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Will the enterprise market spend significant IT budget on Windows Vista in 2007?



Make your precious equity dollars go farther - think about leveraging venture debt

By Anurag Chandra, Managing Director, Lighthouse Capital Partners

Extending the entrepreneurial runway.
There is no question that in today’s fundraising environment, capital efficiency is paramount. Ray Lane, among other industry leaders, has commented that a software startup should require no more than $20-25 million to achieve positive liquidity. This means that today’s entrepreneur needs to stretch every dollar to achieve success.

Making equity dollars last is particularly important – since they come at the high price of forking over a percentage of company ownership. Although the price is high, these precious equity dollars are often a critical factor in an emerging software company’s success. Yet taking this equity investment means accepting painful dilution due to the low valuations given to companies at this early stage. So what’s the alternative?

Enter venture debt
Venture debt offers a low-cost method for venture-backed companies to leverage fixed assets and their enterprise value to get more runway out of their equity dollars. These types of loans can give a young software company the extra time and resources needed to reach major product or customer milestones. And, being able to achieve important milestones such as shipped product or securing a first customer can provide real uplift in valuation and significantly reduce dilution at the next VC financing round.

Venture debt is usually offered in two forms: “growth capital” and equipment financing. Growth capital provides operating capital that can assist in product development, product or geographic expansion, acquisition of complementary technologies, or just about any key operational imperative. Typically the cost of such capital is interest, along with principal, paid over a fixed period of time (generally 24-48 months, depending on the company’s risk profile) and a small pledge of stock warrants. There may also be a “final payment,” which helps the lender earn the appropriate risk adjusted yield, but pushes off the cash outlay by the borrower to a future date so it doesn’t have to part with precious (and typically more expensive) dollars in its early years. Some flexible providers are even willing to structure deals that provide companies with a period of interest-only payments to help preserve cash at critical junctures for a software company. Meanwhile, equipment financing allows a company to borrow against the equipment it purchases, such as computers, manufacturing equipment or other assets, and frees up the equity dollars that would have otherwise been spent to obtain such items for higher value add use, namely research and development or sales and marketing. Like growth capital loans, the lender receives monthly payment of principal and interest plus warrants and possibly a final payment.

Both forms of venture debt are available to promising early stage startups backed by top-tier venture capitalists, usually when they are still cash flow negative. Venture debt may either help you raise less equity than you otherwise would have or help you increase the total amount of capital available to your enterprise with less dilution. From a financial planning point of view, venture debt can be an attractive insurance policy. If there’s risk that critical milestones may slip, having the ability to borrow and extend runway so those milestones can be safely achieved insures a trip to the equity fundraising market with a better valuation paradigm. If the milestones are not in jeopardy and you ending up not borrowing, your worst case is to have given away warrants that typically amount to less than one percent or two of dilution. (Compare this to raising money at a lower valuation by having to go to market with those significant milestones not achieved).

Bank debt vs. venture debt
Established companies leverage their balance sheet assets through typical asset based debt products offered by commercial banks. Venture debt is territory that most banks are wary to enter because early-stage companies just represent too much risk for traditional banks because such companies have no tangible assets. Typical bank financing is tied to receivables. You must have sales revenue and probably “meaningful” sales revenue to attract bank financing. Even then, an established software company with a steady, predictable revenue stream can use accounts receivable financing at best to smooth out cash needs, not leverage its enterprise value to extend runway. For a company that is cash-flow negative or just starting to achieve revenue, it’s worse because it’s tough to rely at all on a formula based A/R line for expansion and growth. If you miss a monthly or quarterly revenue projection, chances are you’ll have less in receivables that anticipated and may have to pay down your outstanding on your accounts receivable line of credit.

Having said that, there are banks that offer venture debt loans to early-stage companies. But be careful. At smaller dollar amounts bankers can convince their credit committees and the federal regulators that monitor their bank to make “aggressive” venture loans, but it is with the understanding that the goal is to grow the lender into a traditional commercial credit, replete with financial covenants and asset-based borrowing, which box in a company. Either it’s the proverbial “banks are only willing to lend you money when you don’t need it” or it’s that the typical slippage in a startup’s projections necessitates a talk with the banker about “waiving” a covenant violation. Banks also typically require young companies to maintain their deposits with them and require a “right of offset” in the loan agreement. This right of offset can be used by the bank at its discretion to pay down the loan in an event of default.

Independent venture debt providers, particularly ones that are private companies, have the ability to structure flexible deals that give you true runway extension. And, the better funded ones can support their companies with these structures at higher dollar amounts and through a startup’s maturation process. The established venture lenders also know how to evaluate and manage the risks involved in dealing with early-stage companies. They are willing to take a lien on a company’s assets when no real assets exist in anticipation of success.

Less expensive in the long run
Perhaps the greatest benefit of venture debt is that it injects money into a business without heavily diluting the equity stake of the entrepreneur or venture capital investors. While equity dollars are necessary in financing a software company’s development and a typical prerequisite to obtaining venture debt, they come at the high price of sharing significant ownership. Venture debt can be a real aid that can enable an early-stage software company to have access to low-cost capital and minimize entrepreneurs’ and VCs’ dilution. An added benefit for VC’s is that they can improve their ROI on a given deal by encouraging their portfolio companies to take on a responsible mix of venture debt along with their equity dollars.

Consider this example. A communications startup determined that they needed a round of financing totaling $47 million, of which $8 million would be needed for equipment. They evaluated whether it was in the software company’s best interest to finance the equipment using debt or equity. In other words, they were weighing whether they should raise $47 million from VC’s, or $39 million from VC’s with the expectation of financing the additional $8 million of equipment through a venture lease. After taking a careful look at options, they concluded that the larger equity sum would cause significant dilution that would be costly to software company employees at time of liquidity; meanwhile the venture debt route would preserve more of the employees’ stake in the company and simultaneously create a stronger balance sheet.


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