Friday, January 23, 2009

True Cost of Venture Debt Part II

First of all, I’ve gotten a lot of great feedback on the venture debt post I posted a couple of weeks ago and have had a lot of great conversations, so thank you to everyone who commented (either on my blog or via email) and keep them coming!

From these conversations and conversations I’ve had with my Bessemer colleagues, I’ve put together a presentation that discusses the venture debt analysis I described before in more detail. I’ve also included a copy of the venture debt model to this blog post so everyone can play around with the model, plug in their own numbers, and reach their own conclusions.

Venture Debt Presentation BLOG v2

If you have any troubles with the embedded powerpoint, you can also reference the pdf below:

Saturday, January 10, 2009

The True Cost of Venture Debt

Given the current financing environment, it’s not surprising that many startups are thinking about raising venture debt for working capital. With venture dollars so few, interest rates so low, and venture debt providers so many, venture debt seems like a no-brainer decision to extend a company’s runway. Why not raise $10m now at a 14% interest rate, rather than raise $10m in equity at today’s valuations and dilute existing shareholders by 25+%? 14% sure does seem like a low cost of capital.

But it’s not always correct to equate the cost of capital for venture debt with the debt’s interest rate. In fact, sometimes the true cost of capital for venture debt can be a multiple of the interest rate. I’ll try to explain why here, and will also try to illustrate which terms you should push hardest for in your negotiation to get the best venture debt deal. (Disclosure: I work in VC, so ostensibly I’m incented to criticize venture debt and elevate equity.)

Most venture debt loans have only a handful of terms:

  • The loan amount
  • The interest rate (and occasionally, an interest only period)
  • The drawdown period (how long you have before you need to drawdown the loan)
  • The repayment period (how long the company has to pay back the principal)
  • Warrant coverageAny transaction costs (i.e. lawyer fees for the company and the bank)
  • [For later stage companies, a bank might mandate that the company maintain a “quick ratio” of (cash + short term AR) / loan amount, or a minimum cash balance, but let’s put these terms aside for now.]
Now let’s take an example company: let’s say Company XYZ has $6.5m in cash on their balance sheet and is burning $500k per month right now (13 months of runway). XYZ wants to keep spending money on marketing, head count, etc, so they expect their burn over the next 18 months to average around that $500k mark, after which they expect to quickly turn cash flow positive (CFP) in 6 months. Given these assumptions, XYZ will need $10.25m to turn CFP. Because their existing cash will only last for another 13 months, they start looking into their financing options.

The company talks to a few investors and venture debt providers and decides that venture debt is the cheapest cost of capital and chooses the following debt deal:

Ceteris paribus, this looks like a great deal. Eager to have the cash in their bank account, XYZ draws down the $5m, bringing XYZ’s cash balance to $11.5m. The $5m should give XYZ more than a $1m buffer to reach the CFP Promised Land with only a little dilution to shareholders and a low, 14% cost of capital.

But in this conclusion, XYZ makes a critical mistake: you can’t evaluate the cost of capital of venture debt without an eye to your company’s cash balance and burn.

XYZ has an ample cash balance to begin with, so although they drew down the debt in the first month, they won't actually need the cash from the debt until the 14th month. But by the 14th month, XYZ would have already paid back $1.8m of the debt in monthly principal payments! So when they get to the 14th month, they actually only have about $3.2m available from the $5m they borrowed. Because seeing is believing, we put together a model to show this:

You may have noticed that the “Cash Available with Debt EoM” row shows that the company’s cash is actually lower than the debt balance. This is because by January 2010, XYZ has already paid the bank more than $600k in interest! With the next month’s principal payment, interest payment, and the original transaction fees, XYZ really only gets the benefit of $2.35m in cash flow from the debt, not $5m. To make matters worse, because the company has been paying down the debt all along, the debt extends XYZ’s runway only four months. When you do the math of the cost of capital (XIRR equation in Excel), the cost of capital for the loan is a surprising 57%, not 14%, and this doesn’t even take into account the dilution from the warrants. Moreover, XYZ will run out of cash when they still have $2m of venture debt to pay off. They’ll either have to go out of business, or raise a new equity round to pay off the debt.

You may believe I did a bit of voodoo with the numbers I presented here in order to make the cost of capital so high, and you would be right if you suspected it had to do with when the company draws down the debt. If XYZ drew down the money in the 6th month instead of right away, their cost of capital would have gone down to 32% and they would have gotten an extra month of runway from the debt. This is because the XYZ would have paid back less of the debt (in this case $700k less) before they actually needed the money. XYZ could have made the debt deal even sweeter by negotiating a later drawdown period, or by negotiating an interest-only bubble. For example, if XYZ had negotiated a 6 month interest-only bubble (in addition to drawing down the debt in the 6th month), they would have extended their runway 8 months, and lowered their cost of capital to 24%. Quite the improvement from 57%.

I’ll admit all I’ve done in this post is pour a lot of cold water on venture debt, and a reader could probably still argue that even a 57% cost of capital is still cheap compared to the dilution from equity. But for what it's worth, here are two cases in which venture debt earns its reputation of having a low cost of capital:
  1. Your company is already cash flow positive, or you have a high degree of certainty that your company will turn CFP with your current cash, and thus you will be able to service and repay your debt from your own cash flow.
  2. The additional runway from the venture debt, even if only a few months, enables your company to reach a major new milestone that will in turn allow your company to raise equity to repay the debt on much more attractive terms.
Good luck!

You can find a copy of the Excel model I put together, and an accompanying powerpoint that explains the model at my blog post here. As always, if you have any questions, drop me a comment and I'll make sure to respond.