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Venture Debt For Startups

I always thought it was crazy for early stage companies to take on venture debt.  Here's a company that just raised $5MM of venture capital, is burning $300K per month and they think it's smart to raise debt?!?  I admit that my view is colored by my one experience raising venture debt in 1999 which did not end well (for anyone).  So recently, I decided to take a look at venture debt and talked to about a dozen lenders, quite a few startups and some other industry experts.  To my surprise, I found that in some cases, it does make sense.

First, a bit about venture lenders.  Various estimates put the number of firms that have serious venture lending businesses at 20-30 in the US.  My take is that there are three categories of lenders: (1) banks, (2) dedicated funds with "stable capital" and (3) dedicated funds without "stable capital."  By stable capital, I mean a fund that raises capital from limited partners similar to a venture capital fund.  The capital is committed for a specific period of time (like 5 or 7 years or more).  Bank-backed venture lenders are regulated and tend to invest in less risky areas (like capital equipment or receivables financing).  Dedicated funds tend to be more aggressive and invest in "growth capital" (more on this later).  The permanency of capital is an important factor as this can have an impact on the borrowers stability of capital and the willingness of a lender to work with the borrower should the company hit a rough patch.

For startups, there are three main types of venture debt: (1) equipment financing, (2) receivables factoring and (3) growth capital.  There are other types of borrowing (e.g. acquisition financing, but I'm focusing on these three categories for now).  Equipment financing is borrowing tied to a specific capex purchase, e.g. building out a NOC.  Receivables financing is useful for companies that have material A/R against which they can usually borrow as much as 80-85%.  Growth capital (also referred to as "stretch equity") has availability tied to venture metrics and is useful when the startup can use the extra capital to reach specific business benchmarks beyond those achievable with equity financing alone and that will provide a material step up in valuation (or insurance that they meet those already committed to).

Some key terms/rules-of-thumb for venture debt include:

• Availability: A/R factoring - up to 85% of receivables; equipment financing - up to 100% of specific capex; and growth capital - up to the cumulative amount of capital invested by the lead investor (minus any other debt).
• Repayment: 3 to 12 month interest only period followed by up to 36 month interest plus amortized principal period (i.e. up to 48 months).
• Rates: For working capital financing, a good rate would be prime +1% and for growth capital, a good rate would be prime +3%.
• Warrants: Expect 6-12% warrant coverage on growth capital.  That means take 6-12% of the loan principal and convert that into an at-the-money warrant to purchase an amount of shares at the price of the last equity round.
• Covenants: With growth capital, you can avoid them (including a "MAC" clause), however, most working capital loans will have them.

The process for raising venture debt is straight forward.  The borrower will require some material (which you probably already have from raising your last equity round) including:

• Powerpoint pitch deck
• Financials since inception
• Current cap table
• Board approved forecast
• 1-hour meeting with the CEO to get the "pitch"

After reviewing the materials and the initial meeting above, a lender will issue / negotiate a term sheet.  Once accepted, that will be followed by a half-day diligence meeting with the management team, legal documentation and closing.  The whole process typically takes 4-6 weeks from term sheet to close.

So in terms of who to borrow from, my assessment is that banks will offer the best price but on the least favorable terms.  The dedicated funds will offer the most flexibility, but will cost more.  Consequently, I'd go to banks for equipment or receivables financing, but to the dedicated funds for growth capital.  If you think you'll need both (i.e. both equipment/receivables financing as well as growth capital), I'd go to the dedicated funds for growth capital first and then work w/ banks to get additional financing later.

With that, I'll wrap this up with a few other comments in FAQ format:

• When should I raise venture debt?  The best time to raise growth capital is in conjunction with or immediately after raising a round of equity, i.e. when there is the most capital in the company.  It can be done at other times, but often with less favorable terms.  More lenders will require a minimum of 9 months of liquidity in the company before investing and look to add an additional 4-6 months of runway.
• What is a "MAC" clause?  It stands for Material Adverse Change and is a protection for the lender to call the loan principal in the event the company hits a rough patch.  For growth capital, this should be avoided at all cost.  Something as simple as the founder leaving the company could result in your loan being called.
• What collateral do I need to pledge? Many lenders will seek a blanket lien against all of the company's assets (with the exception of equipment financing which may be secured against specific assets).  This can be avoided with some non-bank lenders.  Sometimes lenders will "split the baby" and take a lien on non-intellectual property assets.
• How many bids should I get? I recommend companies focus on 3 to 5 lenders maximum.  Soliciting bids beyond that is time consuming and ends up sharing sensitive information too broadly.
• Is the recent market volatility/credit squeeze affecting venture lending?  The short answer is yes.  Less so with the dedicated funds, but some lenders leverage their investment by borrowing "wholesale" and lending "retail" and you have to imagine their liquidity is being squeezed along with everyone else.  You should expect terms to tighten and prices to rise.  If you think you will be in the market for venture lending in the next 6 to 12 months, consider borrowing now to get better rates/terms.
• What diligence should I perform on the lender? The most important question to ask is, "what were your three worst deals and who were the venture investors involved in them?"  I would then use my existing venture investors to check out the lender with the equity investors who have experience working with them in a troubled situation.  One third to half of every venture lenders portfolio will eventually have some sort of trouble, so learning how they behave in these situations is probably the best diligence you can do.
• How much equity does a venture lender end up with at an exit?  Typically the lender ends up with less than 1% of the total equity.  If they end up with more, it was probably a work-out situation.
• How much is too much debt?  Most lenders will tell you that too much is when debt service exceeds 30% of monthly cash burn.  You should target 10-20%.
• What about using brokers/advisers? I highly recommend using a "buyers rep" or adviser in the process.  There are people who specialize in this and having the experience of someone who's done 30 deals in the last 6 to 12 months is well worth it.  The cost is minimal.  If you're interested, I know of a great adviser I'd be happy to recommend if you inquire.

