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!

Addendum:
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.

11 comments:

dherman76 said...

Excellent post. There are many other reasons to go with venture equity such as reputation, connections, advice, etc. Debt is great for many reasons outlined, and this is a terrific read for all entrepreneurs.

Jason Adler said...

This was great. In some ways, isn't this a bad deal even for the lender? If your borrower runs out of cash before becoming CFP, that doesn't create a very strong long-term customer. I would think there would be some incentive for the lender to structure the deal to allow the company to get close to CFP so the lender avoids loss from default.

Sarah Tavel said...

Darren -- Thanks! Much appreciated as always.

Jason -- You raise a good point, but I think this is why venture debt providers often care so much about who the equity investor in the company is (and rarely provide venture debt to a non-venture backed company). Debt is always senior to the other shareholders, so they know they are going to get their $ off first. This protects the debt providers because 1) by the time the company would have run out of cash, the co has already paid back a majority of the debt and even in a fire sale, would prob be able to return more of the principal to the debt provider and 2) incents the VC investor / shareholders to raise $ with equity.

Outsideshot said...

I'm curious about a couple of things... Why did you choose to use the XIRR function (which I thought was for irregular cash flows) as opposed to the IRR function? And, what "guess" did you use for the XIRR function (doesn't the guess affect the outcome)?

Lastly, though the impact may be trivial, isn't there an opportunity to earn a return on the funds that aren't deployed that would reduce the effective rate (i.e. if you take the $2.35M that will "remain" when cash is low and put it in a CD, won't you get a few points back)?

I'm not taking issue with the thesis that venture debt is often more costly than it appears, but mostly looking for a better understanding of this analysis.

Regardless, thanks for a very interesting and thought provoking post.

Sarah Tavel said...

@OutsideShot: Great questions.

Re: XIRR function: Unlike a mortgage payment, which is characterized by equal monthly payments of principal + interest, venture debt is typically structured as equal principal payments + interest on the debt balance (which consequently decreases each month), so the cash flows are irregular and I needed to use the XIRR function to calculate the cost of capital.

On the the CD front, you're absolutely right. I didn't mention it in my blog post because it was already long enough and the difference is marginal (CD interest rates are fairly low right now, and many companies are choosing to put their $ in t-bills instead), but in the model I put together for our portfolio companies, they can plug this # in and get the benefit.

Wallen's said...

Interesting post.
Thanks

hanchee said...

Sarah, I was wonder if you've done similar analysis comparing the dilutive effect of equity vs. cost/dilution of venture debt? Also curious whether you've had this discussion with Bessemer's GP Felda Hardyman who sits on the board of a bank that provides venture debt.

Sarah Tavel said...

@hanchee thanks for the comment. Obviously a CEO needs to do their own analysis of the dilutive effect of VC vs. cost of venture debt. that often involves some kind of scenario analysis, which unfortunately, despite my best efforts, I haven't figured out how to automate in Excel. :)

Edward said...

Hi Sarah

I have been reading your post on venture debt, and can't work out how you got the cost of capital of 57% when using the XIRR function. In your model which I have downloaded I see a cost of capital 16%.

Also with regards to your use of the XIRR function this is used when cash flows are not at regular dates and not when cash flows are not the same. IRR can be used when cash flows change each month provided the timing is equal for each payment, eg daily, monthly or annually.

Sarah Tavel said...

@Edward - thanks for the comment. In the first post, I think I may have used different parameters than what I have in the model. Did you change the inputs to correspond to what I have in the post?

And you are right re: XIRR / IRR -- my mistake. There was another reason I had to use XIRR but now I can't remember; I'll see what happens when I update the model.

JSchott said...

Interesting post, although from the perspective of a venture debt provider I would argue the scenario described is quite unusual and pretty irresponsible as a lending case (It certainly would not make it through our credit commmittee). Standby facilities are a niche in the overall VD sector and should not be used as a standard case for judging VD.
From some of the other comments (amoritizers, sponsored deals etc.) I get the impression the author has a pretty US centric view of VD. However, there are different approaches to VD, and for venture companies and entrepreneurs it is just a question of doing their homework and finding them instead of going with the first best VD provider and lamenting about the terms afterwards.