AboutBorn and bred in NC. Spent 2 years in NYC but back in the Tar Heel State. I work with venture-backed companies that are trying to change the world. Along the way I've developed a few thoughts on the world of venture capital, venture debt, technology, start-ups and what it means to be an entrepreneur. This is where I share those thoughts.
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This is my personal blog - the thoughts shared here are solely mine and do not necessarily reflect the opinion of Square 1 Bank.What is Venture Debt?
In my conversations with various venture capitalists about venture debt, I have sometimes heard VCs say, “we think what you’re doing is great, and when our companies need debt we’ll be sure to introduce them to you…but right now they don’t need debt and we don’t see their banking relationship as a strategic one which requires our input.”
It’s a point which is fair. In the grand scheme of all the things start-up entrepreneurs have to deal with, the place where they park their cash is not at the top of the list. While every start-up needs a bank, it’s not necessarily as important as other service provider decisions (I’d argue that your attorney is your most important service provider choice).
The fact of the matter is that before you need a loan, there are no shortage of places to park your cash. You can use your local bank, a large money center, or one of the few banks focused on start-ups. But I do think there are a few ways that these venture banks can be strategic for start-ups,
A bank that works exclusively with start-ups is valuable for precisely that reason - they understand the unique needs of early stage ventures. The inherent act-swiftly-and-fly-by-the-seat-of-your-pants style of a start-up is antithetical to a traditional bank. As a result, many entrepreneurs find that when they’re in a jam and need a quick action for a seemingly mundane task, the big banks do not have the wherewithal or attention to detail for a small customer to make the mundane task happen.
The result is valuable time spent on a phone (or, worse, stuck in telephone operator never-never land). The opportunity cost of this lost time is immense for the task-strapped entrepreneur. And in this sense, finding a partner who understands one-off needs and can act quickly is strategic.
I liken it to the analogy of a race car driver who is responsible for carefully navigating around the track at 150mph+. What would happen if there were a flashing light on the dashboard panel which was not mission critical but required the driver to hold down a button for 10 seconds every lap. Could the driver make it work by pressing the button and continuing along his way? Likely. But it also would hinder the performance of the task at hand - getting around the track as fast as possible.
By establishing a relationship with a bank, even before there is a need for debt financing, you can set yourself up for enhanced financing options down the road. Banks love to work with customers without an immediate debt need as the customer’s deposits are a cheap source of capital to lend to other clients. Once this relationship is established, the bank is likely to want to keep the relationship if a debt need arises for the deposit-only customer. Thus, by starting a relationship early with a venture bank, you can establish some trust that could be beneficial as needs arise.
In addition, the active venture banks work with hundreds of venture capital funds around the country in providing deposit and loan services to their portfolio companies. The network of relationships with these venture funds is extremely valuable and can be a great way to get an introduction to a specific firm you may be targeting for an equity raise. VCs love to get warm referrals and banks love to show potential deals to VCs. When this type of “matchmaking” works, it’s a win-win-win for all parties. Most of the venture banks have programs designed to help companies with navigating the fundraising process - at Square 1, our program for pre-VC companies is called Square Roots and has had numerous success stories.
In summary, while a start-up can definitely choose to bank with any number of financial institutions, there are some definite advantages to working with a dedicated venture bank. I’m obviously somewhat biased in this conversation given my current role as a lender for Square 1 Bank, an active venture banking institution. Similar to our main competitor Silicon Valley Bank, Square 1 remains committed to working with entrepreneurs at all stages.
Over the last few months I’ve been thinking a lot about a framework for the way I look at the world. I think it applies across both personal and professional facets of life, and across a multitude of layers within these buckets. The irony is that this worldview with seemingly infinite reach is inherently not complex; rather, it’s that there is Power in Simple.
Before I go on I want to acknowledge two things up front: 1) I’m far from the first person to opine on the incredible power of looking at things in a simple light. My hope is not to come off as some guru of life philosophy, but rather to make a few meaningful points about how simple is good with respects to entrepreneurial companies. And 2) I recognize that a mantra like there is Power in Simple makes me sound like either a grizzled octogenarian or a New Age theorist who’s about to pimp a balance bracelet of some sort. I happen to be neither, and hope you won’t hold that against me.
