TRINITY CAPITAL INVESTMENT SMART FINANCING: THE VALUE OF VENTURE DEBT EXPLAINED Alex Erhart, David Erhart and Vibhor Garg ABSTRACT This paper conveys the value of venture debt to startup companies and their venture capital investors. Venture debt is shown to be a smart financing option that complements venture capital and provides significant value to both common and preferred shareholders in a startup company. The paper utilizes mathematical models based on industry benchmarks for the cash burn J-curve and milestone-based valuation to illustrate the financing needs of a startup company and the impact of equity dilution. The value of venture debt is further explained in three primary examples that demonstrate the ideal situations and timing for debt financing. The paper concludes with two examples that quantify the value of venture debt by calculating the percentage of ownership saved for both entrepreneurs and investors by combining venture debt with venture capital. INTRODUCTION TO VENTURE DEBT Venture debt, also known as venture 2. Accounts receivable financing Venture debt is a subset of the venture lending or venture leasing, is a allows revenue-generating startup capital industry and is utilized worldwide.[2] type of debt financing provided to companies to borrow against It is generally accepted that for every venture capital-backed companies. their accounts receivable items four to seven venture equity dollars Unlike traditional bank lending, venture (typically 80-85%). invested in a company, one dollar is (or debt is available to startup companies could be) financed in venture debt.[3, 4] without positive cash flow or significant 3. Equipment financing is typically Therefore, a startup company should be assets to use as collateral.[1] There are structured as a lease and is used able to access roughly 14%-25% of their three primary types of venture debt: for the purchase of equipment invested capital in venture debt. such as network infrastructure, 1. Growth capital is typically manufacturing, R&D, etc. This paper will explore some of the structured as a term loan and most common uses for venture debt and can be used to replace or augment This paper will use the term “venture illustrate the value provided to startup an equity round, finance M&A debt” to encompass all three types of companies and their venture capital activity, or provide additional financing. However, it is important to investors following the introduction of two working capital. note accounts receivable and equipment important concepts: the cash burn J-curve financing are specific to companies and milestone-based valuation. All generating revenue or purchasing mathematical models and assumptions equipment, respectively. are included in the appendix. ©2016 Trinity Capital Investment | www.trincapinvestment.com 2 FIGURE 1 CASH BURN J-CURVE FIGURE 1: CASH BURN J-CURVE:TOTAL CASH NEEDED NET INCOMETO ACHIEVE PROFITABILITY PER QUARTER One of the most persistent challenges YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR5 YEAR 6 YEAR 7 for a startup company is to sufficiently $6M capitalize the business from the inception $4M of the company until profitability. Many recent studies have identified lack of cap- $2M italization as one of the primary reasons $0 businesses fail.[5, 6] Understanding the - $2M typical cash flow and financing needs of TOTAL CASH NEEDED a startup company is foundational when - $4M exploring the benefits of venture debt. - $6M The J-curve is commonly used to illustrate STARTUP PHASE Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Q9 Q10 Q11 Q12 Q13 Q14 Q15 Q16 Q17 Q18 Q19 Q20 Q21 Q22 Q23 Q24 the tendency of a startup company to produce negative net income initially, and then deliver positive results as the MILESTONE-BASED is helpful in illustrating the relationship company matures.[7] The typical startup VALUATION between capital raised and company company will take at least six to eight Many entrepreneurs turn to venture capi- valuation—the two most important factors years before becoming profitable.[7] [6] tal for financing as well as mentorship, in determining equity dilution. strategic guidance, and other support. Figure 1 shows the net income per quar- However, venture capital, as with all Figure 2 below displays the company ter for a startup company. While actual equity investment, results in equity dilution valuation over time for a typical startup financials will vary by company, the for entrepreneurs and existing investors. company. Progressively, the business is concept of increasing losses preceding Equity dilution refers to the reduction in rewarded for achieving major milestones increasing profits is common to most busi- ownership for a share of stock caused by an increase in company valuation. ness models. The negative net income by the issuance of new shares. Minimiz- Thus, the optimal time to raise funds is im- area above the “J” represents the total ing equity dilution is one of the most mediately following one of these valuation cash needed to achieve profitability. In compelling