The Value of Debt in Your Startup

Most technology and life science entreprenuers know they have fleeting windows of opportunity to successfully develop and ship their concepts to optimize their economic gains. Given the frantic pace in our ever accelerating world, the old economy notion of incremental growth supported by internally generated cash flow (profits) runs counter to the need to beat today’s competition to the punch. For this reason, third party investment, often from established venture capitalists, is commonly used to quickly add critical financial, human and physical resources to a start-up company.the value of debt in a startup

Despite current market conditions, access to early stage capital by U.S. early stage technology and life science companies is very strong.   Presently, hundreds of U.S. venture capital firms have billions of committed capital for start-up companies. So with all this capital available, where does debt fit into a start-up?

Debt, usually in the form of equipment financing and working capital, is often used to augment invested capital. This practice provides shareholders with less ownership dilution and a longer “runway” before the next equity “event” is required. Debt reduces the owner’s overall cost of capital.

Role of Equity

Typically, equity dollars are used to rapidly hire the people needed to build out the product, market and sell the product, and manage the overall corporate processes. Equity is sometimes used to acquire complementary businesses or assets that are not otherwise eligible for debt financing. With the introduction of third party equity, the company usually provides a seat on the board of directors for the investor. The directors are expected to help with all aspects of the business, but are heavily relied upon for recruiting, business development, strategic planning and financing activity.

Due to the inherent risks, investors who fund early stage companies receive a hefty percentage of the company. In exchange for their venture dollars, investors obtain ownership ranging from 25% to 45% of the company with the initial (Preferred Series A investment) equity event. The byproduct of a venture investment is the founder/s now has/have a smaller piece of a bigger pie.

Venture capitalists take high-risk positions with their venture dollars, investing millions and spending countless hours nurturing a fledgling start-up. Therefore, the economic return to third party investors has to be attractive. Over the years, a solid benchmark for annual venture capital returns is 20%. Of course, actual results from year to year can swing wildly, as witnessed by performance of funds before and after the March 2000 meltdown of Nasdaq.   To attract funds from limited partners, returns on venture investment are expected to exceed that of safer investments such as bonds, public equities and money market.

Role of Debt

Debt, usually provided by banks and leasing companies, is commonly used to support asset growth. Asset growth includes additions to capital expenditures, accounts receivable and, to a lesser extent, inventory. Occasionally, providers of debt can fund working capital needs just prior to closure of an equity event, to support acquisitions or for longer term working capital.

When debt is added to the capitalization pool, the financial resources available for the shareholders increase. For example, when using term debt to buy equipment, the company avoids using equity dollars. This means the equity dollars can be used for other purposes; adding additional staff and/or extending the period when the next equity event will be required. Extending the need for the next round of financing – even 30 to 90 days – by using debt financing can be critical. This extra time can allow management to achieve key technical milestones, close on crucial hires, ink a strategic alliance or add a new high profile reference account so as to positively influence the level of interest and valuation of the next round from investors.

It is not atypical for a venture fund to write off up to 25% of its investments due to failed businesses. Obviously the “upside” enjoyed by venture funds on the remaining 75% of their portfolio must be strong to generate the 20% annual returns noted previously. Equity investors are repaid through liquidity events such as IPOs or a sale of the business.   Lenders, especially banks (who are regulated) have far less tolerance for risk than equity investors. The commercial banking industry has a bad debt average ranging from .25% to .75% of loan portfolio. Therefore, banks have to “be right” over 99% of the time. Leasing companies generally have a somewhat higher threshold for losses than banks, but cannot begin to absorb the level of losses a venture firm can withstand. Debt providers expect to be paid back, whether from cash reserves, liquidity events, positive cash flow or sale of assets. Given this lower appetite for risk, lenders can accept less return on investment than equity investors. This means that the cost of debt to a start-up is inherently less than the cost of capital from investors.

Additionally, debt dollars are not tied to control issues at the board level. While many debt providers require warrants, the percentage of a company given up by shareholders to obtain debt is far smaller than given to shareholders, representing usually .25% to .5% of the company versus the 25% to 45% noted above.

 

The following illustrations demonstrate how debt can leave greater ownership of the company for incumbent shareholders.

 

Example #1 – Without Debt

 

Year 1                                    Year 2                                    Year 3

 

Sales                                    $             0                        $ 2,000                        $ 10,000

Net Profit                        $     (500)                        $   (500)                        $         0

 

Equipment                        $       200                        $     400                        $   2,000

A/R                                    $           0                        $     300                        $   1,700

 

Total Assets                        $       200                        $     700                        $   3,700

 

 

New Debt                        $            0                        $            0                        $            0

 

Total Debt                        $            0                        $            0                        $            0

 

New Equity

Capital                                    $       700                        $   1,200                        $   3,700

 

Total New Equity            $       700                        $   1,900                        $   5,600

 

Retained Earnings            $     (500)                        $   (1,000)                        $   (1,000)

 

Total Equity                        $       200                        $       900                        $   4,600

 

PreMoney Value                        $   700                                    $     6,000                        $ 30,000

(3X sales except Y1)

 

Beg # shares                               500                               1,000                               1,167

Price per share                        $     1.40                        $       6.00                        $     25.71

PreMoney/# shares

 

New Equity Capital            $     700                        $     1,000                        $     3,000

#new shares issued                   500                                 167                                 117

 

 

Founders Shares                   500                                 500                                 500

VC Round A                               500                                 500                                 500

VC Round B                                                                     167                            167

VC Round C                                                                                                         117

Total Shares                             1,000                               1,167                               1,284

 

Post Money Value

(# shares X Price)            $   1,400                        $     7,002                        $   33,012

 

Founder Ownership               50%                            43%                           39%

 

Value of Founders             $       700                        $     3,011                                $   12,875

Ownership

 

Example #2 – With Debt

 

Year 1                                    Year 2                                    Year 3

 

Sales                                    $             0                        $ 2,000                        $ 10,000

Net Profit                        $     (500)                        $   (500)                        $         0

 

Equipment                        $       200                        $     400                        $   2,000

A/R                                    $           0                        $     300                        $   1,700

 

Total Assets                        $       200                        $     700                        $   3,700

 

 

New Debt                        $       200                        $     400                        $   1,000

 

Total Debt                        $       200                         $     600                        $   1,600

 

New Equity

Capital                                    $       500                        $     600                        $   2,000

 

Total New Equity            $       500                        $   1,100                        $   3,100

 

Retained Earnings            $     (500)                        $   (1,000)                        $   (1,000)

 

Total Equity                        $           0                        $       100                        $   2,100

 

PreMoney Value                        $       700                        $     6,000                        $ 30,000

(3X sales except Y1)

 

Beg # shares                               500                                 857                                 943

Price per share                        $     1.40                        $     7.00                        $   31.82

PreMoney/# shares

 

New Equity Capital            $     500                        $       600                        $     2,000

#new shares issued                   357                                   86                                   63

 

 

Founders Shares                   500                                 500                                   500

VC Round A                               357                                 357                                   357

VC Round B                                                                       86                               86

VC Round C                                                                                                             63

Total Shares                               857                                 943                               1,006

 

Post Money Value

(# shares X Price)            $   1,200                        $     6,600                        $   32,000

 

Founder Ownership               58%                               53%                               50%

 

Value of Founders       $       696                        $     3,498                                 $   16,000

Ownership

 

In the simplified examples above, the Founder improve their ownership position from 39% to 50% of the company after three rounds of third party equity.