? Talking about raising venture debt. So, couple reasons why you would want to raise. One is, you want to extend that equity runway from a fresh run of capital. Think about it as a compliment to the latest equity round that you’ve raised. If need ten million dollars to get to your next milestone, you can go out and you can raise all ten in equity, or you could do seven in equity, three in debt, bringing down your overall cost to capital.
Another reason that you may want to raise venture debt is to actually act as an insurance policy because maybe you actually have a shortening of your runway that’s an unanticipated business performance.
A third reason is avoid setting the valuation. If you’re at a point in your business where you have a lengthy amount of time between your next milestone and you see a relatively large gap between the last equity round and the next one, you can avoid setting the valuation in case there’s a bump in the road and you may have a down round. And additionally, you can also use it to avoid a bridge round.
Final two points. Large purchases. If you have large capex or M & A that’s coming that you want to be able to fund, you don’t necessarily have to use 100% equity to fund that. You can obviously finance it. It’s in the growth projects during the interim between your last capital raise and your next equity round. And finally, for the later stage companies, the ones that are just about to break even, you can use the debt as a bridge to profitability.
Now the important thing to remember about all these reasons with the exception of profitability, is that the reason you’re raising venture debt is not as a final stepping stone to your business. You’re doing it as an interim step before you go out and raise additional equity.
So let’s take a look at an example here as to how we should think about the dilution and the cost of the debt versus the equity. So let’s assume you’ve got a CPG company that’s been in business for two years. And to date, the co founders have provided 100% percent of the equity capital, so they have 100% stake in the company. They go out, they raise their first round of institutional equity, and they’ve raised one million at a ten million dollar valuation. So management now has to move at 10%.
We’re now three months down the road and we say we have to extend our runway. We’re burning cash at a faster rate. We still have more time before we hit our next milestone. How can I extend that runway? So the question is do I want to use debt or should I go out and use equity?
Well, lets take a look at the equity first. So we go out and we raise our series B. We’re gonna raise three million at 15 million. So now we can see that the management has actually diluted itself 18 percentage points just to gather another three million dollars. And the series A investor has diluted him or herself by two percentage points.
When we look at the debt scenario, we take out that same three million dollars of capital, but now we’re in this and we have a 12% interest rate, we have an 8% warrant coverage and a 12 month IO period. So what does that look like? Well, you see the management is actually diluted only about five and a half percent, and the series A investor is diluted less than one percentage point.
So now we’re chugging along. The business has been crushing it. We’ve gone 12 months down the road. We hit our milestone. Everything is going great. We want to raise our next round of institutional equity. So we’re gonna raise our series C. We’re gonna raise five million dollars at a 50 million dollar valuation. So now we need to see what are the consequences of us having raised that series B, or having gone out and got the debt? Lets look at the series B first. Based on that dilution from that series B you can see that after the series C the management team is diluted significantly, to less than 65% ownership stake. All the way down from the 90%. The series A investor is also diluted relatively significantly down to 70.2%.
On the debt side, however, you can see management only is diluted down to 76%, and the series A investor about eight and a half percent. So the conclusion we get from this, management is saving over 11 percentage points by raising that three million dollars in capital from the term debt lender rather that going out for more institutional equity. And I know I’m talking specifically to the management teams here, but for the VCs, it’s obviously beneficial for you too.
So now we’ve decided, okay, we’re gonna go out and raise debt. We’ve pitched equity before, we just had our equity round. Well how do I do out, and how do I pitch lenders? Well the key understanding that you need to have is, the difference between how an equity investor is gonna think and how a financing lender is gonna think. And so the way I like to think about it is that equity investors are thinking, how do I win? And the lenders are thinking how do I not lose? And it’s a big difference. But what’s special about the venture debt is that you still need to sell that growth story to the lender, because the lender this thought process is … I know you’re a cash-burning company, how am I going to get paid back?
The way I’m getting paid back is I believe you have the ability to go out and raise the next round of institutional capital, a larger capital amount that I’ve lent you, at a higher valuation.
The best time to do this is right after that equity round. You have an optimistic investor group, you have a fresh valuation, the growth story is hot, it’s probably gone around Silicon Valley, and it’s gone around New York, and people have heard about it. It’s got a lot of buzz. Now is the opportunity for you to go out and raise that additional capital.
