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THE TEMPTATION TO CONTRACT DEBT

• 29th April 2020

Is your startup cash-strapped? To pursue your plan and keep growing, you need to find ways to finance the acquisition of assets, fixed and current. Considering debt as the solution? Maybe you should. But also, maybe not.

Introduction: the role of corporate debt in the economy

Corporate debt plays a fundamental role in financing economic growth. Total global corporate debt, including bonds and loans, is approximately $66 trillion (Source: Global Research, March 30, 2020). Borrowing money for an enterprise is a conventional way to obtain cash and effect growth. In the EU and in the US corporate debt represents more than 70% of GDP in average. In terms of debt versus equity, there is a disparity between the two regions: US corporations show, in average, corporate debt amounting to about one third of total corporate equity, while in the EU, in average, debt amounts to more than half of total corporate equity.

Within each region, the whole spectrum can be found from unindebted, cash rich businesses to highly leveraged ones. Among the latter, debt could be a lifeline when raising equity is impossible.

1. Traditional Lenders and the Startup Risk

Traditional lenders, essentially regulated financial institutions such as banks, provide funding to businesses based on an assessment of a set of risks, of which the credit risk is the most important. They follow strict rules to evaluate the capacity of the borrower to honor its contract to pay interest and pay back the principal according to a determined schedule. Borrowers ’erratic cash flow and limited working capital are indicators that are often deemed the cause of default. This makes the world of high-technology startups an unlikely candidate for such funding.

Yet a few traditional institutions venture into lending to startups. Asset-based lending (ABL) is the instrument they use for qualified startups.

“ABL is a specialized loan product that provides fully collateralized credit facilities to borrowers that may have high leverage, erratic earnings, or marginal cash flows. These loans are based on the assets pledged as collateral and are structured to provide a flexible source of working capital by monetizing assets on the balance sheet”. (Office of the Comptroller of the Currency). For the borrower, an ABL facility is often more expensive than other types of commercial lending. Interest rates and loan fees are generally higher, and

a. Major categories of ABL
ABL encompasses short-term credit as well as long-term credit. Short-term when it finances working capital, long-terms when it finances fixed assets, both tangible and intangible.

i. Working capital funding
Asset-based working capital loans fund short-term operating needs, unless the cycle from order to delivery is long, as for aircraft manufacturers for instance. ABL provides fast-growing companies with the cash to fund growth by financing increases in receivables and inventory. It is the most valuable debt financing.


ii. Equipment leasing and financing
It is used for financing a physical asset, therefore it is a long-term financing instrument, with a 3 to 10 years horizon, depending on the economic life of the equipment. Equipment loans tend to be a relatively conservative type of financial product. In most cases, entrepreneurs should be able to demonstrate the ability to service the equipment loan or lease.

If the equipment to finance is rather unique, finding a lender to finance its acquisition will prove difficult, as the potential resale of the equipment in case of default would be more than challenging for a non-specialist.

b. requirement from the lender
Traditional asset-based lenders funding businesses including startups, have specific requirements, in addition to the collateral mentioned above. They want to make sure there is a strong sales record, as well as a strong business credit history, based on an established record of borrowing and repaying previous loans.

Startups become qualified when they have consistently generated significant operating cashflow compared to revenue, quarter after quarter. A two-year record with a minimum 7% ratio of cashflow on revenue would meet the requirements. Such requirement restricts the ability of startups to tap into this financing pool.

c. Pricing
The perception of risk is high for ABL because of the lack of financial performance, and the type of business, unless the lender is specialized in the industry of the business. It rarely occurs with startups unfortunately. Focusing on interest rate to evaluate the cost of a loan is misleading. Additional costs, such a loan administration and origination costs, paid as upfront fixed costs, render the overall cost of ABL quite high. Investigation, administration and oversight of the collateral is required throughout the term of the loan, involving frequent reporting.

Specialized ABL lenders, who are the ones with attractive value propositions to startups, have higher origination costs, as a percentage of transaction costs, than banks. These costs are proportionally higher for smaller credits.

d. Credit to early-stage startups with long-development cycle
Progress from startups with long cycle is harder to monitor for lenders who are reluctant to target them for their loan portfolio. Office equipment leasing facilities to startups are the only ABL that has been popular across the board, independent of the space or the stage of the business. Businesses with high burn rates easily find lease financing for this type of hard asset. Its cost is irrelevant when it acts as a liquidity breather.

