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Subordinated Debt or One Stop Shopping


In rapidly growing companies, every CFO knows the value of having a commercial banking relationship. Banks are a good source of low-cost financing as well a whole suite of other services. Banks have the infrastructure to provide lines of credit which can be used on an as-needed basis to minimize interest costs. In addition to providing short term working capital loans under these lines of credit, standby letters of credit can be issued as a replacement for a cash-security deposit on your real estate lease. It’s a capital efficient and cost-effective model and banks excel at providing emerging growth companies with financial solutions.

Venture debt used as a compliment to bank debt…

Venture debt firms typically provide additional venture debt on a subordinated basis behind the banks as an alternative to raising additional equity. Venture debt firms charge a premium in the form of higher interest rates and warrant coverage to compensate for the higher risk of being a subordinated debt lender. Let’s say you want to borrow $10M and the bank is willing to provide the first $3M. The bank charges you 5% interest and amortizes the debt over 36 months. Your monthly payment would be a little over $89k. A venture debt firm provides the remaining $7M at 12% interest and amortizes over the same 36 months. Your monthly venture debt payment is $230k. Your blended cost of funds is 9.9% (.3 X 5% + .7 X 12% = 9.9%) in addition to any warrants that are granted. That’s a very good deal compared to raising equity.

Venture debt used as a replacement to bank debt…

Some venture debt funds have tried to supplant these commercial banking relationships with large single-tranche or “unitranche” venture debt facilities. The venture debt firms pay off the banks and have a first lien on the assets of the business. These are sold as “one stop shopping” solutions or “lower blended-cost” credit facilities. Let’s say the venture debt firm lends the full $10M at 9% and amortizes over the same 36 months resulting in a monthly payment of $315k (vs. $319k in the previous example). Your blended cost of funds is 9% and that initially looks compelling vs. the 9.9% alternative. As the CFO you recommend the lower cost alternative to the board and you receive faint praise before they move on to more important agenda items.

Focus on the cash…not the interest rate!

Flash forward 12 months….Let’s say your company isn’t meeting its forecast in the near term. Cash is tight and the lender is getting justifiably nervous. They have a first lien on your assets including control of your bank accounts. Each month you pay out that $315k payment until you are forced to raise an equity round at what are likely to be unattractive terms (assuming the capital is available at all). This is in stark contrast to what would happen if you had chosen the first option. Under the first scenario, If the bank gets justifiably nervous, they have to satisfy themselves that you’re worth at least $3M and that the VC’s will support the company…you have a $3M problem – not a $10M problem. The bank can call a material adverse change default in their loan documents and stop the payments to the subordinated lender…your monthly payments drop from $319k per month to $89k. The subordinated lender is contractually obligated to sit on the sidelines until the senior lender, the company and the VC’s cure the default at the bank. After you satisfy the senior lender they can permit payments to resume on the subordinated debt. In an environment of frothy valuations and abundant availability of capital, it’s easy to lose sight of how you might find yourself short on operating performance at a time when you are also short on cash. CFO’s don’t get fired for paying a certain interest rate…they get fired for running out of money.

Tim O’Loughlin

Investment Partner

Eastward Capital Partners

432 Cherry Street

West Newton, MA 02465

o: (617) 762-3611

c: (617) 947-6272

www.eastwardcp.com

How to Evaluate Venture Debt Alternatives

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About venturedebt

venture debt firm providing growth capital for emerging growth companies

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Tim O’Loughlin

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