I believe it is this: https://www.investopedia.com/terms/w/warrant.asp So an option, but one provided by the original company.
Health IT from the Investor’s Chair 7/9/14
From a recent HIStalk post:
CareCloud borrows $25.5 million from a growth capital lender. I’m never cheered by a company taking on debt just like I wouldn’t be thrilled about a relative signing up for a home equity loan, but I guess it’s good news to be found credit-worthy and to have your plan for using the money vetted by someone whose objectivity is inarguable given their interest (no pun intended) in being repaid.
Investor’s Chair Thoughts
Let me present an alternative viewpoint on venture debt. Debt can be a great part of a company’s capital structure. Let’s use my favorite fictional company, eEngageLytics, as an example.
eEngageLytics has an outstanding business with high recurring revenues and a good margin profile, but needs growth capital to continue to expand, hire more sales people and finally sponsor HIStalk! In fact, with an additional $25 million, it would grow even faster than it has to date, and I have a fancy business plan to prove it!
Rather than sell more shares through a venture fundraising though, I’ll finance it through venture debt, as that can be a much more capital efficient way of funding the company. This fact remains true even if I expect to raise more equity capital in the future: the longer I wait, the more eEngageLytics will grow, and the higher the valuation will be for a subsequent equity round. Raising some debt right away allows me to kick the can down the road a bit, perhaps until after eEngageLytics is actually profitable (another major valuation inflection point).
How does the debt versus equity math work? To help us understand more clearly, let’s start by assuming that eEngageLytics would be valued at $100 million in its Series C round. That would mean that the company would have to sell 25 percent of its equity to current or new investors to raise the $25 million it needs to support its meteoric (but achievable) growth plan. Not only would an equity capital raise involve diluting current investors (who would now own a smaller slice of the eEngageLytics pie), but there would likely be other restrictions and obligations demanded by the investors (such as a board seat or two, some kind of dividend and many other “bells and whistles” inherent in a Series C preferred stock).
Now, there are, of course, other costs and complications inherent in both options:
- Like all lenders (except maybe Mom), venture lenders charge interest – but we’re currently living in a very low interest rate environment, so the CFO must model out the difference between the interest payments from debt and the dividend payments that equity investors often require. Venture debt for a quality company like eEngageLytics is running between 5-9 percent of the total amount (varying based on how much and when I actually pull down the money from the $25 million commitment – another example of the flexibility of debt financing). Let’s call it 7 percent on average, so that’s a max of $1.75 million per year.
- Also unlike Mom, debt holders always want to be paid back – often before a liquidity event, so our company must have a way to pay back out of future cash flows (a topic our lender will obviously focus on).
- Venture lenders have other ways to get paid besides the interest payments. There’s generally a warrant component, which allows them to purchase stock at a preferred rate – but it’s typically less than 1 percent, so dilution is minimal (especially in comparison to an all-equity deal).
- There’s typically various fees associated with the debt commitment, similar to closing costs for a mortgage; but, again, they are typically fairly reasonable (in this example, the likely fee would be about 1 percent of the total loan amount and some end of term fee to the lender (around 3 percent of the aggregate amount loaned.) Contrast that to the 6-7 percent ($1.5 – 1.75 million) that an investment bank would generally charge for a capital raise of this size.
- Don’t forget, however, that the availability of debt of this size is highly stage dependent. When eEngageLytics was developing its products and getting its first few customers, it was a bad credit risk and could barely get a corporate credit card – hence its need to fund through equity. Now that it needs money “only” to accelerate growth and tide itself over until profitability (or to buy hardware, or to make an attractive acquisition, etc.), it’s a far better candidate for debt.
Taking the various fees and interest payments together, eEngageLytic’s CFO can generally calculate an effective interest rate (like my mortgage broker does) and we see that, in this case, I’m paying a fully loaded interest rate of 15 percent per year, inclusive of the various fees. That’s about $3.75 million per year. Factor in the effects of compound interest and it costs current shareholders $32 million to repay the loan (assuming they borrow the full amount over the three-year term we’re using for illustrative purposes).
Let’s now flash forward a few years and assume that I’m able to sell eEngageLytics for a cool half a billion dollars (maybe a national payer like Aetna or United will step up – they’re always good for that). Had we sold 25 percent of our equity, the earlier eEngageLytics shareholders would collectively receive gross proceeds of $375 million (75 percent of $500 million). Fortunately, however, the management team are regular HIStalk readers (or get good advice from other sources) and, realizing that the amount of money they raise in no way equals how cool they are, raises the $25 million in debt rather than equity capital. Factoring out the debt repayment discussed above, and eEngageLytics shareholders in this scenario receive $468 million, a whopping $93 million more (which will allow even Inga to buy a few new pairs of shoes!).
So, bottom line, I see using debt as part of a company’s capital structure as a powerful tool to grow a business while minimizing dilution to founders, employees, and other shareholders. Here in the Bay Area (as shown on the HBO series Silicon Valley with occasionally frightening accuracy), the size of one’s capital raise is often viewed as a proxy for all sorts of things – “coolness” being just one of them. The bottom line is that entrepreneurs need to consider all the costs and benefits of different sources and types of capital, and when it’s appropriate, to use each to fund a business.
Finally, to return to Mr. HIStalk’s home equity loan analogy: assuming I’m taking out equity for a good reason (say, to renovate my kitchen, not to go on vacation), I’d rather have to pay back the loan (debt) than have to share part of my house (or proceeds when I sell it) with another party if I allow them to purchase some of my equity instead. Debt has responsibilities that equity doesn’t (such as an obligation to repay), but it typically allows the borrower more control and the opportunity to maintain their ownership. Which option makes sense depends on the situation.
Ben Rooks spent a decade as an equity analyst and six years as an investment banker. He has many friends who are venture capitalists, but he’d rather see returns go to entrepreneurs then to investors! Five years ago he formed ST Advisors to work with companies on strategic issues, only one of which is capital structure. He lives in San Francisco and absolutely loves e-mail.
This is a solid explanation of why venture debt is (often) a superior financing mechanism for the founders and existing shareholders, but it ignores other stakeholders in the process. Adding leverage adds risk and a drag on the business that an equity raise would not.
eEngageLytics (which is not yet profitable) now has $1.75M less per year to spend on R&D or other development. They have a set of business covenants hanging over their head – which with a $25M default on the backend, is much more punitive than giving up a board seat to an equity investor.
Venture debt is like any other leverage – higher risk, higher reward. This is the founders and investors making a bet on their business, which you can’t blame them for. But for an unprofitable business like eEngageLytics, taking on venture debt instead of equity adds business continuity risk for its clients, employees and other stakeholders. Taking a venture debt deal at 2x trailing revenue seems like a pretty risky alternative to an equivalent capital raise.
Great, great post – thank you!
Thanks Debtor, you raise excellent points well worth consideration.
Thank you, Ben Rooks. This is a good description with examples that make a complex problem easier to understand.