Smart Financing: the Value of Venture Debt Explained

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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 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 VALUATION 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 VENTURE DEBT FUNDRAISING 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 VALUATION COMPANY basis, there are three common use cases 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

Management and employees would VENTURE DEBT INSTEAD OF EQUITY SERIES A benefit from less dilution due to the FUNDRAISING

smaller equity raise. Existing investors VALUATION 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 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 VALUATION 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. Venture debt could have helped bridge this gap until $60M the company is back on track. $50M

VALUE OF VENTURE DEBT $40M $30M The final section of this paper expands on these general use cases and $20M quantifies the value of venture debt by $10M calculating the percentage of ownership saved for entrepreneurs and investors. 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 following examples are based on a complex model developed by Trinity FIGURE 7 Capital Investment. The model demon- FIGURE 7: NET INCOME PER QUARTERNET INCOME PER QUARTER strates how small changes in the timing YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR5 YEAR 6 YEAR 7 and structure of a startup company’s cap- $6M italization plan can significantly impact $4M ownership percentages for both common and preferred shareholders (representing $2M founders, employees and investors). $0

- $2M Let’s consider a startup company that is planning the same net income ramp - $4M as depicted in Figure 1. Figures 6 and - $6M 7 show the company’s revenue and net income plans, respectively. 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

©2016 Trinity Capital Investment | www.trincapinvestment.com 5 FIGURE 8 All mathematical models are driven FIGURE 8: EQUITY ONLY EQUITYCAPITALIZATION ONLY CAPITALIZATION PLAN PLAN from the net income J-curve depicted in TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW Figure 7. In the following examples, it is DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE assumed the company produces revenue $20M at the first point of a positive delta in net SERIES C income, which occurs in the fourth year 185 M $27M of operation. SERIES B 105 M $15M Figure 7 shows the company plans to SERIES A burn roughly $200,000 per quarter for 37 M COMPANY VALUATION COMPANY VALUATION COMPANY the first year and then steadily increase expenses until revenue is achieved in year 4, at which time quarterly losses Example 1 decrease until the company becomes profitable in year 6. The company ramps Series A investors. Common shareholders If the company raises each round as revenue to over $50 million per quarter would likely include founders, employ- planned, at the end of their Series C in year 7, where revenue is assumed to ees, and friends and family that provided financing the founders and employees be 10X net income, or conversely, the seed funding. would own 37% of the company and the company produces net income equal Series A investors would own 25%. to 10% of its revenue stream. (10% is a TABLE 1: OWNERSHIP typical number for most profitable com- BREAKDOWN–EQUITY ONLY Example 2: panies.) Refer to Appendix B for more Common Series A Capitalization with details on model assumptions. Shareholders Investors Equity and Venture Debt Founding 100% 0% If the same company would plan a smaller Example 1: Series A 59.5% 40.5% venture debt round after each equity Capitalization with financing, they could raise less equity over- Equity Only Series B 41.3% 28.2%* Series C 36.9% 25.2%* all while still providing the business with In this example, the company plans more capital and a longer runway during *Assumes Series A investors do not invest pro to capitalize the business with equity rata in future rounds. Refer to Appendix B. each raise. But more importantly, they only, without any venture debt. would benefit from less equity dilution. Figure 8 shows the company plans to raise $15 million in Series A to develop FIGURE 9 FIGURE 9: EQUITY ANDEQUITY VENTURE AND VENTURE DEBT CAPITALIZATION CAPITALIZATION PLAN PLAN their product, $27 million in Series B to develop their marketing and sales TECHNOLOGY PRODUCT MARKET & SALES REVENUE CASH FLOW DEVELOPMENT DEVELOPMENT DEVELOPMENT GROWTH POSITIVE channels, and $20 million of growth $16M capital in Series C once they sign their $15M DEBT SERIES C first set of customers. 191 M $15M $10M SERIES B DEBT To minimize dilution, the company plans 111 M to raise each round of equity immediately $15M $6M following each major milestone achieve- SERIES A DEBT 37 M VALUATION COMPANY ment. Table 1 shows the ownership VALUATION COMPANY percentages at the end of each equity financing for common shareholders and Example 2

