Month: February 2014

The Debt Stack

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There are multiple types of debt and there are multiple ways to use that debt.  From the perspective of a venture backed businesses – debt can become very dangerous if used incorrectly, but can also be a very helpful low cost source of capital.  Different lenders will take a different type of lien.  A lien is a form of security interest in a business, meaning if you can’t pay back the loan the lender can take the assets it has a lien against.  A bank takes a lien against your house in a mortgage or against your car in an auto loan.  Your house or car is the collateral, against which the bank will loan you money.

Working Capital Debt – Revolvers

The easiest, lowest cost and often the first type of bank financing many businesses can access.  This is known as Asset Backed Lending (ABL), where the bank will take a lien against various forms of working capital.  Working capital financing is typically secured by the accounts receivable (A/R) of a business (A/R is the payments from customers for products and services previously delivered).  Another form of working capital that you can borrow against is inventory.

Typically venture backed businesses can borrow up to 80% or 85% (the amount you can borrow is known as the advance rate) of the total value of A/R from qualified customers, that is not older than 90 days.  This means customers with quality credit, who are current on all outstanding bills.  Inventory typically has a 50% advance rate, but is often slightly more difficult and complicated than A/R financing.

Rates for working capital financing are usually the lowest, and are based on the amount the borrower has outstanding every month. In addition to the balance monthly, there is an unused line fee or commitment fee, where the bank will charge the borrower a percentage of the total revolver amount that is not drawn.  Additionally, there is a very small warrant associated as well (a warrant is a right to a number of shares of equity, that doesn’t cost the bank anything, until the day it exercised – at which point the bank would only exercise the warrant if it were to generate more money than they cost).

Interest rates are typically set at LIBOR + 2% – 4%, with a LIBOR floor of 1.00%, unused line fees are typically 0.5% and warrant coverage is between 0.25% and 5% (warrant coverage is calculated as the value of the equity if a warrant is executed as a percentage of the full debt amount – i.e. 5% warrant coverage on a $1mm revolver would represent $50k of equity value).

Working capital facilities typically have no amortization but are simply due in full upon maturity.  Almost always, the facility will be extended, meaning it is never due.  Revolvers will have a specific lien against the assets, but they often require a blanket lien against the entire business as well.

Senior Term Debt

After working capital facilities, companies can often also raise a small senior term loan.  This is structured as a lien against the business, with no specific liens.  Often, a bank will extend a term loan in conjunction with a working capital facility.  Meaning a company can borrow an additional amount, beyond the working capital facility.  This is only known as senior debt, if it is from the same lender as the working capital facility.  The costs are similar to a working capital facility, but obviously a little higher as the risk is higher.  The term becomes a consideration, and can include an interest only period.  An interest only period is a set amount of time, during which a borrower will pay only the amount of interest due each month, with no principal amortization.  In the event the facility comes from a second lender, it is considered a subordinated loan.

Subordinated Term Debt

A subordinated loan means nothing more than it is subordinated.  It still will have a lien on a business, but the banks lien will be second in line after the senior lender.  Subordinated debt will cost the most, and will require the most consideration for a borrower.  I will cover these considerations and costs in a future blog, going into to more detail.

Other Debt

There are obviously other forms of debt as well, most common are equipment financing and vendor financing.  Equipment financing is borrowing for specific equipment (such as server racks for software companies), where the collateral is specifically defined and does not have a lien against the business.  Vendor financing is the same as equipment financing, but not from bank, rather the actual supplier of the business.  This is like getting a car loan from the dealership.

Bueller…  Bueller…  Bueller?  Anyone still reading?  Sorry.  It got dense quick.  I promise, this is interesting and fun, but there is a basic understanding of how various types of debt work, and how they interact.  We got some terms (advance rate, collateral, revolver, sub-debt, LIBOR, liens), and now have the basis for debt.

Basics of Debt and the Venture Market

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We’ve covered a bunch of dynamics relating to raising capital thus far, all of which was focused on raising equity.  The second type of capital a company can raise is in the form of debt.  Like with equity, I’ll attempt to break this down, starting with some of the basic tenants of debt in this intro blog, and move into the more nuanced components of venture debt going forward (disclaimer: I have worked at NXT Capital Venture Finance for the past two years making venture debt investments.  We are no longer making new investments, but do maintain a portfolio of active loans.).

How does it work?

We all are familiar with debt, and likely understand a decent amount about it.  Home mortgages, car loans, credit cards, student loans, etc. are all forms of debt, typically where we as consumers borrow money from a bank in order to buy things.  There are two basic things we need to know about a loan, the interest rate and the length of the loan.  Most debt is structured in this way, with various tools and methods to help match borrowers needs to their ability to pay the loan back.

Looking at a mortgage as an example, the standard mortgage is 30 years with the current national average of 4.23% annual interest.  With monthly payments, your mortgage would cost you $2,453.85 a month for the next 30 years (there is some cool math that helps us calculate this number, but like most people these days, I use a calculator or excel to find that payment value).  At the end of the 30 years, the house is all yours with no mortgage.  To really understand why we pay $2,453.85 a month, we need to know the various parts of the loan: interest and principal payments.

Thinking through how the math works is important.  Each month, the bank will calculate the interest that you owe for that month, and the rest of the payment will go towards paying down the amount you owe (known as the principal of the loan).  In the first month of our mortgage, we will owe 4.23% divided by 12 (we only owe one twelfth of the interest, because we pay it twelve times in a year) multiplied by the current balance of $500,000.  That comes to $1,762.50 of interest in the first month.  We know that the monthly payment is $2,453.85, so in the first month we would pay $691.35 ($2,453.85 minus $1,762.50) towards the principal balance.