There’s no doubt in my mind that the development of my simple is better framework has been influenced in large part by the Lean Startup movement and focus in certain tech circles on Minimum Viable Product. Folks like Eric Ries have done a great job of introducing the idea that, especially in SaaS and web-based start-ups, agility and ability to make rapid changes are paramount. It’s not necessary to build the perfect product before releasing to the public. Rather, it’s better to release a minimum viable product - one which has been developed in a leaner, less costly manner – and then iterate continuously over time based on market feedback to make the product better and better.
You don’t have to have a product development background to grok the idea of MVP both as a user and on a theoretical basis as the most efficient way to develop online products in an age when releases can be instantaneous and mistakes reversed with huge economic implications. Yet, as you dig deeper into MVP, there is a tendency to be overwhelmed by all the information and suggestions out there. And then there’s the counter argument – that there are times when the fat start-up is more appropriate. Then you’re putting together your investor deck to pitch for a round of funding and resort to vomiting out the entire potential product roadmap in an attempt to showcase all your product could be over time.
And what do you have to show for it? A convoluted amalgamation of ideas that are nearly impossible to decipher for an investor and even less coherent for you as the operator as you try and determine how to direct limited resources in the most effective way.
The answer, I think, it to get back to the simplest of all questions: At the most basic level, what is the market pain or new value that you’re trying to create. Why does your company need to exist?
By framing your complicated world in the simplest manner, it’s possible to then classify next steps with a new, clearer lens.
I was reminded of the power of simple last week when I listened to a talk at NYU by Albert Wenger of Union Square Ventures. Albert talked a lot about how USV uses a thesis-driven approach to their early-stage Internet investments. They establish theses for the way the world is changing and then look for companies who have launched and grown a user base with a mission that fits in with one of their theses.
A great example of this thesis-driven investing in action was the firm’s investment in Etsy, the online marketplace for handmade goods. USV believed that there would be a growing market for unique, one-of-a-kind products that were completely different than the mass-produced items one could find at Wal-Mart or Amazon.com. Now there are a million questions one could ask about the Etsy model – exactly how big is the market, how would you build sellers to scale, what is the right transaction fee structure, how could they compete with eBay – and those questions have undoubtedly been asked and debated ad nauseam. But at the core, Albert and USV made a bet against a thesis which is proving to be true, and Etsy is growing rapidly (and adding features along the way!)
Of course, living out a simple is better framework is not just for visionary investors or founding CEOs. The fact of the matter is that every member of a company’s team is responsible and capable of living out this mission in real time. At Square 1 Bank we exist to provide banking services and debt financing that help venture-backed companies grow. At our very core, our goal is to grow outstanding loans while minimizing losses. I can go on and on about the best ways to accomplish these goals – about the implicit contract between VCs and lenders and theintricacies of covenants and why this or that internal process is good or bad. But at the end of the day, I’m realizing more than ever that my daily actions should really be driven by a simple framework: does this increase the likelihood of making more loans without exposing the Bank to undue risk? If so, it’s likely a good action to continue repeating.
I’m interested in how others – both those creating new products/companies and those in non-product manager roles - have adapted the simple is better approach. I hope you’ll contribute to the discussion in the comments below.
In the last week I’ve been the witness to two divergent but equally telling stories of customer service from two companies who have nothing to do with each other. I was not involved directly with either customer service interaction – rather, I heard about the experiences through old fashioned word of mouth – which makes the instances all the more valuable for sharing and learning from.
The first case involved Intermedia, which is the world’s largest provider of hosted Exchange email services. It seems that during the latter part of last week, Intermedia experienced technical issues which resulted in email service outages for multiple days. For a company with an SLA guaranteeing 100% data protection and less than six minutes of Exchange hosting downtime per year, this is a huge deal.
My company doesn’t use Intermedia for hosted Exchange so you may wonder how I heard of the issue in the first place. It turns out that First Round Capital does use Intermedia and I saw a tweet from Josh Kopelman expressing his concern and a call for help (or at least an update from Intermedia). Apparently the message did not get through, and Kopelman followed up with an extensive and somewhat scathing (albeit deserved) blog post that does not speak kindly of Intermedia’s efforts.
In contrast to this rather sad attempt at customer service, I received a forwarded email today from a good friend. He and his wife had ordered a pair of pants from Bonobos as a gift for a parent’s birthday. For those who don’t know, Bonobos is a NYC-based company that makes unique men’s pants with a goal of eliminating “khaki diaper butt”. In addition to making extremely fashionable pants, Bonobos strives to provide unparalleled customer service, going as far as to call their customer care team “Ninjas.”