2. Another Emerging Lending Option: Non-Traditional Lenders

a. Shadow banking
So-called shadow institutions that developed around the world in the last twenty years are unregulated financial businesses. They are not depositary institutions and do not have access to the support of a central bank as lender of last resort. Some shadow banking institutions extend credit to businesses who are not able to appeal to traditional lenders.

b. Peer-to-peer lending
Peer-to-peer lending is technically part of shadow banking. The parties arrange terms for a transfer of cash based on each side requirements. Theoretically, one can infer that it should be the ideal fit for early-stage startups that can craft its borrowing needs to minimize the pain on cash flow generation. Startups however must find the right match among lenders.

The main advantages of peer-to-peer lending are its transparency and a lower cost of borrowing compared to traditional ABL. It is still in its infancy and represents an infinitesimal part of global corporate lending, under 0.1%, though it is its fastest growing segment.

3. Venture Lending

Pioneered in the US by Silicon Valley Bank in the 1980s, later by Imperial Bank (now part of Comerica) and some years later by the famed fast-rising and fast-falling unregulated Sand Hill Capital, venture lending since the dawn of the 21st century has spread its wings to Europe and Asia. Venture lending is available only to venture capital-backed startups having raised at least a Series A equity financing. It is supplied by technology banks and unregulated venture debt funds. Venture debt is usually provided over a three-year term, or longer for biotech borrowers. In most instances, only interest payments are due during the life of the loan, and the principal is paid back at the very end of the term, easing the pain on cash flow for three years or more. Venture debt is generally senior debt. It gets therefore a preferential treatment over other outstanding obligations in the event of loan default. Venture capital lenders can then seize control of the company or its assets or force it to liquidate.

Venture lenders employ the same risk assessment tools than most bankers. The edge they have is in their domain knowledge in various technologies and their ability to do a good due diligence on the business, the management team and the quality of the technology. They certainly understand startups better than other lenders. This explains why, when the lender deems the risk quite high, intellectual property is used as collateral.

Unlike regular lenders, venture lenders underwrite loans based on the track record of the venture capital firms who invested in the borrower, and the amount of equity raised by the borrower in VC rounds. Most of the time, the venture capital investor assists in renegotiating terms in case of default, which can cost founders equity to be significantly reduced.

Pricing is a function of the risk profile of the startup. The interest rate charged by funds is higher than the rate charged by venture banks. It is not rare for funds to ask for a prime rate + 8 % as interest rate. Today (April 29, 2020) in the US, that would equate to 11.25%. Yet interest is only one part of the cost in venture lending. The price structure also includes stock warrants, to remunerate the risk to fund new, still unprofitable businesses. This is the only case when lenders trigger some dilution in startups. The level of dilution is in average between 1% and 3% of total equity.

Advantages of venture debt as promoted by lenders are:

I would somewhat agree with the first two points, and not more.

The negative aspect of venture debt appears when a new round of equity funding occurs: Investors finance the future. They will not agree to add cash to a company that will use it partly to pay back debt. To induce them to accept the situation, present shareholders, i.e. founders and investors, would have to agree to very favorable terms for the new round, triggering likely a severe dilution. That is exactly what lending was supposed to avoid. I found Howard Marks in an article on Forbes Magazine , on 5/13/2018, resumed clearly the main impediment to take on venture lending: “Many times companies find themselves in trouble before they succeed, and venture debt is a nail in the coffin. Equity is the safest route in every situation, but the cost can scare young entrepreneurs.”.

4. The Special Case of Emergency Bridge Loan Programs

Generally guaranteed by a government institution, it provides temporary relief to small businesses, including startups, following exceptional economic devastation. Its lower cost is attractive. It aims to maintain a lifeline to businesses distressed by a liquidity crisis. In 2020, many revenue-stage startups are bound to use such program.