In month two, we don’t start with $500,000, because last month we paid $691.35 towards the principal.  Rather, we start with $499,308.65, meaning we multiple that number by 4.23%/12.  If you continue this for 360 months (30 years x 12 months), you will end up with a principal balance of $0 at the end.

This is an example of a standard amortizing loan (amortizing means you are paying one amount every period that includes both the interest and the principal until there is no outstanding principal balance).  Another type of loan is known as a bullet loan.  A bullet loan pays only the interest throughout the entire term of the loan, and repays the full principal balance only upon maturity (maturity is the date the loan is due, using our mortgage example, this would be 30 years after we started the loan).  Most bonds you can buy in the public market are bullet loans, with the full amount of the loan repaid on the maturity date and interest payments made ever quarter.

There are all different structures that can go into the loans as well, but if you are really interested in learning more about loans, I suggest buying a book or taking a class – sorry.  There is just too much to cover in my blog, so I will try to keep the concepts at a high level, with enough understanding to see how venture debt works.

With this basic review done, we’ll be able to dig in to the debt stack at a venture backed company. We’ll explore when and how to best use venture debt to maximize the value of a business and the ultimate return for the founders, venture capitalists, and the venture debt lenders!

Return of the Jedi

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So, we get it.  Companies raise money, they need to set a valuation to raise said money, and they sell some of the business to raise that money (money, money, money).  There are some important things to understand in the fundraising process, and there isn’t enough time to cover them all, so I’ll stay on the ones I think are important.

Signaling

Raising money is very much so a marketing move.  There is (hopefully) positive press that can come from a capital raise.  When you raise money and announce your valuation, that sets expectations in the market – namely it shows what investors think the business is worth today.  It also figures into what investors think it COULD be worth in a few years.  Venture investors target a 3x to 5x multiple of their money in any given investment.  Generally, that means the business needs to sell for three times the amount of the last round.  So, raising money at a $250mm valuation suggests that the business should be able to be sold for between $750mm and $1.25B.  That is a lot of money.

In addition to the signal and expectations from a valuation, the existing investors’ involvement in each round matters.  If a venture investor invested in the Series A and Series B rounds, but doesn’t invest in the Series C, it doesn’t look so good.  It typically signals that the venture firm has less conviction in the future prospects of the business.  Some seed funds and early stage investors will not typically continue investing for the entire lifecycle of the business, but usually investors continue to fund a business if they think it will be successful.

Pro-Rata

This concept of continuing to support a business is demonstrated in a cap table through pro-rata investments in subsequent rounds of financing.  That is investor speak for putting up your fair share of the next round of equity.  There are a few ways to calculate what “pro-rata” represents (either your share of a future round of investment or the amount required to maintain your ownership percentage in the business).  There is a great post on Brad Feld’s blog here about pro-rata if you are interested.  Not even all VCs agree on what “pro-rata” means…

Liquidation Preference

In a standard venture deal, there is a concept known as a liquidation preference (again, covered by Brad Feld well here).  The liquidation preference is a set amount of capital that the preferred shareholders (venture investors receive preferred shares in a business with each investment) receive in preference (i.e. BEFORE) the common shareholders.  Founders and employees of the business receive their shares in the form of common shares.

This means, when the business is sold, those investors will receive a set amount before the common shareholders.  Typically, there is a 1x liquidation preference (meaning 1x the amount invested, so a $5mm capital raise will include a liquidation preference of $5mm).  There are two ways to calculate what this means: Participating Preferred Shares and Non-Participating Preferred Shares.

Participation

Non-participating shares have a right to receive either their liquidation preference OR their fully diluted ownership percentage.  Participating shares receive both their liquidation preference AND their fully diluted ownership percentage.  Let’s use an example to show how this works.

Assume that HotStartup raised one round of financing equal to $5mm at a post-money valuation of $20mm (meaning they received 25% of the business), with the founders retaining the remaining 75% of the business in the form of common shares.  In any sale of the business for less than $5mm, if there is a liquidation preference – the preferred shareholders would receive all of the capital.  If the business sells for more than $5mm, there are a few different outcomes.

If the shares are participating preferred shares, in a sale of HotStartup for $30mm, the investor would receive the first $5mm (their liquidation preference) AND 25% of the remaining $25mm ($6.25mm).  The investor would return a total of $11.25mm, with the founder getting only $18.75mm.

If the shares are non-participating, the investor has the right to EITHER the liquidation preference OR their ownership percentage of the total sale.  So in our last example, they would get EITHER their $5mm liquidation preference OR their 25% of the $30mm ($7.5mm).  Obviously they would take the $7.5mm, leaving $22.5mm for the founders.

The difference between participation and non-participating shares is huge (in our simple example, the difference between $3.75mm!).  Despite this, I have encountered countless management teams that do not know if the investor’s shares in their business are participating or non-participating.  For reference, according to PitchBook, 60% of rounds in 2013 were non-participating, with 30% have uncapped participation and 10% have a cap on the participation (meaning a limit to the amount that the investor may receive both their liquidation preference and ownership percentage).

There are TONS of nuances within a term sheet, and I highly encourage every founder to have an experienced lawyer look through the terms of a deal on your behalf.  There is too much that can be slipped into a term sheet and the legal documentation, all of which can have an enormous impact on the potential economics.

This was a long post, and was one of a three part trilogy (part one here, part two here).  There is a lot involved in a capitalization table, and even more nuances in the legal documentation.  There is no harm is asking for help, there are tons of resources, and lawyers are always available (at their normal billable hours…).  Don’t sign a contract unless you know what it means, it could cost you literally millions of dollars.