©2016 Trinity Capital Investment | www.trincapinvestment.com 6 In the previous example, the company IN CLOSING [4] Darian M. Ibrahim, “Debt as Venture raised a total of $62 million without any Capital”, William and Mary Law School, Venture debt is a smart and critical venture debt. In this example, the com- 2010, 1179. source of capital for today’s entrepre- pany raises a total of $77 million with neurial companies. As a complement to both equity and debt financing. Example 2 [5] David M. Townsend and Lowell W. equity financing, venture debt provides requires more capital because debt service Busenitz, “Resource Complementarities, growth capital to extend the cash runway payments are factored into the company’s Trade-Offs, and Undercapitalization in of a startup company in order to achieve expenses. Additionally, the company is Technology-Based Ventures: An Empirical the next milestone while minimizing utilizing venture debt to provide a longer Analysis”, 1. equity dilution for both employees and in- runway as an insurance policy. vestors.[9] Venture debt can be structured [6] Patrick Gordon, “Venture Debt: A as a term loan, accounts receivable line TABLE 2: OWNERSHIP BREAKDOWN – Capital Idea for Startups”, Kaufman of credit or an equipment lease and can EQUITY AND VENTURE DEBT Fellows, 1-3. be provided by a variety of lenders. Common Series A Shareholders Investors [7] Christian Diller, Ivan Herger, Trinity Capital Investment is a leading Marco Wulff, “The Private Equity Founding 100% 0% provider of venture debt financing. J-Curve: Cash Flow Considerations from Series A 59.5% 40.5% For more information, please visit Primary and Secondary Points of View”, Series B 51.5% 35.1%* www.trincapinvestment.com. Capital Dynamics, 19-21. Series C 47.4% 32.3%* Trinity Capital Investment has produced *Assumes Series A investors do not invest a short video, The Value of Venture [8] Leader Ventures, “Venture Debt pro rata in future rounds and debt terms Debt Explained, to accompany this include 6 months of interest only payments Overview”, 6. followed by 36 months of fully amortizing white paper. The video is available on payments at a 12% interest rate. YouTube at www.youtube.com/c/ [9] Brian Feinstein, Craig Netterfield, Refer to Appendix B. trinitycapitalinvestment. and Allen Miller, “Ten Questions Every By layering in smart debt along the way, Founder Should Ask before Raising the founders and employees would own Venture Debt”, 2. 47% of the company after Series C and REFERENCES the Series A investors would own 32%. That’s 17% more ownership for employ- [1] Rich Bowman and Stefan Spazek, ees and investors due to venture debt. “Best Practices for Sourcing Venture Debt”, Capital Advisors Group, 1 Note this analysis assumes all debt capi- March 2012, 1. tal was provided by traditional venture debt funds and does not incorporate [2] Simon Walker and Barry Vitou, any lower cost debt from senior lenders “The Rise of Venture Debt in Europe”, such as technology banks, which would British Private Equity and Venture further minimize dilution. Though outside Capital Association, May 2010, 5-6. the scope of this paper, combining venture capital with both senior and subordinated [3] Gaétan de Rassenfosse and venture debt will ultimately provide more Timo Fischer, “Venture Debt Financing: debt capital at a lower blended cost, re- Determinants of Lending Decision”, sulting in maximum ownership savings for Strategic Entrepreneurship Journal, both common and preferred shareholders 2016, 1. in a startup company.

Cash Burn J-Curve (Figures 1 and 2) cash burn and net income loss are between quarters, which means Nix-1 is the lowest net income per quarter. The cash burn J-curve depicted in Figures both $200,000 per quarter for 1 and 2 is based on a model devel- one year. • In Figure 9, milestone based valuation oped by Trinity Capital Investment, and • Series A financing occurs in the prior to Series A, B and C financings includes the following assumptions: first year of operation, following are assumed to be $20M, $59M, and technology development. Series B $65M respectively. The post-money • Following company formation, occurs in the third year of opera- valuation after each round would cash burn and net income loss are tion, following product develop- include the milestone based valuation both $200,000 per quarter for ment. Series C occurs in year five, and the size of the equity raise. one year. This represents a typical once the company begins to ramp period in which the entrepreneurs revenue. • Revenue based valuation is assumed to are self-funded, prior to a Series A • Following Series A, quarterly net be 3X revenue. Revenue based valua- financing. income is represented by the fol- tion is used once its value exceeds the lowing formula, where q repre- previous milestone based valuation. • Series A financing occurs after sents the number of quarters from one year of operation, and ex- Series A investment: • Financing terms provided by debt penses grow as the company hires 2 lender include 6 months of interest only personnel and purchases neces- NI = 0.05q + (-0.95)q + 0 payments followed by 36 months of sary equipment. • Quarterly revenue is calculated by: fully amortizing payments at a 12% –using the net income value at • Following Series A, quarterly net interest rate. income is represented by the fol- the end of year 7 (NI24) and assuming the revenue at that lowing formula, where q repre- • It is assumed Series A investors do not point (R ) will be ten times net sents the number of quarters from 24 invest pro rata in future rounds. Series A investment: income (R24 = 10*NI24).

2 NI = 0.05q + (-0.95)q + 0 –using the value of R24, the revenue for each quarter is Appendix B: Model Assumptions calculated by the following for Ownership Percentages formulas:

(Figures 8 and 9) x ∑ q=2 for ( NIq - NIq-1 ≤ 0 ), then: It should be noted that all assumptions for revenue and the revenue based valua- Rq = 0 tions are derived from the net income J-curve. Therefore, the only true variable Or, net income is still growing is the J-curve itself. more negative until q = x.

The final examples depicted in Figures After that, 8-9 and Tables 1-2 are based on the ∑ 24 for ( NI - NI > 0 ), then model developed by Trinity Capital q=x q q-1

Investment and include the following NI - NI q q-1 assumptions: Rq = * R24 + Rq-1 NI24 - NIx-1