WikiFraudsters Beware!

CalTech computation and neural systems graduate student Virgil Griffith (pictured) recently launched WikiScanner which cross references all of the anonymous postings on Wikipedia with a database that matches IP addresses with the organizations that own them and put the searchable results online revealing some interesting, if not fraudulent behavior.

There are over 34 million anonymous posts by nearly 200,000 organizations.  It will take some time, but I'm sure some embarrassing behavior will be unearthed.  Wired magazine already has posted some finds that raise eyebrows including:

• BBC censors excerpt from BBC-commissioned report criticizing the BBC's tendency to self-censor.
• McKinsey & Co. deletes criticisms that they "...restate the obvious with business jargon."
• Blockbuster inserts advertisements into its own page.
• And my favorite, the Baltimore Orioles dis pitcher Sidney Ponson as being a "fat...disgrace."

I suspect this won't be the last we hear from the WikiScanner!

Don't You Love It When Science Fiction Becomes Reality?

The cars in iRobot were cool, but this makes the Segue look like a 30-year old Huffy 10 speed!

Board Management Tips for Startup CEOs

Startup boards are very different beasts than those of mature companies. For CEOs, it is an important and often underestimated part of their job to manage the board..."What? I have to manage my boss(es)?" For first time CEOs, it’s often the a new thing that they have to manage 4, 6 or more bosses at the same time. So with that in mind, here are a few tips on managing a startup board:

(10) Create an agenda/calendar. It is good form to schedule board meets for the entire calendar year. How many depends upon the stage of the company, but for most venture-backed startups it varies between 6 and 12 (not counting the unscheduled board calls for things like financings and acquisitions). Once you close your Series A, you’ll probably start with monthly meetings. If things go well, by the time you close your Series B, you’ll still have monthly "meetings," but every other one might be a call instead of an in-person meeting. By Series C, you’ll be either down to 6 meetings per year (if things go well) or back to once per month in person (if things don’t go well).

Anyway, for monthly meetings, try to keep a format something like “third Thursday of the month” so that you can keep a regular spacing between meetings (otherwise you’ll inevitably end up with board meetings three weeks apart and nothing really new to discuss).  This will be tough for your VC board members, because all 8 of their portfolio companies will be trying to do the same thing. It is also a good idea to indicate on the board schedule when certain major topics will be discussed, for example, review of first half performance versus budget (July), strategy review (September) next year budget (November), compensation plan (December), etc.

(9) Be prepared. It is easy to underestimate the preparation time required to have a good board meeting, particularly for companies that just raised their Series A and are starting formal board meetings for the first time. The initial meetings will require more time, but as you get a format and rhythm down, less time will be required. Initially, as CEO, you’ll probably need 1-3 days (spread out over about a week) to prepare for each meeting. Your CFO will probably need about the same amount of time, or perhaps a little more. And then, depending upon what your business does and its stage, you will probably need about a half day from the head of sales, CTO or head of operations/service. Other functional heads will only need to spend time if they are preparing for a specific agenda item like product strategy review. You typically want to start preparation 2 weeks before the meeting (which gives you about a week after the end of the last month in which to get preliminary numbers for the previous month).

(8) Deliver materials early. There is nothing more frustrating for a CEO than the fire drill board package creation the night before the meeting (and there is nothing more annoying for board members than not being able to adequately prepare for a meeting). For startups, best practice is to get the package out 3 days before the meeting (so if the meeting is Thursday morning, the package goes out Monday). Two days is acceptable and anything less is bad form worthy of a rebuke.

(7) Don't bring the whole crew.  There is a temptation to invite your entire management team to participate in board meetings, particularly when the company hits a rough patch.  Don't.  You will want to invite certain managers to the meetings (head of marketing and sales in particular for Series B-ish companies), but do that judiciously and only for a portion of the meetings.  For the most part, you will want to meet with the board without your team for the majority of the time.  Be explicit in the agenda when you expect your team to attend and when not.

(6) Make sure the financials are accurate and well presented. Ideally, your head of finance should own the financials and operating metrics part of the board package. However, the finance function is typically a role that early stage companies hire junior people into who don’t have a lot (or any) experience presenting to boards. If that is the case, I’d recommend getting an experienced startup CFO to join your advisory board with the specific task of helping organize the financials and review the financial package. I recommend sending the financials as a separate package from the board presentation.  Also, allocate time in the preparation process for a review of all the figures and include a fresh set of eyes where possible. Inaccurate numbers can kill a board’s confidence in management.