In the forwarded email, I got to see the effect of a Ninja in action. Apparently the ordered pants had not arrived in time through a mistake by Bonobos. Rather than copping out or providing an excuse, the Ninja took full responsibility, as seen in the email below:
Date: Monday, April 19, 2010, 1:22 PM
[customer name redacted],
Happy belated birthday! Sorry that your order is also going to be a bit belated. 100% our mistake in not getting that to you in time.
I just wanted to reach out to say happy birthday, apologize for the delay, and see if I could send you one of our polos on the house. They’re very breathable, lightweight, and good for the Louisiana heat and humidity.
I’m glad to send one your way on the house if you want to tell me any size or color preferences.
Hope your week is off to a good start.
John, Ninja Manager
In short, the response from Bonobos to a potentially bad scenario could not have been more different than the actions (or lack thereof) from Intermedia. Through this example, we see a few defining principles of customer service in the Internet area taking shape. Josh touched on several in his post, but there are a few more worth talking about here:
I was talking with one of my friends who is an associate at a large PE fund and he brought up the interesting point that he has “no idea whether or not my bosses think I’m doing a good job.” He believes he’s performing and is putting in the requisite time in the office - but at the end of the day, it’s unclear how he (as an associate) is being judged by the partners in the firm.
This made me think about young VCs - the associates and principals at venture funds who often don’t have direct voting say in investment decisions but are many times the “feet on the street” most accessible and meaningful to know for entrepreneurs. Venture funds have a relatively long life cycle with respect to understanding overall performance - the typical fund can have a 10 year investment horizon during which it will realize returns. Funds are judged by fairly simple, quantitative metrics - an internal rate of return.
But there’s an additional and important question to ask - how are (and how should) the individuals in the firm be judged? For the partners, performance is likely tied to specific investments they “own”, and partners are inherently tied to the lifecycle of the fund.
I wonder, though, what is the best way to understand the impact a younger member of the fund investment team is making. For the young investment professionals out there - how do you find you’re currently reviewed? Is it mainly qualitative and based on partnership feedback?
For entrepreneurs and related parties in the VC world - it’s important to understand the dynamics of different funds and how they operate. In some funds, non-partner professionals have a lot of say in the final investment decisions; in others, this sway is almost nil. Attempting to get a read on a investment professional’s place in the fund hierarchy can have a huge impact on efficiency and effectiveness of interaction for your specific goal.
The first iPad units are shipping and we’re surely headed for a deluge of opinions from far and wide about what the iPad means as a product and how successful it will be. And I’m not just talking about opinions from the geek tech rags which have covered these topics ad nauseum already. Real mainstream America wants to know – as evidenced by several of my friends who have asked for an opinion on Apple’s latest product creation.
My friends ask me even though I’m a regular guy, albeit one who happens to dabble in the murky waters of technology early adoption. But I do play in the technology world, placing me squarely in the proverbial middle of the Chris Dixon Techie vs. Normal Venn diagram – I’d call myself a “Normie”. It makes me a potentially dangerous source of technology prognostication – or perhaps an important one. Because as Dixon states, “Techies are enthusiastic evangelists and can therefore give you lots of free marketing. Normals, on the other hand, are what you need to create a large company.” And his further assertion – “techies are only occasionally good predictors of which tech products normals will like.”
In my explanation to my even more Normal friends, I keep coming back to the assertion that the iPad will be a transformative product – not necessarily because of the bells and whistles of iPad version 1.0. But because of a broader shift we are in towards full on mobile computing, with anytime anywhere consumption occurring with regularity not just for techies, but for Normals all over the developed world. In this sense, the iPad is a revolutionary product, rather than just an evolutionary one.
To explain what I mean I’ll step back only a few years to the birth of the iPhone in the US (I will choose to focus only domestically at the moment because I have even less expertise in knowing the international wireless market; I fully realize, however, that parts of Asia were and are ahead from a pure mobile functionality standpoint). Prior to the iPhone the mobile device had already evolved to the point where it was relatively normal for individuals to want and need access to email and (crappy) internet access in a mobile device. But this evolution was over a long period of time. It’s hard to remember because the world has changed so rapidly since, but as recently as Q3 2005, the mobile market was still massively not smartphones – of the ~825 million phones sold in 2005, only 45-55 million were smartphones. By Q3 2006, only about 5% of the total phone market was smartphones.