benefits of venture debt. drivers, resulting in less equity dilution for this example, the company will need a to- The milestone-based valuation model the same amount of capital raised. tal of $58 million of capital over 6 years. Most entrepreneurs find it takes more FIGURE 2 capital over a longer period of time than FIGURE 2: TYPICAL STARTUPTYPICAL STARTUPCOMPANY COMPANY VALUATION VALUATION OVER OVER TIME TIME expected to become cash flow positive. TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE Note the capital requirements and time- lines in this model are representative of SERIES C FUNDRAISING a company that develops and manufac- tures a product. While actual results will SERIES B FUNDRAISING VALUATION vary by company and industry, the lessons learned from the following sections will SERIES A FUNDRAISING hold true for any venture-backed startup. COMPANY VALUATION COMPANY COMPANY ©2016 Trinity Capital Investment | www.trincapinvestment.com 3 FIGURE 3 The milestone-based valuation model FIGURE 3: VENTURE VENTUREDEBT TO DEBT EXTEND TO EXTEND RUNWAYRUNWAY TO NEXT TO MILESTONE NEXT MILESTONE provides a framework that will be help- TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW ful in illustrating the value of venture DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE debt in multiple scenarios. SERIES C FUNDRAISING PRIMARY USES OF SERIES B FUNDRAISING VENTURE DEBT VALUATION VENTURE DEBT While there is no one-size-fits-all TO REDUCT EQUITY SERIES A approach to venture debt and each FUNDRAISING COMPANY VALUATION COMPANY transaction will vary on a case-by-case COMPANY basis, there are three common use cas- es for venture debt that demonstrate its benefit. Venture debt can extend the Use Case #1 cash runway of a startup company to: 1. achieve the next milestone/ Use Case #2: This is a great use of debt as it reduces valuation driver. Extend Runway to equity dilution for both employees and 2. become “cash flow positive.” Cash Flow Positive current investors, and propels the com- 3. provide insurance for potential pany forward during a critical Venture debt can extend the runway of mishaps or delays. period of growth. Alternatively, if a company to be “cash flow positive”. it were not feasible to completely Use Case #1: Let’s assume a startup company was eliminate their Series C financing, the Extend Runway to planning to raise their final round of company could leverage venture debt Next Milestone Series C equity financing once they re- to extend their runway long enough ceive their first revenue from customers. Venture debt can extend the cash to push series C out to an even higher Instead, the company could leverage runway of a startup company to valuation, reduce the size of round, venture debt following their Series B and the next valuation driver. This is per- or both. completely eliminate their last round of haps the most widespread use equity financing. of venture debt .[8, 9] Let’s assume a startup company was planning to raise a large Series B financing after devel- FIGURE 4 VENTURE DEBT TO EXTEND RUNWAY TO CASH FLOW POSITIVE oping their product. Instead, FIGURE 4: VENTURE DEBT TO EXTEND RUNWAY TO CASH FLOW POSITIVE the company could raise a smaller Se- TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW ries B and then leverage venture debt DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE to fund the company until it receives its first revenue from customers, ensuring Series C is raised at a higher valuation. SERIES B FUNDRAISING VALUATION Management and employees would VENTURE DEBT INSTEAD OF EQUITY SERIES A benefit from less dilution due to the FUNDRAISING smaller equity raise. Existing investors COMPANY COMPANY VALUATION COMPANY would also benefit from less equity dilution, or less cash required to main- tain their ownership position. Use Case #2 ©2016 Trinity Capital Investment | www.trincapinvestment.com 4 FIGURE 5 Use Case #3: FIGURE 5: VENTUREVENTURE DEBT DEBT TO TO PROVIDE PROVIDE INSURANCE INSURANCE FOR POTENTIAL FOR DELAYS POTENTIAL DELAYS Provide Insurance for TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW Potential Delays DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE Finally, venture debt can serve as a cushion for what can go wrong. For example, let’s assume the same SERIES B SERIES C FUNDRAISING FUNDRAISING VALUATION startup company in example 2 that was planning to raise their Series C financing SERIES A after producing revenue did not obtain FUNDRAISING VENTURE DEBT PROVIDES CUSHION COMPANY VALUATION COMPANY any venture debt. Unfortunately, their COMPANY customers, who verbally committed to purchase this year slip out to next year and the company doesn’t have enough Use Case #3 cash to last until then. The company still needs to raise a Series C, but now it FIGURE 6 will not be at the higher valuation they FIGURE 6: REVENUE PER QUARTERREVENUE PER QUARTER were expecting. In fact, because they missed their plan, it will likely be a YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR5 YEAR 6 YEAR 7 $70M penalizing down round.