Why Venture Debt: The Facts
In my prior post, I described how the business models of venture capital (both equity and debt) operates. In this one, I will discuss why venture debt is a great source of capital to finance a continuously growing, predictable VC (or PE)-backed business.
Note: this is a series of posts in attempt to break apart the misconceptions about venture debt.
Fact #1: Debt is always cheaper than equity*
The cost of capital (i.e. expected return on capital for banks and venture lenders) is lower. Plain and simple.
For a venture equity fund, 3x is the minimum expected return on money spent. (Otherwise, an LP would invest in a PE fund which has perceived lower risk and higher ability to deploy more capital predictably throughout a business cycle.)
For a venture debt fund, the bar is 1.5x return on invested capital.
For more a detailed explanation, refer to this post.
*Two caveats:
(i) When debt and equity financing is structured ‘correctly’ (i.e. on-market terms from experienced lenders and investors), and
(ii) When the business continues to grow and/or there is little risk of running out of cash and going bankrupt.
Fact #2: Debt is a great tool to finance cash flow
It is very important to understand the difference between (i) working capital and (ii) investment. This is often where the confusion about fact #1 comes from.
In the startup world of software, operational working capital (aka cash flow) is primarily the delta between (i) cash collected from paying customers (especially once >$10–20MM ARR) and (ii) salaries paid to attract & retain talent (plus some hosting costs). This creates a positive effect on the cash flow profile of a SaaS business (even before external funding from investors/lenders; aka ‘negative working capital’) since in theory, it should receive money from customers faster than salaries paid. In essence, it is pushing around money received and paid towards different points in time.
The cost of this ‘movement of cash’ comes in the form of (i) interest and (ii) warrants. Interest is typically paid throughout the duration of a loan or revolving credit facility (aka ‘revolver’, ‘MRR facility’), therefore a business needs to have sufficient cash flow (from customers and VCs) to service it. (Current market terms to be discussed in a future post. Coming soon!)
Investment — whether in the form of equity or debt capital — on the other hand, is the expectation that money is spent on experimental, high risk projects, which in turn could deliver a significant return (or totally fail). High risk, high reward. In the same way that a VC (equity) fund is expected to return at least 3x on invested capital, the money raised by a startup from a VC to build new products and technology, hire and retain talent, enter and expand into new markets should also generate at a very minimum a mirrored creation in business value during the time period in which the money is spent.
The cost is typically in ownership (i.e. shares, options, warrants). The outflow of cash as it relates to equity investments comes when there is an exit event (resulting in 2x or greater holding period compared to venture debt). An exit event is when the business is purchased by another (often larger) company or listed on a stock exchange (when cash rich, low risk public investors replace limited cash, high risk private ones). Or what happens more frequently in VC-backed businesses — ownership is sold to contrarian investors or it becomes worthless (i.e. ‘written off’ aka ‘a donut investment’ — Whoops! Educated gamble failed.).
Fact #3: Boring businesses are the best candidates for debt
The key reasons why many investors love software businesses is because they generate negative working capital and therefore growth (and in turn, capital invested and spent) can be very predictable.
And yes, software is eating the world. Businesses are outsourcing more technology at a faster pace than ever before in order to respond to rapidly-changing customer and market demands. Huge market to capture quickly.
In comparison to say consumer businesses or marketplaces where customers are more fickle and it is more tricky to ‘lock in’ buyers for a long time, software investments are generally lower risk — economies of scale can be achieved sooner, in a more predictable fashion. The outcomes are less binary in nature. The huge benefits of strong product virality and network effects of distribution associated with consumer and marketplace businesses can, of course, fuel much faster growth and outweigh the benefits of inherent ‘stickiness’.
That is the ultimate trade-off — more predictable, safer software businesses vs. high risk, likely bigger outcome consumer plays.
In the next post, I will discuss the 3 common use cases most suited for raising this type of capital. Stay tuned.
(For the record, I have found software to be very sexy since falling into this world in 2012. It’s why I continue to learn as much as possible about these businesses.)