Over the next few years, the market evolved, with the Blackberry gaining in market share in early 2007 due in large part to the massive adoption in the business community. RIMM was able to do 1-2 things, namely corporate email, and do them really well and rode this evolutionary wave in mobile for an upward sloping market share.
Of course, the bigger story here was the launch of the iPhone, and specifically the 2nd generation iPhone 3G which took smartphone adoption to the next level. The iPhone was the revolutionary product which, along with the evolutionary technology progress which had already been made, took smartphones to the next level. In short, the iPhone revolutionized the market from a techie/business power user market to a mainstream consumer must-have. And this meant good things for all smartphone makers – according to Forrester, by the end of 2009 smartphones made up 17% of total US wireless subscriptions, up from 11% the year before. Within the smartphone market, RIMM (Blackberry) market share at year end was 20%, compared to 14% for Apple (and growing at a faster rate).
Stepping away from the statistics for a second, what we’re seeing is the iPhone driving a massive market shift towards mass quantities of consumers who want and are getting access to mobile phones with data/wireless/internet capabilities. In start-up parlance – a smartphone is no longer just a nice-to-have, it’s a must-have. And not just in for the early adopter, big-city kids riding the subway cars of Brooklyn, but for the very normal Mom in middle class suburbia who is finishing up her “new every two” contract and going for the iPhone or Blackberry at upgrade.
This is the second time we’ve seen Apple step in with a product which capitalizes on the evolutionary technology and market forces inherent in the way technology is moving – first with the iPod and now with the iPhone. With this sort of product/market credibility, Apple has built up immense brand respect, loyalty and even love, to the point where mere Normals are willing to accept that maybe the iPad really is not just the next step, but the revolutionary inflection point for mobile computing. Apple has the world’s attention, and they’re taking advantage of it.
I’m not convinced that the final shape this will take will look like the iPad 1.0 we know today. As prices come down and technology evolves, we will see many entrants into the compact, flat, mobile, not-a-phone-but-not-a-laptop device world which will allow us to connect, consume and compute anywhere at anytime. But we will all look back to the iPad as the granddaddy of them all, and wonder how we ever lived without “it” - whatever “it” actually ends up looking like.
In my prior post I gave an overview of the theory behind financial covenants in venture debt deals and some basic examples of the type of covenants used by lenders. With this post we will take a deeper look at what happens when there is a covenant trip and the pros and cons of venture debt deals with covenants.
When a covenant violation occurs (often called “tripping” a covenant), it is technically a violation of the terms of the loan agreement. While the actual repercussions and remedies available to the lender will vary from deal to deal, in general there are several options for dealing with a covenant violation.
First off, most debt deals have a default rate term which provides the lender with the ability to invoke an increase in the interest rate on the loan in the event of a default, and until the default is formally addressed in some fashion. The default rate will typically be noted in the section of the loan agreement dealing with interest rate for the specific loan and there will likely be a cap on the allowed amount for the increase. A lender may or may not choose to invoke the default rate, but the trip of the covenant is the event which allows the action.
Within the loan documents there will be explicit terms which outline the lender’s rights and remedies in the event of a default. The range of remedies is widespread, with the simplest being that most lenders will not allow any additional extensions of credit (i.e. advance requests for more money) as long as the company is in default. The harshest and potentially most damaging term is the ability of the lender to declare all outstanding obligations due and payable upon the event of default. Depending on the liquidity position of the company and/or access to additional capital, this could lead to a scenario in which the company does not have adequate capital to both repay the loan and continue operations.
As noted in Part I of the covenant post, the worst-case instance described above is a very rare occurrence. The vast majority of covenant violations are dealt with via alternative methods. These methods can vary, but the commonality among all is that some action is a requirement – it is not acceptable nor realistic for a violation to remain outstanding in perpetuity.
Depending on the severity and nature of the covenant violation, the likely action is either a waiver of the default or a restructure of the deal either through amended covenants or a new structure altogether. A waiver is the preferred outcome for most companies as it essentially is a get out of jail free card – it is a formal note that a violation occurred but an equally formal notation that the lender is waiving the violation and no longer retains the rights and remedies to address the specific default. There’s no double jeopardy with a covenant waiver. This is a typical response when the violation is minor, due to a timing difference, or there was an event which occurred after the violation which mitigated the risk and overcame the default itself (for instance, a large round of equity which can cover up a multitude of sins in a lender’s eyes!)
