zack mansfield // venturebanker

When Tech Writers Talk Business

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!

Understanding Venture Debt - Part II: Banks and Funds

In my first post in this series about Understanding Venture Debt, I provided a quick overview of the various types of debt facilities available to venture backed companies.  With this post I will provide an overview of two types of institutions which provide the debt financing and the relative cost of capital of each, as this plays a vitally important role on overall venture debt deal terms.

The first type of lender – and the one nearest and dearest to my heart as I work for one of them – is no surprise: banks.  There are somewhere around 8000 commercial banks in the United States.  Of these, only an infinitesimal subset is active in the venture debt market.  Silicon Valley Bank has been around for more than 25 years and is well known in entrepreneurial circles.  My employer, Square 1 Bank, was founded in 2005 by industry veterans and is focused entirely on the venture/PE-backed market.  Other banks with technology/VC groups include Comerica, Bridge Bank and RBC.  And that’s about it (though I may be missing some who play in only certain markets – please feel free to fill in the blanks in the comments).  Out of 8000 banks, only a handful are involved in the venture-backed space.

The biggest thing to remember when looking at banks as lenders is that they are just that – banks.  This means they are regulated by the government and have to maintain various liquidity and leverage ratios as a result.  In addition, the oversight from regulators means that bank debt terms typically are a bit more structured (i.e. covenants) than terms from debt funds.

While bank deals are typically more structured, they also tend to be cheaper in terms of interest rate and warrant coverage.  This is mostly driven by the extremely low cost of capital for the banks.  A standard debt term sheet from a venture bank will carry a provision requiring the company to maintain a total banking relationship with the particular institution.  This means the VC-backed company will maintain operating accounts with all their cash at the lending institution.  VC-backed companies, while often planning to burn cash, tend to be very liquid at the point in time right after raising a round of equity (which, not coincidentally, happens to be the best time to raise venture debt!)

By way of example, take Company X which raises a Series A round of $5 million and secures a $1.5 million line of credit from a bank.  It’s unlikely Company X will use the line of credit in the near term.  Their $5 million in cash sits in the bank accounts earning marginal interest in a money market account.  These deposits, in essence, serve as the funding source for a different bank customer - who we’ll call Company Y - who has a working capital gap and uses its line of credit to fund operations.  Company Y pays the bank an interest rate for the capital which creates the interest margin and (ultimately, after expenses) bank profit.

This isn’t exactly rocket science – in truth, I’ve just walked through commercial banking 101 – but the beauty of venture banks is this relatively low cost of funds.  While larger commercial institutions are constantly seeking to “buy deposits” in an effort to reduce the amount of leverage they need to use, venture banks tend to have customer bases with more than adequate deposits to fund loan growth.  This is important to remember if you’re an entrepreneur and unclear about the requirement to maintain all bank accounts with the venture bank – not only is this a mitigant to credit risk, it’s at the heart of the venture banking model itself.

An alternative source of venture debt capital is venture debt funds.  These institutions can be public or privately held and can have varying funding structures.  Many venture debt funds are captive funds of capital raised from limited partners (similar to a VC fund) and often use leverage as a multiple of the equity base to increase the total fund size.  The result of using leverage is an increased cost of capital, especially relative to the banks.  This results in a need to price facilities at a higher interest rate, with more significant warrant coverage, and many times fudns employ final payment fees which help achieve specific returns, while delaying the cash outlay until a point well in the future.    To offset the increased cost of capital, debt fund facilities tend to contain few or no covenants and many times longer term deals (18-60 months).  It is possible for debt funds to work side-by-side with venture banks, with the funds taking a junior creditor position to the bank’s senior lien.

There are quite a few players in the non-bank debt financing world.  Firms that I’ve had experience working with or competing against include MMV, Escalate, WTI, Hercules, Velocity, Vencore and Oxford.  There are plenty of additional players (Wellington, Lighthouse, etc), and if you check out the Wikipedia entry on venture debt you’ll see some more names.