Now we’ve gone out, we’ve pitched a whole bunch of different lenders, and we have a bunch of term sheets in front of us. What are some of the terms that we want to focus on when we’re negotiating? Well, first and foremost, we want to know what is the size of the loan that we need? That’s going to depend, obviously, on what your use of capital is going to be. You don’t want to provide. Or you don’t to take down too much capital because now you’re paying interest on cash that you’re not using, but at the same time, you want to make sure you’re not taking too little capital that’s not going to get you to your next milestone. So, have that firm understanding as to what the size is that you’re going to need.
Second, we want to think about the price of that debt. The price can be broken down into a couple of components. One is going to be the origination fees, which are usually about one to two percentage points of the total loan. You’re going to have an interest rate, which is typically fixed, and that’s going to be based on prime plus about five to nine percentage points, depending on your credit profile.
Then you also want to think about prepayments. One thing about prepayments is there are two different types that you’ll probably see in the venture debt. One is going to be a make whole, where all of that interest that’s due at the end of the loan is going to be accelerated to your prepayment. The second is going to be actually a tiered penalty on top of that. Not only will you have the make whole, but you may have a step down of a two percent premium, one percent premium, 50 basis point premium, that’s going to be due on top of that if you decide to prepay.
A third term to keep in place, and we spoke about this a little bit earlier, is the drawdown period. The longer that period is, the more beneficial to you, because if you can draw the capital that you need in real time and pay interest on just that capital, that’s going to be the most cost efficient and capital efficient for your business.
If you have a drawdown period of one month, and it’s a ten million dollar loan, and you have five million that you can put to work immediately, well now you have five million sitting on your balance sheet that you’re paying interest on that’s not doing anything for your company.
You also want to think about the maturity. Typically, the term loan is going to be about 36 months after that drawdown period is complete. In addition to the maturity, you need to think about the amortization period. One great thing about venture debt is that you can get some pretty lengthy I/O periods. I’ve seen … They range from about six months, you can go all the way up to 18 months.
The thing to consider with the I/O is understanding when you think you’re going to need to go out and raise that additional round of institutional equity. If you think you go out in 12 months and you raise your series B or series C or series D, an 18-month I/O period actually gives you a tremendous amount of runway. It gives you that six months of cushion to raise that additional equity so that you can have the cash available if you’re still burning to pay down that term loan.
You also want to think about what does the end of that term look like. Is it going to be a bullet amortization or fully amortizing?
Probably one of the most unique aspects of the venture debt is going to be the warrant coverage. What this typically covers is about one to maybe two percent with respect to dilution. So, you need to take that into consideration and make sure you model it out because this is where your real cost of capital is coming in.
The benefit of venture debt is that it is certainly less dilutive than equity, but it still could potentially be dilutive. If you’re great at negotiating, there are ways that you can get around warrants and you go to zero warrant coverage. You’re probably just going to raise the interest rate. If that’s something you’re comfortable with, if you know that you can go out in a couple more months or a year and raise that next round of equity at a significantly higher valuation, absolutely press for it.
Finally, you want to consider the covenants that are in there. The great thing about venture debt on the term side is that there are generally no financial covenants, so you have maximum flexibility with how you can run your business and how you can present those financials. There may potentially be some negative and affirmative covenants. On the negative side, things may be a limitation to additional indebtedness, you may need to subordinate additional debt with the lender’s approval, and then generally your limitations on M&A and dividend payments to your shareholders.
Now you have all these term sheets in front of you, you’ve thought about what the best relationship is going to be, you’ve signed that term sheet, and what does the diligence process look like? Well, remember, the key thing with the venture lender is that they want to know that you have the ability to pay back the loan. How are you going to do that? By understanding the growth story and understanding that you can go out and you can raise an additional round of institutional equity, because that’s how they get the security in the loan itself.
Because of that, the diligence process is actually going to look very similar to the diligence process you went through for the equity side. They’re going to dig pretty deep into your financials, but more importantly, they want to understand the management team. They want to understand the growth story. They want to understand the prospects, and they want to understand your equity raised path, as well as future exits for the company as well.
Then just like you did with the equity lend. With the equity investors, you want to ask for references because this is going to be a long-term relationship that hopefully turns out to be a very positive one. You want to understand if there’s a bump in the road and if things go south, how is that lender going to react? Is that lender going to be willing to have a workout with you? Are they going to move to callback that loan? That’s the question that you need to ask yourself.
Then once all of this is done, you and I have the ability to go out, you’ve got that capital coming in, and you think to yourself, I did such a great job, I’m going to push my enterprise value by 5x now before I go out and raise my next equity, and I just saved my company a tremendous amount of dilution.
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