When a violation is severe or there is a covenant with cumulative or dependent characteristics, it’s often unlikely that a company will be able to comply with future covenant levels after an initial default. In this case, a full restructure of covenants is needed. In many ways, this process takes the same shape as the initial negotiations which led to the original covenant structure. The lender will discuss options with the company and also touch base again with the equity sponsors to determine their level of support, especially when the primary source of repayment is additional equity capital. The new covenant structure may simply involve new levels within the same structure or there may be a different, or added, covenant. In addition, a coveant restructure is often used by a lender as an opportunity to amend the interest rate, amortization terms, charge additional fees, or take on additional warrants. The perception is often that a covenant trip is a signal of increased risk and thus the lender looks to match the change in risk profile with credit enhancements and/or a higher return.
In the event of a covenant trip, it’s important to keep in mind the implicit contract between venture debt providers and VCs which I previously described. For lenders with large numbers of customers, the implicit contract and reputational risk of being seen as too heavy-handed can play a large part in how decisions are made. When considering venture debt providers, it makes considerable sense for entrepreneurial CEOs to ask their equity sponsors how the potential lenders have responded to covenant trips in the past and what type of experience they have in working out deals which don’t necessarily go as planned. Leveraging the historical relationship between venture debt provider and VC will help to not only select the best fit up front, but also in negotiating structure changes if needed in the future.
Of course, not all venture debt deals contain covenants, and it’s worth discussing the pros and cons of having a covenant in a deal. Many venture debt funds will provide structures billed as “no-covenant” loans which functionally act as “cheap equity” for a company to use as it pleases. While cheap relative to the cost of equity capital, the tradeoff with such no-covenant venture debt is often a higher overall cost than that offered by venture debt which contains covenants.
Regardless of whether or not there are covenants in a venture debt deal, virtually all transactions occurring today contain a Material Adverse Change clause. The so-called MAC is a somewhat arbitrary catch-all term which allows the lender to call a default upon the occurrence of events which would represent a material change in the operations or financial condition or the company or in the ability to repay the debt obligation. The obvious conundrum with a MAC is that it’s necessarily broad to capture a variety of potential circumstances and the definition of material change can mean different things to the various parties sitting around the table. It can also mean different things for different types or stages of companies – an early stage company may be at 10% of plan and still able to raise a significant follow on round of equity; a more mature company may be at 75% of plan and have no plan for how to continue as a going concern.
Combining the opaque nature of the MAC with the inherent complications of implicit relationships and contracts between parties can lead to very uncomfortable and messy situations when a lender feels it has to resort to calling the MAC. Ironically, it is typically these situations which blow up in the face of all involved and give venture debt as a whole a bad name with some in the industry.
With this knowledge as a backdrop, one can then understand the paradoxical nature of covenants in venture debt deals. While at first glance covenants seem to be the fuse which, when lit, can blow up a company, covenants can functionally serve the exact opposite purpose. By providing an explicit outline of expectations of all parties, covenants create definition in the deal which allows all parties to react rationally and transparently, even in suboptimal scenarios. There is certainly considerable freedom and value in doing a debt deal with no covenants – and given the option of two deals with identical structure (pricing, term, etc) one would always choose the deal without a covenant over one with one. Yet, I hope this two part overview of covenants in venture debt deals helps to demystify the terms and provide some insight into how the presence of covenants in your debt deal may not signal the end of the world as you know it.
There’s no way to talk about venture debt without bringing up the notion of financial covenants. The simple mention of the word “covenant” evokes a connotation of doom and fear in the hearts of many entrepreneurs and equity investors alike - perhaps in part caused by horror stories of overzealous lenders using a covenant trip to invoke remedies (read: sweep cash or foreclose on assets) which led to the demise of a company. While there are certainly exceptions which prove the rule, the vast majority of debt deals which contain covenants don’t lead to such a disastrous outcome. A proper understanding of the way covenants may impact a debt deal is an imperative which deciding how (and if) to pursue venture debt.
