Playing with Fire

A few thoughts on Venture Debt in the light of recent news.

Last week there were two big news in the venture world from the west. The first one was:

Walmart acquired Modcloth

Debt, as most of you would know, sits on top of equity. As a result of this ModCloth faced trouble raising the next equity round after having raised a $20M debt round. In the end Walmart pounced and acquired the company for a great price (quoted at roughly $70M) right when the debt was due.

And then 6 days later, this came out:

Struggling music service SoundCloud raises $70M in debt

SoundCloud has been trying (unsuccessfully so far) to raise an equity round for some time now. But in the end it did not find a suitor and ended up raising the debt to survive.

So what do the two have in common? You guessed it. Venture Debt.

I decided to write about venture debt for early stage companies (read before reaching good unit economics). At GREE, we have done only one deal, as far as I can remember, where venture debt was used as an instrument to complement the equity round. This was very recent, so the story is yet to unfold on that one, but overall the contribution margins in the company seem good enough to support the debt. Due to my limited experience in this space, I decided to first start with some thoughts from industry leaders on this subject.

Fred Wilson:
I’m not a fan of venture debt for early stage companies. If the startup is getting the money because of the credit worthiness of my firm and the other firms in the deal, then I’d rather be putting more equity in instead and getting paid for my capital at risk. I’ve told this to every venture debt lender who has come to see me so it’s not a secret how I feel about this kind of funding.

Dan Primack:
(1) Debt is not inherently troublesome for startups, particularly if it’s supplementing equity as opposed to substituting for equity. But startups must recognize that not all cash is created equal.

Erin Griffith:
The best time for startups to raise debt are: (1) when the company is growing, but not fast enough to get a bunch of new equity investors interested, (2) when unit economics actually work but there is a valuation gap or management does not want to be diluted further, (3) when the company is close to profitable and equity is too expensive or will take too long to raise, (4) the company is more than ten years old and equity investors are tapped out in their older funds.

I think all of the above make a lot of sense. However, the Asian market is a bit different. There are only a handful of firms giving out early stage Venture debt in this region and they usually only come as part of syndicates or follow-on after a big equity investor (in the hopes that their principal at least will be safe and the equity investors won’t let the company die). As a founder, you usually don’t get the option of raising debt without a parallel equity round happening.

Let’s think of this from both the investor and the founder perspective. The debt investor will seldom put in money if it sees a possibility of company not being able to pay them back, usually the case when the company is not doing well. However, the debt investor will be more than happy to put in money when the company is doing well and has a strong equity investor backing it to be able to get (almost) guaranteed returns. In the latter scenario, the company will likely find equity investors giving it a fair value regardless and the founder doesn’t really need the debt investor. The only time I see this working from both sides is when the company is doing well, the equity investors enter a hot deal, and the founder is strong willed enough to push back on some equity dilution by taking on debt to part fund the capital requirements. It’s only the equity investor who loses in this case. And also the business model still needs to be strong enough to sustain the interest repayments, other wise the founder risks losing everything. It’s like playing with fire, and not all are meant to be fire artists.

‘How did you go bankrupt?’ Bill asked. ‘Two ways,’ Mike said. ‘Gradually and then suddenly.’ — Ernst Hemingway, The Sun Also Rises

For me, the below conditions must be satisfied to make it worth a company’s while to raise debt at an early stage.

1. Company has large working capital requirements, but doesn’t want to dilute further: some business models have intensive capital requirements, where funds need to be parked aside. Founders do not like diluting themselves in such cases and debt becomes a good option
2. Company has good enough unit economics to pay off the interest: if you are seeing Contribution Margins greater than your interest coupons and are positive that you’ll be able to generate the coupon from your cash flows then this starts looking like a good financial strategy
3. Company is growing: If KPIs are not doing well, and continue to be flat or declining, when the time comes to repay the debt the company might not be able to find an equity investor to cover the debt repayment. An exception is FourSquare as it managed to pivot to an enterprise company after raising debt capital. It did however end up taking a down round 3 years later. I would say it was lucky and whether or not it really ends up being successful remains to be seen still
4. Company is not getting the fair value from equity investors: If the current equity holders are not giving the founders what they (the founders) feel is the fair value and they are getting an offer from a debt investor, usually they end up taking the offer. This was what happened with FourSquare.

All in all, in very limited scenarios does it make sense to think of Venture Debt in my opinion. And even when you raise it, remember that you have to be prepared to withstand the heat.