When traditional companies approach a commercial lender or bank to request a loan, there are some clear guidelines on how banks decide how much credit to grant to a prospective borrower. In general, working capital lines are used to finance accounts receivable and your lender assigns a pretty standard 75-85% advance rate – making the size of the facility tied to your working assets and needs. For term debt, banks generally look for the business to have at least 1.2X Cash flow / current maturities of long term debt…leaving some room for cushion. If a business is generating $1.2M in cash flow and wants to borrow on a three year term loan, the loan amount shouldn’t exceed $3M …Cash flow of $1.2M / ($3M in term debt/ 3 years) = 1.2X Cash flow coverage. Some banks use different multiples but you get the general idea.
For technology companies, the working capital lines of credit pretty much work the same way as traditional companies in that the amount of your accounts receivable times your advance rate implies a maximum borrowing limit. Even if you set the amount higher, you would be constrained by your borrowing base formula. Sizing term debt for emerging growth companies isn’t so straight forward.
Cash flow in many technology companies is negative as the entrepreneurs are spending money to grow the business. While many companies forecast future positive cash flows, the potential variance from plan is pretty wide and generally takes longer and costs more than many companies predict. Future projected cash flows don’t necessarily materialize but the debt service is generally fixed on a schedule. Even when companies do perform to plan, they often add discretionary spending on marketing, sales and future product development to maximize their exit potential. Venture debt is very tempting – borrowers get a nice infusion of cash at the closing with minimal dilution but every day thereafter, the debt increases the burn rate. The question is how to optimize the leverage without going too far. Here are some qualitative questions to help zone in on an answer for your business:
1. What percentage of my burn rate am I willing to dedicate to future debt service?
2. Will that debt service impede my ability to raise future equity as investors want their cash to go into the business – not to a venture debt firm?
3. What’s my sensitivity analysis on my forecast in a downside scenario and can I service the debt?
4. How will potential acquirers look at the debt?
5. What’s the reputation of my lender when companies are off-plan?
Sizing venture debt facilities isn’t formulaic or uniformly performed. Lenders who have an incentive to deploy capital to meet sales goals in many cases, over-lever emerging growth companies with often painful results. Just because someone will lend you more than they should, doesn’t mean you should take it. The right amount of venture debt is a very effective financing tool – all good things in moderation.
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.
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