(For the purpose of this post we’ll focus on financial covenants related to performance levels or minimum financial standards required of a borrower. It is typical for debt deals to contain other “negative covenants” (i.e. things the Borrower won’t do, such as take on additional debt or allow additional liens on collateral), but in the interest of clarity we will focus on the financial covenants.)
At the very basic level, covenants are used by a lender as a mechanism for mitigating risk by setting parameters of minimum performance/financial condition that the lender is comfortable with at the outset of a deal. While I downplayed the negative connotation of covenants a bit above, the reality is that covenants are indeed a big deal, because a violation of a covenant gives the lender a legal right to enact remedies which may be counter to the desires of management. While covenants typically get the bad rap, they only point towards the bigger reality – taking on debt is a big decision that should not be taken lightly. Using venture debt usually means giving up a blanket lien on all assets (and sometimes intellectual property). Therefore, when there is an issue with a debt provider, literally the entire company’s future hangs in the balance.
With so much to lose, why would anyone employ venture debt, especially in a start-up? The exchange works quite well, in most cases, because of the ability of specialized lenders to create structures which avoid the “worst-case” scenario and the relationships within the industry and implicit contract between lenders and venture capitalists which helps to shape rational decision-making by all parties. Venture debt works best when everyone understands the perspective of the others around the table and there is a mutual dialogue which helps to align the interests of all parties. It may seem counterintuitive but my ideal customers are those who are initially scared silly by the idea of covenants and thus take the structure very seriously – I find that these customers are the most prudent and financially responsible; and when things don’t go as planned, they are swift to react and communicate prior to a covenant trip, allowing for a clean resolution.
Financial covenants can take all different shapes and forms but the most common are either performance covenants or metrics which require certain base levels within the company’s balance sheet. Smart lenders attempt to structure covenants which not only track the company’s performance to plan, but also tie directly into the metrics the equity investors are tracking when considering additional investment. The specific metrics may change over time – for instance, for an early stage company (pre-revenue or very early stages of revenue traction), the focus of the Board may be on growing users, revenue, monthly recurring revenue, or bookings, each of which could be a potential covenant for the lender to track. Another popular performance covenant is EBITDA, as it implicitly captures the top line while also ensuring that expenses (and burn) are not way out of line with revenues. Performance covenants are typically set at a discount to the company’s Board approved plan and measured monthly or quarterly.
Typical balance sheet covenants include standard financial ratios – Liquidity Ratio, Quick Ratio, Current Ratio, Debt/Equity, or Debt Service Coverage. For companies which are using debt to bridge to a next round of equity, a covenant which ties in to both performance and the balance sheet is a remaining months of cash requirement - lenders will sometimes track the company’s burn and require a term sheet or commitment from investors before allowing the company to fall below a minimum level of cash.
A final category of covenants is custom numbers which make sense for a specific business model or stage. For instance, in SaaS companies or models with a strong reliance on monthly recurring revenue, it’s not uncommon to see a covenant tracking churn, as this is a leading indicator of overall performance.
As a matter of practical advice for companies negotiating venture debt, the discussion around covenants should be open and transparent between company and potential lender. The best covenant structures are those which align naturally with the stated goal of the company– for instance, an EBITDA covenant which is set at a discount to the company’s plan but forces towards eventual profitability at the end of the year if that is the goal of the Board. When setting specific performance levels, agree on levels which work for both sides and avoid a situation in which there is so much front end negotiation that the covenant level ends up being set at a level where there is no choice for the lender but to act swiftly to preserve capital.
It’s important to remember that lenders do not extract any great joy in invoking remedies after covenant defaults (in spite of what the horror stories may say). Covenants are a necessary means for mitigating risk for lenders that don’t have any other means of driving behavior. Though the lender has a first position lien on assets, this is typically a passive position with much less ability to affect overall decision than the equity holders or management who sit on the Board. Covenants are a mechanism for setting inflection points to address concerns, and are often the method by which a debt deal is able to remain on track by dealing with the issues at hand rather than letting them spin further out of control.
It should be noted that not all debt deals contain covenants. While covenants are very often found in venture bank deals, transactions with venture debt funds do not typically carry as stringent a structure and there are certainly venture debt deals without any defined covenants. In the next post in the series, we will examine the remedies available to a lender when there is a covenant breach and the pros and cons of having a deal with covenants.