5. The Lenders’ Pitch Bait

Lenders intent on addressing the difficult market of startups have built a very rational pitch based on five essential arguments.

a. Benefit of the deductibility of interest
Entrepreneurs are seduced by this advantage as it makes loans cheaper than equity.

b. Loans are non-dilutive
Entrepreneurs of fast-growing startups with an ambitious plan are always keen, sometimes too obsessively, to keep dilution of equity as low as possible. Their investors are even more paranoiac about it. I have memories of investors trying to force founders and management into borrowing to accelerate growth without diluting their shares, despite the potential danger it represented.

c. Loans can solve a liquidity crisis
Loans allow management to gain time to think through a permanent solution to their financial trouble.

d. Lenders can grant a grace period before triggering the pay-back period.
In some cases, companies with high visibility in upcoming revenues are facing a temporary gap in liquidity. Some lenders tailor a solution to ease the pain of the borrower by extending a grace period prior to the payment of the first instalment of the loan.

e. Startup businesses can build up credit ratings very quickly
This is a self-fulfilling argument. The more you borrow, the more you can borrow later, and the earlier you start, the better! Credit-rating agencies cannot hope for more!

6. Why we are staunch opponents of indebtedness in startups

Let us go back to basics, namely survival of the fittest. Lenders expect cash flow from borrowers’ operations to be acceptable to service the loan and the interest payments. If a borrower’s financial condition is deteriorating due to market changes, the seizure and liquidation of its working assets would accelerate its demise.

a. Balance sheet matters
Entrepreneurs must focus on maintaining a minimum of “orthodoxy” as to what makes a healthy balance sheet. Major among their worries is the constant availability of a minimum of working capital, never allowing long term assets to be funded, even partly, by short term liabilities.

b. Incidence on Value
By taking on loans, a business alters its valuation. Though EBITDA could actually increase if the cash injected fuels growth, uses of funds down the road will be applied to reimburse the principal of the loan, while pretax net income will be reduced by the amount of interest, ultimately reducing equity growth. In addition, as mentioned above, an outstanding loan on a company seeking equity funding makes matters difficult in subsequent financing rounds as it will affect the valuation accepted by potential new investors.

c. Incidence on growth rate
Growth is boosted by the intake of the loan, as it is its purpose. Down the road however the ensuing diminution of available cashflow will hamper the long-term growth, all things equal. If structural changes occur, as they usually do in startups in their initial development, the incidence on growth will be only a minor bump.

d. It is all about risk
Startups follow the best path for survival. If there is no recurring cash flow from operations, the business is still fragile and prone to fail if any additional burden is brought in. Early-stage startups must only raise equity to fund their development and early revenue stages. Inexpensive interest rates as those offered today do not represent an opportunity. Running a startup with a balance sheet devoid of financial liabilities for as long as possible must be a rule to abide by.

7. Options left to Startups in Dire Need for Cash

Common sense is not so common, said Voltaire. Hence, I dare offer below basic common-sense advice to startup founders and leaders tempted to taste the nectar of debt.

Startups are almost always in need of cash. In the same token, there is always a tier of investors ready to fund startup development and growth at each level of risk. Before starting to investigate the world of investors with an appetite for cash-strapped ventures, entrepreneurs must first seek to maximize working capital. It is a constant effort aimed at optimizing working capital requirement. Three main lines of action come to mind.

a. Reduce clients’ payment terms.
Seek customer financing as much as possible. As a startup your business offers a unique value proposition. Customers are eager to adopt your product or service. Without going as far as asking to share in the product development, it is not uncommon to ask for a full or partial down payment when the order is signed. This is of great help to hard tech startups who may have a long production cycle.

b. Extend payment terms to suppliers.
Startups have rarely any leverage on this parameter of working capital unless many suppliers compete for the account. Then payment terms can be used as a differentiator to select the supplier. It has more value than a slight variation in price.

c. Act promptly when any change in inventory turnover occurs.
I know many startups optimistically build inventories to fulfill the promise of budgeted revenue. Caution is of the order in this field. An idle inventory is costly.

d. In addition to these three levers, practice frugality with all operating expenses.
A simple dashboard can take care of it.

Last, if the call for a lifeline is urgent, turn to your present investors. They are the ones who know your business. A shareholder’s advance with some good incentive kicker works wonder. Debt is only your very last recourse, after all options have been exhausted.