The focus of the next posts will be on more specific terms, structures and the implicit factors which guide the venture debt process.

Understanding Venture Debt - Part I: What is Venture Debt

One of the great values of the web is the democratization of information – anyone can look up anything at anytime and likely find an answer.  Within the entrepreneurial world, and more specifically the world of venture capital, this has led to a surge of transparency in an industry which has historically had a bit of a black-box or club mentality.

Today there are a ton of fantastic resources out there for entrepreneurs looking at the inner workings of raising venture capital.  Some of the best ones are created and maintained by venture capitalists themselves – Mark Suster, Fred Wilson and Brad Feld come to mind.  Mark Davis has created an invaluable resource in his “Get Venture” blog.  And sites like Venture Hacks can help people navigate all kinds of aspects about the start-up process.

With all the resources out there, I’ve been surprised about how little information is available regarding the small subset of the VC world that I’m most familiar with: venture debt.  Sarah Tavel of Bessemer wrote two posts about venture debt a year ago, and if you do a Google Search for “venture debt”, you’ll see she’s prominently displayed on the first page of results.

As a lender for a Square 1 Bank, I spend parts of everyday explaining to entrepreneurs and those involved in our industry some of the intricacies of debt financing to venture-backed companies.  Based on the above-mentioned facts, I thought it would make sense to run through a series of posts about venture debt: what it is, how the process works, the in’s and out’s of terms, etc.  I’m not yet sure how many posts will be in the series, but I’m hopeful it will allow those involved in the entrepreneurial world to have a better understanding of the part venture debt plays in VC-backed companies.

Understanding Venture Debt – Part I: What is Venture Debt?

There are several different forms of venture debt and stepping back and viewing the issue at a high level makes sense in helping to understand the whole.  Venture debt ostensibly refers to debt financing which is offered to companies who have a professional investor as a significant equity-holder in the company.

The reason the venture investor is important is because most often, companies in the market from venture debt do not have the underlying levels of financial performance (namely a history of profitable performance) that a traditional lender (read: regular commercial banks) looks to when underwriting a loan.  Venture-backed companies tend to be cash rich after raising a round of funding, but often have plans to burn through a portion or all of the round of equity financing in order to rapidly grow product development or (hopefully!) sales.

In general, “normal” commercial lenders are scared silly by the idea of a company planning on burning through their cash.  Over the last 25 years or so, a variety of institutions have popped up who understand the dynamics of the venture world and have gone out of their way to establish carefully cultivated relationships with the venture capitalists and entrepreneurs who are part of the ecosystem (in my next post I will provide an overview of the players in the space).  By leveraging the relationships and understanding of the dynamics which are at play with venture-backed companies, venture-lenders can effectively provide loans to companies who are burning cash while minimizing loan losses, leading to a workable business model.  Thus, an alternative form of capital is available for entrepreneurs called venture debt.

Within the broad umbrella of venture debt, there are a few different types of loans which are available and appropriate for different stages of VC-backed companies.

• Accounts Receivable-based Line of Credit – this type of debt is useful for companies that are generating revenue and assets in the form of Accounts Receivable.  Many times, companies will see a working capital gap caused by the time it takes for them to collect accounts receivable and the terms under which they must pay their vendors.  It is possible to leverage the billed accounts receivable, often at a discounted rate of 80% of the AR base.  There are many types of lenders who will finance AR, and I will touch on the various aspects in a later post to get into the details.  This is often the cheapest and least risky form of venture debt as the loan is tied to a quick asset.  Other names for this type of loan facility include AR Line, Formula Line, and Receivables Line.
• Equipment Term Loan – If a company has the need to purchase a significant amount of capital equipment, it’s possible to finance the purchase.  This allows the company to use the proceeds of the equity round for the purpose of funding growth in sales and marketing.  Lenders sometime require the advances on the loan to be supported by invoices for equipment to specifically tie the loan to equipment, though not always.  If the company’s plan shows continued cash burn, it’s likely any long term debt such as this will include covenants related to minimum liquidity or a requirement to raise additional equity (a discussion around covenants is certainly an issue I will address in future posts). 
• “Venture Debt” Term Loan / Non-Formula Line of Credit – Often this is what people think about when they hear the phrase venture debt.  This type of capital looks and feels in many ways like equity in the short term, with the obvious caveat that it’s debt and will have repayment terms associated with the note.  Term loans typically have multi-year terms (3 years is the norm, though some are longer) while Non-Formula lines of credit (i.e. not tied to AR) typically have a 1 year term.

