I saw a question posted on Quora recently about how to find the right venture debt firm. The original question is here…http://b.qr.ae/mbMpkx
While it’s still a small industry (roughly $2 Billion lent annually), it’s relatively easy to find the 15 or so active venture debt firms in the country. You’ll likely get referred by your VC, part-time CFO or one of the technology banks (SVB having 70% market share in most markets). Once you’ve got the firms identified and have rec’d term sheets, how do you decide? That’s the trickier question.
Most CFO’s create an excel spreadsheet to compare the business terms.. .Lenders names go on one axis and the terms on another – with a focus on the least expensive IRR. That’s the wrong approach from multiple levels. First, an entrepreneur should choose based on the reputation of the lender and the firm…especially in troubled situations. If you are off-plan and out of cash, no one on the board will remember the IRR. It’s at that point that you’ll learn the workout or work-through strategy of the venture debt firm first hand. I’d suggest doing some reference checks on the lender on the front end. CFO’s don’t get fired for choosing the wrong IRR; they get fired for running out of money.
Secondly, it’s just mathematically the wrong approach. CFO’s don’t want to calculate an IRR because that is looking at the deal from the lender’s perspective. You want to look at the deal from the entrepreneur’s perspective. The lender’s IRR ≠ the borrower’s cost of capital. If the money were equally valuable on both sides of the table, it would never change hands. The money needs to be more valuable to the borrower in order for there to be an economic incentive for the deal to happen. But how valuable is it? It depends on the desperation of the borrower.
Desperation comes in at least two flavors: 1. Companies that are financially hurting and; 2. Companies that are appreciating in value quickly. The first type of company wants to borrow to avoid looming disaster – this is often just postponing the inevitable but not always. The second type of company needs debt capital because the opportunity cost of taking equity is prohibitively expensive. The faster the company is appreciating in value, the more expensive equity is and the cheaper debt is in comparison.
The first step is to build the debt into your company’s f orecast model. Create one version for each of the term sheets that you are seriously considering. Here are some approaches:
1. Plan A: Look at the loan balance of the financing at your lowest projected point of cash. Venture debt amortizes so you need to look at how much cash the deal generates at the low-point of cash in the forecast. Which deal gives you the most cash when you need it?
2. Flame-out: Create scenarios that cause flame-out (lower revenues and margins till you run out of cash on a projected basis). This tells you how much room you have to make intelligent mistakes with impunity…something that is critical in the highly volatile land of emerging growth businesses. In some deals you’ll see that you have amortized most of the debt by the time you flame-out – no value created.
3. Covenant Thresholds: Take a look at your covenant thresholds – the point where you have just broken a covenant on your senior debt. Is your venture debt cross defaulted with your senior debt? What’s the reputation of the senior lender and venture debt firm in working through these situations? Again, how much senior debt and venture debt is outstanding at the covenant threshold?
In short which deals give you the most cash when you need it? You can then compare the economics costs to the liquidity created in each scenario. I can walk you through several other approaches…just reach out to Tim…contact data below:
Eastward Capital Partners
432 Cherry Street
West Newton, MA 02465
o: (617) 762-3611
c: (617) 947-6272
Eastward Capital Partners – providing $1 – 10 million venture debt, growth capital and equipment financing to venture-backed, emerging growth companies since 1994. We also provide expansion capital to non venture backed companies.