In my first two posts on Understanding Venture Debt, I provided a general overview of different types of venture debt facilities and a brief look at the banks and funds who are actively involved in the space. With this post I hope to shed some light on one of the less-obvious but highly important aspects of the venture debt landscape: the “implicit contract” between venture capitalists and venture lenders.
Before going any further, I should pause to point out that my use of “implicit contract” here is borrowed from a fantastic academic paper put out by Darian Ibrahim last year entitled “Debt as Venture Capital”. Ibrahim is an Assistant Professor at the University of Wisconsin Law School and conducted a great deal of research in the venture debt space for the paper – I’d recommend that everyone spend the time to read it. His work was certainly part of the inspiration for writing this blog – at best I hope to expound on more than a few of Ibrahim’s ideas; at worst, I hope this blog will serve as one more anecdotal data point for those, like Ibrahim, hoping to better understand the venture debt space.
At the core of the implicit contract between venture lenders and venture capitalists is this: the vast majority of venture-backed companies are burning cash and do not have sufficient financial fundamentals to secure traditional commercial debt financing. In the absence of future cash flows from operations, venture debt firms underwrite many of their loans based on an understanding of the likelihood of the company’s ability to raise additional equity capital in the future.
This reliance on future equity financing is one of the reasons that venture lenders spend so much of their time developing and nurturing relationships with the venture capital firms who serve as the professional sponsors of entrepreneurial companies. While offensive to some first-time entrepreneurs, the reality is that for many venture lenders (especially for early-stage or cash-burning companies), the capitalization plan in the eyes of the venture investor/Board member is far more important than the exact details of the business model of the company itself. (There are exceptions to this rule, of course – asset-based lending and cash flow lending being prime examples. For the purpose of this discussion it’s most appropriate to think of true “venture debt” designed to bridge to an additional round of equity or to eventual cash flow breakeven or an AR based loan to a company which is still burning cash and in need of future equity.)
As a venture debt provider is conducting due diligence on a potential loan, a conversation with the sponsoring VC firm will be the most important aspect of the diligence process. The lender will want to understand the details of the VC’s involvement to date and future plans for financing: how much capital the VC has into the company; the amount of capital specifically reserved for the company for follow-on investments; metrics the VC is watching for valuation or continued support reasons; the total capital need expected over the life of the company. In addition to these company-specific questions, the lender will want to understand the dynamics of the specific VC fund: how much dry powder is remaining at the fund level; how the VC ranks the company within its own portfolio; whether or not the entire voting contingent within the partnership is supportive of continued funding.
Venture lenders rely on the direct comments from the equity holders along with macro-level statistics around probabilities of future equity financings when assessing venture debt risk. Venture capitalists tend to be rather smart individuals and understand the dynamics at play and therefore are aware that their statements hold considerable weight in the evaluation of a portfolio company’s credit-worthiness. Yet in the vast majority of venture debt loans, there is no explicit or legal promise by VCs to repay the venture loan. Thus, the “implicit contract” which exists between venture lenders and VCs revolves around the mutual understanding of future equity funding, which is ostensibly the primary source of repayment in many venture debt transactions.
Negotiating the dance which is the implicit contract is of paramount importance for both the lender and equity investor and has far-reaching implications for both parties as well as the entrepreneur running the company. It’s particularly important to note the following when considering venture debt:
1. Importance of Clear Communication: Because all parties involved in the transaction are relying on implicit indicators, it’s imperative that transparency and truthfulness win out above all else to maximize long term value for all parties. This starts from Day 1, when a discussion begins around venture debt. Honest communication around the capitalization plan and intended use of debt will help to avoid a situation in which debt is misused or too much leverage is employed. Remember: an inappropriate use of debt in a venture-backed company is not good for anyone. It exposes the lender to losses and can serve as the albatross weighing a company down from potential success.
2. The Impact of Implicit/Explicit contracts: Venture lenders must understand that VCs who serve on the Board of a particular shared portfolio have both the implicit contact with the lender and the explicit contract of their fiduciary responsibility to maximize shareholder value. These explicit-implicit considerations will serve as the drivers in Board decision making and need to be considered by the lender. The complication with this reality is that the scenario in which explicit-implicit contracts can be most at odds with each other (in a down case when the company has not performed as well as planned) is precisely when the implicit contract is of most importance. In these cases, more than ever, clear and open communication is needed in order to navigate the situation in a manner which minimizes value lost on all sides.