That’s a good overview for now of venture debt.  In my next post, I’ll look further into the types of institutions which provide these various types of financing: venture banks, debt funds and the like.  Feel free to provide feedback in the comments section about particular aspects of the venture debt landscape which you’d like to know more about.

If you build it, they may come - but will they pay?

I was reviewing a business plan/slide deck last week for a consumer web/technology entrepreneur who is beginning conversations with investors regarding a Series A round of funding.  The founder has made amazing progress to date, building a scalable technology platform, several branded sites, and some notoriety in the space he’s attacking.  When you get into the details and realize that the founder has done all this by himself in a true “bootstrapping/nights and weekends” manner, it’s even more impressive.  There is a valuable infrastructure set up and the potential to scale with the help of invested capital.

As I worked through the plan and provided some feedback, I was struck by a familiar characteristic I’ve seen in countless companies started by technical founders – an inability to connect the dots between the “coolness” of the technology and the actual value that the technology has in the market.

Put a different way, the problem can be characterized by a simple question: “What you’re building looks really cool, but who is going to pay for it (and how much?)” It’s a question which is almost too simple, and yet is often not treated with the correct amount of rigor in the earliest stages of planning a venture.

First, a bit of theory.  It’s a commonly held belief that companies are worth the “present value” of their future cash flows.  This dynamic is often overlooked or misinterpreted when looking at companies that pursue venture capital.  Since these companies can be very early in their life cycles (and even pre-revenue), it can be very difficult to predict future streams of cash flows.  Often a VC will attempt to project possible exit multiples and probabilities based on industry dynamics.  These dynamics are tied to a variety of variables, but almost always include some combination of revenue, EBITDA, free cash flow, etc.  This provides a framework for justification of the VC’s given level of investment.  It’s what allows the partnership to agree that a $1.5 million dollar early stage investment for 30% of the equity shares in a company is a good use of capital.

Implicit in all of the above is the understanding that at some point in time, the company will begin convincing a customer base to pay real, hard cash for their product or service.  Most aspiring entrepreneurs focus on the type of revenue model they will employ – monthly subscription, enterprise license, transaction based, SaaS, price per widget, and ad supported are all examples on the technology side.  Many founders are aware of the different types of models and even go through the motions of explaining the type of model their company will employ.  Often this is coupled with a top down picture of the general market segment they’re attacking and the reason they’re sure to be successful.

The mistake that is often made is there is too much focus on “this is a billion dollar market” and not enough deep-rooted detail around “how and why will someone in the billion dollar market pay for what we’re offering.” (And this is without getting into the issue of market vs. addressable market which seems to bite many entrepreneurs and is surely a topic of another post).

I’m sensitive to the fact that projecting revenues is really hard for start-ups (believe me, as a banker I see tons and tons of financial projections per year and can usually count on one hand the number which accurately reflect actual performance at year end).  It can be even more difficult to project for a nascent industry or one which is being attacked with a new technology or application.  I’m not even suggesting that an entrepreneur has to know exactly how the company will make money or exactly how much someone will pay for a product or service.  What I am saying is that fleshing out potential models and potential revenue streams is an absolute necessity when putting together your plan, especially when considering the idea of raising angel or venture capital.

