The Inherent Friction between Founders, VCs, and Venture Debt
"No conflict, no interest" — Felda Hardymon
In the world of venture and B2B software startups, we often hear or read about a company raising “X” million at “Y” million valuation which is “Z” multiple of ARR. What does the valuation really mean?
This article will explain the distinction between Enterprise Value and Equity Value, and how this topic relates to the inherent friction between founders, VCs, and venture lenders.
What does Enterprise Value and Equity Value mean?
Enterprise Value represents how much a business is worth today. In theory, this is what all shareholders (i.e. founders, operators, VCs, and venture lenders) should maximize at all times. It is calculated by adding Equity Value to Debt and subtracting Cash.
For a startup, we often refer to Pre-Money and Post-Money Valuation like so:
Post-Money Valuation = Pre-Money Valuation + Invested Capital
Pre-Money Valuation = Post-Money Valuation - Invested Capital
For a venture-backed startup raising money for the first time, the Post-Money Valuation represents the Equity Value of the business based on growth expectations and operating margins. The Pre-Money Valuation reflects the Enterprise Value of the business today.
Equity Value = Enterprise Value + Cash
Enterprise Value = Equity Value - Cash
Enterprise Value (“EV”) measures the true value of a startup, as it ignores the type of external funding in place (i.e. equity, debt).
So when a VC says “our fund will invest €5 million for 20% of the company”, the Post-Money Valuation (or Equity) is €25 million, whereas, the Pre-Money Valuation (or EV) is €20 million.
For sub-scale venture-backed B2B software businesses that are not yet profitable (typically less than 100 to 250 FTEs or €10–30 million ARR/revenue), investors and lenders value a business based on the EV to Annual Recurring Revenue (“ARR”) or EV to Forward Revenue (typically 12 months from now) as it allows the software startup to be compared to other private startups or public software companies that operate in related markets and have similar business characteristics and/or metrics.
When an established company (e.g. Salesforce, SAP, IBM, Oracle, Microsoft, Amazon, Twitter, Google, etc.) buys a startup or when a software business decides to IPO, strategic and public investors focus on EV. This is the fair way to compare ‘like for like’.
Inherent Friction between Founders, VCs, and Venture Lenders
Equity Value changes with new funding going into the business.
When a startup raises venture debt, a small portion of equity (ca. 1–2% fully diluted warrants/options) is taken to compensate for the equity-like risk associated with parts of the business perceived to be predictable. Predictable growth is what VCs would also like to fund.
In addition, the cash inside the business (received from customers, investors, and lenders) is used to finance interest payments and pay back capital borrowed.
For these reasons, certain VCs — for instance, larger funds that have ample capital — are hesitant when it comes to using venture debt. All things given, a VC fund would rather invest its own money than finance the return on investment for a venture lender, especially for its fund winners. However, VCs who value fund diversification and/or have had good experience working with venture lenders in the past will tend to be favorable of using venture debt.
Debt is always cheaper than equity when it comes to financing a steadily growing business with negative working capital (read this article, as well as this second one and third). This is because the cost of capital — also known as IRR or return expectations promised to Limited Partners (“LPs”)— is lower.
This means that founders get to maximize ownership in their business by using a combination of equity and debt, when appropriate. Venture debt is suited to fund short-term movements in cash (i.e. working capital) or Enterprise Value.
It does however come ‘with strings attached’ — you have pay back borrowed money sooner than the exit of the business, including the monthly interest. This requires a predictable commercial engine and strong forecasting.
Venture capital (equity) is only ‘paid back’ in an exit of the business (i.e. sale, IPO, secondary), which is not guaranteed and would tend to happen much further into the future than 3 years (the length of a typical venture loan, and often less for a cash flow facility).
As a result, the key questions a founder, VC, and venture lender should consider when funding a high growth startup are:
How much external capital do I require aside from cash received from customers?
What portion of this will be spent on working capital and invested into predictable growth vs. experimental growth?
How much will this business be worth in the future?
What is my level of confidence in the team’s ability to deliver on growth promised over the next few years?
How much would a buyer pay for the business when the startup runs out of cash?
What is my level of confidence that the VC will continue to fund the business if the team does not deliver on growth expectations?
Funding a high risk/reward startup when the intrinsic value is unclear is equal parts science and art. It ultimately comes down to conviction in market urgency and the team’s ability to execute on its strategy. The latter requires constantly measuring, iterating, and communicating data-driven decisions in order to effectively scale and profitably grow.
As part of SaaStock Local, I will be speaking with Mads Fosselius of Dixa and Jeppe Rindom of Pleo about the ‘new normal’ we live in, lessons from the last recession, and how to grow a business in times of uncertainty. Join us on Thursday, May 14th at 4–6pm CEST!