3. Implicit Contracts still have consequences when broken: In a world in which there was no future repercussions for near term actions, implicit contracts would have no weight. But how we act today does have implications on the future. Venture debt can be an attractive, efficient, non-dilutive source of capital for VCs and entrepreneuers as they grow companies. But it only works if the actions of the parties involved are in line with expectations. As Ibrahim noted, this is largely enforced by the market – if a VC fails to live up to their implicit agreement for continued support, the likelihood of securing additional debt financing down the road for a different portfolio company is unlikely. Similarly, a venture lender which develops a reputation for taking an overly heavy-handed approach to managing credits is a lender who will have trouble finding new business from top tier VC firms.
The implicit contract dynamics of venture debt are pervasive, and surely are not limited to the points outlined in this post. Rather, the intricacies are complex, not unlike the relational dynamics which define all relationships we have in life. Not surprisingly, the VC and venture debt providers who are able to successfully “dance the dance” together tend to enter into deeper and deeper relationships over time - with more interconnected portfolio company relationships and more aggressive (and valuable) debt terms. It is for this reason that the implicit contract is perhaps the most important facet to understand in the entirety of any discussion around venture debt.
Like a lot of people in the VC/tech world I spend a good amount of time each day scanning the various online tech rags for the latest industry news. While these sites are generally great sources of information and, more importantly, instigators of conversation, they are also frequently the source of frustration when the focus turns from technology to attempting to describe business prospects or financial information of the companies they cover.
I was reminded of this point yesterday when I saw the ReadWriteWeb story about the 2010 Facebook revenue projections. Let me preface by saying I’m a huge fan of RWW and think they typically do a top notch job of reporting on the web. But in this particular case, the writer (Jolie O’Dell) made a mess of reporting the story when it came to describing Facebook’s projected financials (projections which happen to be murky at best given the private nature of the company’s commentary on the matter).
My concern may be considered minor semantics by some, but I think there’s meaningful value what is admittedly a pet peeve - the confusion between revenues and profit in description of a company’s performance.
In the first sentence of the article, O’Dell references the fact that Facebook “made” upwards of $700 million in 2009 before stating that the company expects 2010 revenues of $1billion. It’s an ominous way to begin the write-up, as it has the potential to confuse revenues (which is what O’Dell is really talking about) with profit, which is what is typically talked about when a company is said to have “made” money in a given period.
O’Dell clarifies a bit later in the article by fleshing out the revenue projections. She then makes the point that the $10 million in projected Facebook credits revenue is puny compared to the almost $600 million in “cash flow” from performance and brand advertising.
In and of itself, the description of the advertising revenue as “cash flow” is not necessarily wrong – the revenues from this type of advertising are indeed driving the company’s cash flow. But by trying to avoid using the word revenue over and over and instead using “cash flow” O’Dell continues to complicate the discussion at hand – which is Facebook’s revenues. In order to talk about cash flow, we’d have to understand the underlying expenses as well, including both operating expenses and fixed asset/capital expenses necessary to scale the business. This notion of “free cash flow” is a different, and very important one, compared to the discussion about Facebook’s revenues. And by tossing around the terms interchangeably, the message is clouded and the discussion cheapened.
Based on comments from Facebook last year, it seems the company will be cash flow positive (i.e. generating a profit) this year – though there’s no indication of the magnitude of this profit. It’s safe to say that the number is relatively small at this point in time. Which makes the last statement from O’Dell the most perplexing and disconcerting:
Facebook has stated it will not comment on these figures or speculation about future revenues. However, it is completely clear that this company has found a way to make the Web dramatically profitable.
There’s nothing clear (yet) about how profitable Facebook is and/or will be. And it’s certainly premature to say whether or not the company will find a way to make the Web “dramatically” profitable. What is clear is that the company continues to grow both its top line and presence in the lives of web users. I’m hopeful that as Facebook (and Twitter, foursquare, etc) continue to mature, the financial savvy of the reporters who cover them will increase as well. Otherwise, we’re in for a confusing ride.
Note: I completely understand and respect the potential irony of calling out tech reporters writing about financial stuff given the fact that I may, from time to time, comment on technology on this blog without having a background as an engineer or technologist. I’m hopeful that when the day comes that I confuse the technology issues at hand, someone from the tech side of the equation will help clear things up for me!