(5) Keep a consistent format. Be consistent both in format and in the presentation.  For example, don’t change the presentation of the sales pipeline for each board meeting. Keep the discussion in the same order from meeting to meeting and use the same terminology.

(4) Preview big news. Part of effective board management is previewing big news one-on-one with board members, particularly “bad” news. While it takes time to do, it ultimately shortens the decision cycle as you can address issues and questions that would otherwise come out in a group session (and require follow up in another group session). On the other hand, don’t stretch out previews too long, lest the issue gets "tired."

(3) Be Transparent. Every startup has bad news that comes along with the good, hopefully more of the latter. The key is to be completely transparent from day one and continue that as the business grows. Boards will naturally gravitate to the bad news, but be careful not to personalize it and begin to couch information to avoid getting beat up in a board meeting. Key to this is delivering accurate and timely financial reporting as well as other key business metrics. When in doubt, disclose.

(2) Be optimistic but balanced. You wouldn’t be at a startup if you weren’t an optimist, but be careful to not drink the whole glass of Cool-Aid. Your board members, particularly VCs, are as concerned with what can go wrong as well as right, more so in the early stages of the business. For example, when discussing last month’s (or quarter’s) sales wins (which every CEO loves talking about) also discuss sales losses and postponements and when talking about the next release, also discuss problems in delivery.

(1) Demonstrate that you (and the business) are in control. Overall, you want to use board meetings as a forum to show that you are in control and so is the business. If you have delivered materials early, then you should expect that board members have read them. You should not spend time walking your board through monthly bookings and cash burn figures. Obviously, board members can (and will) ask any question they want to, so if you find yourself fielding questions mostly about minutiae, it probably means your board is worried you (and more importantly, the business) are not in control. Plan your presentation, speaking tone and body language to deliver the message, "I'm in control."

How to Pitch the Press

Guy Kawasaki blogged about this panel put on by Redfin on the topic of startups pitching the press.  It's an hour-long video (so grab a cup of coffee), but helpful in addressing the issues small companies wrestle with when trying to get press coverage.  Panelists include TechCrunch, WSJ and others.  It's nice to see the tables turned on journalists where they're having to *answer* questions!  Some of my favorite bits include:

• Journalist: "PR companies suck the life blood out of startups."
• If you get asked a question you don't want to answer, like "what is your revenue?" respond in one of two ways: (1) be straight, e.g. "I can't comment on that right now, but I can tell you how big and how fast this market is growing..." or (2) if appropriate, ask if you can answer the question "on background" (as opposed to "off the record").  On background means that the fact can be used if corroborated by someone else, but not attributed to you.
• What happens if you misspeak and say something silly or absurd?  You beg for a retraction and you definitely do it personally (i.e. don't send in your PR firm to clean up your mess).

Topics Covered On This Blog (So Far)

Taking a page from my friend Noam Wasserman's playbook, I'm posting a categorized summary of some of the content on my blog.  So here goes:

Raising Venture Capital:

Dating...er...Fundraising Etiquette
How to Get Introduced to VCs
Top 10 Tips For Entrepreneurs Pitching VCs

On Startups:

10 Things To Consider Before Joining a Startup
Interview with Professor Noam Wasserman
Sales Learning Curve
Startup Compensation
Startup Entertainment
It's Lonely at the Top?

Industry Commentary:

Death of Headhunting
I Need a Social Network Aggregator!
Overjustification Effect and Web 2.0
Plaxo 3.0
The Future of Job Recruiting?
MIT $100K Business Plan Contest

Personal Commentary:

2007 University of Michigan Solar Car Team
Alternative Energy No Longer Just For Tree Huggers
Just When You Thought You Were A Good Dad
I want That Job!

Plaxo 3.0

I have been a user (and fan) of Plaxo for a long time.  For those not familiar with Plaxo, it provides a contact synchronization service between Outlook, LinkedIN, Gmail, Yahoo, mobile phones and more.  Recently, they launched version 3.0 of their product and with it a new strategy of being what I call a giant "European plug adaptor" for personal information.  For anyone who has traveled Europe, you know the hassle of dealing with all the different standards of plugs.  I have (had) the same problem with all of my personal information and Plaxo has elegantly solved that problem.  For a few dollars per month, they provide a very valuable service.

I mentioned in a previous post how Plaxo works great synchronizing between Outlook and LinkedIN.  Not only does it save me time otherwise spent updating, it delivers real value by automatically finding and updating information that I would otherwise not know.  Looking at their product strategy, I'm sure it won't be long before Plaxo offers synchronization with Facebook and other social networks where users have personal information. 

With 15 million users and growing, Plaxo is well positioned to become the "social network aggregator" everyone has been buzzing about lately.  There is a hint of this with the introduction of the new "Pulse" feature which filters, blogs, Amazon anf Flickr for information about people in your contact list.  A personalized filter of the web...very cool!  I have discovered blogs by people I know using this feature and it allows me to keep abreast of what my network is interested in. 

Keep an eye on Plaxo, I think we'll see great things from them.