I’ve found that going back to basics can be very helpful when doing this sort of analysis.  Most likely the new venture is a constant source of conversation with your close friends, colleagues, lawyer, mentor or even your spouse/significant other.  Try bouncing your revenue model ideas against these outside observers (it helps if this person is outside the nitty gritty of the start-up; even someone with little to no technical/industry expertise can be very valuable).  Explain the revenue model and why you think potential customers will pay for your product or service.  When you’re pressed to back up your claims, see if additional research provides some quantifiable bottoms-up data to support your thesis.  Even better, go out and get some customers to pay you for your offering – there’s no greater market research than actually getting into the market and selling.

In the process of explaining your story (and answering the subsequent questions), you’ll uncover details that were either taken for granted, ignored, or were inevitable blind spots suffered by all entrepreneurial founders.  Talking out your model in plain English requires a progression of thought which is very different than an Excel model put together to show a hockey stick growth curve that will satisfy investors.  As you go through this process (preferably multiple times) you will find your start-up idea improved in multiple ways:

1. You’re likely to understand the underlying dynamics of your potential business in much greater detail.  Talking it out may lead to the creation of new products/features or the removal of ancillary ideas that don’t add incremental value.
2. You get comfortable telling your story to outside observers.  This will prove to be incredibly valuable as you pitch to potential investors.  Sure, your friends and family network may not ask the hard questions that a VC will ask, but just getting comfortable with the story is half the battle.
3. You may realize new and important details around the potential size and scope of your venture.  Are you starting a business with potential for $2MM in annual revenues, $10MM, or $100MM?  The answer has an enormous impact on the type of capital you really need.

In short, if you build it, they may come.  And even if they come, they may or may not be willing to pay for the “it” that you’re building.  But there are several long term rewards for applying some very simple rigor in the early stages of business planning when it comes to hashing out your business model.

2009 Venture Capital Stats: What’s the Real Story

The 2009 venture capital numbers are out, and if you believe the headlines, the news is not good.  By now many are familiar with the raw numbers - $17.7B total invested by VC firms in 2009, down 37% from 2009.  As one who is involved in the industry, I’m continually frustrated and surprised by coverage and analysis related to aggregate VC financing statistics.

There is a general tendency among many to employ the “bigger is better” philosophy at all times.   A quick glance at a cross section of reporting outlets confirms that most chose to focus on the year over year decrease in total funds invested (the easy story) without going to the next level.

By way of example, Massachusetts High Tech wrote that “On the whole, 2009 was the VC sector’s worst investment year on record since 1997”.  Venture Beat noted that “On the bright side, the worst hit came from numbers that we’ve already reported on, since investments really plummeted during the first half of this year.”

In both cases, the insinuation (either directly or implicitly) is that lower funding totals are inherently a bad thing.  The problem is, I’m not sure this is actually the case. (To give credit where it is due, the astute Dan Primack of peHub noted as much in his post).

This “bigger is better” mantra is not unique to the press nor new to the industry.  In fact, at PwC Money Tree meetings all around the country there was no doubt many a conversation related to how the respective region compared in total funding dollars relative to other regions around the country.  This region-centric VC jingoism, while understandable in the sense of a desire to see investment dollars flowing to one’s home region, seems to be a rather elementary and crude way to determine success and failure.  All too often, for regions outside Silicon Valley, the total dollar amount is driven largely by a handful of very large deals.  Looking at totals on an aggregate basis is not necessarily helpful for determining the health and true access to capital for entrepreneurs in the region.

The other main theme, which again is a familiar refrain, is the lack of seed and early stage money and deals done in 2009.  There’s no doubt that effective seed and early stage investing is of vital importance for the overall health of the industry.  What isn’t as clear is whether or not there is adequate seed and early stage capital coming into companies.  The nature of venture capital, which involves highly selective investments (a VC may invest in 2-3 deals in a year in which he/she looks at several hundred or even a thousand deals) leads to many disgruntled would-be entrepreneurs.  Therefore it’s easy for a populist rallying cry to emerge declaring, “if only there were more seed and early stage capital.”  My response to this cry is typically twofold:

1) Perhaps there is a need for more true seed and early stage capital.  But as an entrepreneur, it doesn’t make much sense complaining about the capital that isn’t available when that time can be used doing anything and everything necessary to create value in order to secure some of the capital that is being put to work.  I’ve typically found that the best entrepreneurs do just that – and raise money in due time.

