A couple of years ago, Sarah Tavel from Bessemer Venture Partners wrote a piece on evaluating the true cost of venture debt. You can read her post here…http://www.adventurista.com/2009/01/true-cost-of-venture-debt.html It’s a useful way of evaluating the cash impact of amortization on a debt deal. In the end though, she solves for the wrong variable to evaluate the true cost. So how do I calculate the true cost of venture debt? Hint: don’t reach for your calculator, reach for your wallet! It will help to look at the cost of a VC investment for some perspective.
What’s the cost of a venture capital investment? If a VC invests in an early stage technology co mpany and ultimately achieves an IRR of 40%, that’s considered a great outcome and it is. Would anyone say that the cost of the VC investment to the entrepreneur was 40%? No, that’s the IRR from the VC’s perspective – not the entrepreneur’s.
VC IRR ≠ Cost of the deal to the entrepreneur.
What did the VC investment cost the entrepreneur? In order to determine the cost (on a forecasted or retrospective basis) the entrepreneur needs to model the company’s performance under at least two scenarios: 1. Exit value with the VC investment; 2. Exit value without the VC investment. The entrepreneur can then look at his/her individual share of the company and determine which one puts more value into their wallet. There are countless variables that need to be sensitized here but most entrepreneurs get the basic concept without needing to be coached to the right way to analyze taking a venture investment. Now back to debt….drum roll please…
The process is exactly the same. Because debt deals have interest rates, you may be tempted to calculate an IRR. That’s mathematically wrong because it looks at the deal from the lender’s perspective. The entrepreneur will want to model the company’s performance with each of the term sheets that you have for venture debt options. Which one works the best? Which one results in a greater exit value for the team and investors? Factor in the interest only period, the rates, fees and economic terms. Factor in the reputation of the lender.
In addition, factor in the impact of the deal on your ability to raise more capital. To all of the CEO’s that tell me that they don’t need to raise another round, I say “Remember that World War I was the war to end all wars…didn’t exactly turn out that way.” When you approach new investors, will they be afraid of the increased burn rate from the amortization? Worse yet, will they be scared away by a maturity date on a note on the horizon with no amortization schedule (bullet loans).
The true cost of venture debt is measured by looking in the entrepreneur’s (and other stakeholders in the company) collective wallets post exit. That’s the economic impact net of the costs! The answer is measured in dollars …not in percentage rates. You can’t spend percentage rates.
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Eastward Capital Partners – providing $1 – 10 milli on 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.