Debt Follow-up: a guest post from Ali Hamed of CoVenture
Two Truths and a Take, Season 2 Episode 4.5
Hello everyone! We have a bonus episode today, as a thank you for everyone who shared and commented on last week’s post on debt coming to startup financing. Some of you liked it; some of you hated it; and that’s great. And it shattered all records of anything I’ve ever posted before, drowning me in inbound email in the process.
(Also, right on schedule, check out this $90 million Series B from Astranis, announced on Thursday. I did not know about this ahead of time, but it’s the kind of financing I think we’ll see more of in the future.)
If Michael Milken was 25, today — I bet he’d work at some top tier VC fund and think: why do we have so many sophisticated ways to price equity, yet debt is COMPLETELY unavailable no matter the value/merits of our portfolio companies?
(1) Debt is good to take when a borrower has some level of certainty of a future cash flow, or when it can be secured by an asset. For example: Clearbanc lends money to e-commerce companies who might spend the cash on ad-spend, which then creates revenue, and therefore can pay Clearbanc back. Produce Pay borrows money to then finance shipments of perishable produce, which are nearly certain to be realized into cash, allowing Produce Pay to pay back its own debt.
(2) Debt is bad to take when just used to finance high risk growth spend — because that high risk spend does not come with a certainty of cash flow, and therefore when the loan matures, a startup might not be able to make its obligations and go bankrupt.
After all, debt is leverage. When you are confident, you should borrow. When you’re unconfident, you should take equity.
And debt comes in many different forms. Corporate debt, or Venture Debt, essentially lends money to startups who can then use the cash for operations. We at Coventure aren't huge fans of this, because the cash used for operations creates a fairly uncertain outcome in terms of cash flow, making it un-obvious that a borrower can payback. Often, the underwriting is less about the use of the cash/cash flows of a startup, and more about the strength of the equity sponsors in the deal. I wouldn’t want to be an entrepreneur who was borrowing on the strength of who my investor was, rather than on the strength of who I was. It creates a lack of control.
There is asset-backed debt, which we think highly of. You can borrow against an asset, meaning that if things go wrong a lender just claims your asset (think a building). If you have assets, you may as well do this. If things go well, you repay the debt. If they go badly, you lose your asset but not your company. This is opposed to selling equity, where you’ve sold part of your assets whether or not something goes well. Seems dumb in comparison. The problem is many technology companies don’t have much in terms of assets.
One trend that is an important identifier of equity/debt beginning to blend is the premium placed on SaaS revenues. Markets will buy SaaS revenues at high multiples (i) because they are high margin but also (ii) because of their predictability. “Cheap equity is essentially expensive debt.” So starting to see equity get priced closer to debt for the perceived certainty is showing markets are beginning to give technology companies “credit” for debt-like stability.
So… how will debt come into the tech world first? For one, it already has a bit. Online lenders started borrowing capital from hedge funds to finance the loans they were originating. LendingClub, OnDeck, Prosper etc. did this first. The new wave is companies like Clearbanc, SecFi, Produce Pay, etc.
Next, you’re starting to see companies like Teampay, Divvy, and Brex begin exploring offering credit to customers as a way to catalyze their sales process. GE built a whole financing business based on this. We’d expect to see a similar dynamic. Essentially, SaaS revenues are EXACTLY this — it’s the financing of an expensive sale (like AWS), where the debt is financed through payback periods, and interest/principal is paid in the form of subscription revenues. It’s not hard to see why SaaS revenues would then get refinanced out later by lenders.
The way SaaS revenues will get financed at maturity is this:
· Putting the contracts into an off-balance sheet SPV
· Writing into SLA’s that the contract is between the company and its affiliates
· A stipulation (maybe a confession of judgment) that if the corporation goes BK the contract and IP immediately transfers to an SPV, which then is owed the cash flow (this is what will make SaaS lending Asset-Based financed, and not corporate lending).
Eventually, mature unicorn companies with stable business models will begin to issue bonds. There is a lot of talk about how Direct Listings will replace IPO’s. I think Bond issuances will prelude all of them.
A company like Stripe or Airbnb could have easily tapped Bond markets. Would you prefer to get paid 5% on bond issuances from a small $800M public company with lots of leverage, or 8% by Stripe who would only have $1B of senior securities? And 8% is certainly cheaper than the equity being raised.
One challenge is that ratings agencies will have trouble rating bond issuances by high growth companies that are artificially losing money/not producing cash flows as a way to chase new market opportunities. I wouldn’t be surprised to see companies like Carta turn itself into three companies: (i) A SaaS company with positive cash flows, (ii) an exchange that is in R&D and (iii) whatever their next business line might be, which will also be R&D.
The SaaS company could get underwritten on its profitability, and the debt raised could finance the R&D of the other two businesses. Lyft could separate out each of its cities into their own businesses, and raise debt into those subsidiaries as well.
A lot of bond issuances don’t happen, in part, because debt markets don’t know how to underwrite these companies. But also because the VC’s on the boards of these companies want to keep plugging more equity into these companies, so why encourage accessing debt markets?
In short — yes, debt is coming to tech. The companies and their business models are more mature than they used to be. VC used to be used to finance risky technology. Now it’s used to finance the implementation of proven business models.
But it’ll take some re-thinking, and will happen in steps.
Special thanks to Ali for offering to cross-post here. You can find his original essay here:
Also, in case you missed it, you can read this week’s regular issue here:
Have a great week,