2) The sad reality is that there are a lot of ideas that simply are not appropriate for venture capital investment.  You can say a lot of things about venture capitalists but the vast majority spend tons of time each year reviewing hundreds of pitches and plans.  If you’ve found yourself pitching to numerous VCs and getting the same negative feedback, chances are the market is trying to tell you something about your proposition.  Keep in mind, however, that this doesn’t necessarily mean that your idea is bad – there is also the likelihood that venture capital simply isn’t the right form of financing for your venture.

For those of us deeply connected to the VC world, it’s time to dig beyond the quarterly and annual results. I’d love to see us talking more about Kedrosky’s “Right Sizing the Venture Capital Industry” and Fred Wilson’s “VC Math Problem” and whether or not the industry can sustain deployment of $25B in capital on an annual basis and still deliver the returns necessary to justify the fees and carry.  I’d love to see a breakdown of not just dollars invested in various regions over time, but the corresponding return on invested capital over the last 10 years for those same regions.  We’re all aware that less capital was invested in 2009, but how will more conservative methods of reserving capital affect returns in the coming years?  Given the large amount of capital raised by venture funds from LPs in the last 5 years ($143B between 2004-2008), how much has been invested and how much is still on the sidelines?  What is the lagging impact of the lower total amount raised by funds from LPs in 2009 ($13B)?

These are the real stories that are begging to be addressed in more detail.  Hopefully we will continue the conversation on this blog and in other outlets as we head into 2010.

So What is a Venture Banker?

I love what I do.

It’s nice to be able to say that.  I’ve been on the other side of the happiness equation, pounding the phones doing cold calls for a venture-backed start-up.  I was young and eternally optimistic and had just the right amount of naivete and enthusiasm to think I could change the world by selling a SaaS CRM application that was “way better than Salesforce.com”.

Or so I thought.

It turns out the start-up had a flawed go-to-market strategy, no clear idea of how to grow sales and a significant cash burn.  After a few months it was clear to me that my personal role was not a great fit, and that the company’s prospects for success for slim to none.  So I ended up leaving the start-up and switching industries altogether.

That’s how I found myself at a bank.  But not any old bank.  A bank which focuses entirely on the type of companies that I had grown to love - entrepreneurial companies that have raised venture capital.  At that point in time, Square 1 Bank was still very much a start-up in its own right, having opened its doors a mere 15 months earlier. I had been familiar with the bank’s story and ended up finding a job as an analyst.

In retrospect, if I’m truthful about things, I didn’t have a great grasp on exactly what a venture bank was when I took the initial job.  I was very familiar with the venture capital world but didn’t totally understand how a bank and venture debt fit into the equation.  There was not (and still isn’t) a ton of information available breaking down the industry.  But what I did know was this - Square 1 billed themselves as “entrepreneurs serving entrepreneurs” - and that sounded like something I wanted to be a part of.

My banking education was fast and furious, like that of many who join an entrepreneurial organization.  There were times when I felt like I was just treading water as I soaked up everything I could about credit risk, covenants, and the other various and sundry details which make the industry work.  Before long I found I was able to swim a bit, and then I graduated on to life not as an analyst, but as a lender.

And that’s where I find myself today - as the commercial banker to a number of fantastic venture-backed companies in the New York metropolitan area.  Everyday I get to interact with entrepreneurs and the investors who fund the “next big thing”.  I see tons of business models, countless applications of technology, and the nitty gritty of what does and doesn’t work in a start-up.  And along the way, I help to finance the dreams through venture debt facilities.

I’m a venture banker and I love my job.  Still have no clue what a venture banker is?  Well stay tuned, and you just may find out.