If you’re in for a long race, venture debt financing could give you the air you need to get to the next peak in better shape. Photo courtesy of Christopher Michel.
Raising venture debt is always an interesting subject for startups. For some CEOs it is completely off their radar, and for others it is a taboo subject. In between these extremes, there’s a growing number of startups using venture debt effectively to buy time for a higher valuation, making it a cheap form (in terms of amount of stock it costs) of financing while the value of your company rises.
I thought we could shed some light into whether venture debt is a good thing for your company by creating a simple model you can use to project its long-term effects on your valuation and on your stock and explore if it makes sense for you. For a sense of the value of this exercise, under a relatively conservative growth scenario, Venture Debt could save the company from having to give away 3% of equity. Before getting into detail about how this model works, it’s worthwhile to spend some time reflecting on a couple of issues you will need to think through before raising money this way: covenants and purpose.
Covenants and Purpose
Many think that some banks and venture debt providers require excessive terms and may tie up the company with covenants that hurt you in the long-run. Our experience with this is that most of the terms and covenants can be negotiated, with the exception of the investor support covenant, which requires the venture investors of your company to agree they will continue to support the company or the covenant is triggered. Even the MAC (Material Adverse Change) covenant, which seems to be the most draconian of all because it gives the venture debt provider the option of not following up on their promise if there is a significant change in the company (based on their definition), can often be negotiated. What you need here is a supportive board that has a venture investor with venture debt experience, working closely with you and your CFO to ensure you get the best deal for the company.
Putting in place venture debt is best done right after a VC raise. You can usually structure it to pull the funds much later – and face only a small portion of the costs before pulling the funds. The goal is to have it available in the future in order to buy time for growth so that the next round comes a bit later, giving you more time to increase the value of your company. This means that growth should be the purpose for making your case to raise venture debt with your board. Emergency money or, worse, an excuse just to spend more, is what this kind of financing can unfortunately be wrongly associated with. Although if it comes down to using it in the event of an emergency, that can also be a valuable use, but in that case, it’s usually just to give another shot at pivoting and potentially save the company rather than juice value. In any event, raising venture debt with growth in mind, before you need it, will help you get better terms with debt providers and negotiate favorable covenants.
The basic assumption behind our model is that you’re raising venture debt for the purposes of growing. As such, the spreadsheet helps you look at two scenarios of growing: with and without venture debt. The results, once you input your numbers, are quite simple:
If there is a positive number answering these questions, then you should take a closer look at venture debt. We plugged in numbers to show you how it works, feel free to substitute these with yours (red fields are input fields and the two key outcomes are highlighted in yellow).
Click here to access the spreadsheet.
The model begins by assuming a venture raise just happened (Cash at the End of Period 0, $10 million in the example). In the example, you raise $5 million in venture debt, giving away 0.2% of equity (0.1% when you put the facility in place and the other 0.1% when you draw the money), and paying a setup fee of $30,000. Cash burn is the same in both cases ($3 million), except for the venture debt payments. The example assumes a valuation growth of 25% every period (in this case, every 6 months). Note that you pay the bank the initial fee ($30,000 in the example) even though you don’t draw the venture debt of $5 million until you need it in the third semester.
This model is built to show the debt enabling a six-month funding delay in your next round ($20 million in the example) and assumes the same valuation for both scenarios, as it is just comparing financing structures in isolation. The result in the example: you raised money at a valuation of $97.6 million in the last semester rather than raising it at a valuation of $78.1 million six months before. The net value saved was $3 million, leaving you with 3.07% in equity you can keep. Not too bad!
Does venture debt work for you?
If you plug your numbers into our model through this link (red marks indicate input fields), you will see the impact of using debt in addition to equity for some of your financing. The model buys you time, but you need to keep in mind that growth needs to happen.
Venture debt works when it buys you time for a better valuation because things are going well. You pay for this time with debt and not with equity, saving you equity in two ways: initially by raising debt, and then afterwards by using that debt to get to a better valuation. If your growth scenarios come to fruition, venture debt enables you to raise money a bit later than you would, when the value of your company is higher. That is a great deal if you’re good at forecasting. You can also explore the impact of the debt using different growth scenarios, thus further exploring the potential value or the downside. Have fun 😉
Are your sales people farmers or hunters (or maybe both)? Photo courtesy of Silicon Valley entrepreneur and photographer Christopher Michel.
A few weeks ago, our friends at Norwest Venture Partners (NVP) wrote an interesting article on how CFOs should approach sales compensation (Sales Compensation Leading Practices: Tips for Entrepreneurs Building Recurring Revenue Businesses, by Terri McFadden). We’ve seen how our portfolio companies share the pain of modeling for recurring revenue that Terri talks about when it comes to compensating their business development team. In her words, “recurring revenue can be a minefield for CFOs who are trying to figure out how to compensate their sales forces, she goes on to indicate that, “one false step can explode the ambitions of a company trying to establish itself in the market.”
You definitely don’t want to be DOA by not paying close attention to how to create a compensation plan that makes your SaaS recurring revenue business model one your team can sell effectively. We’ve come across clients who created a plan on the fly by relying on their accountants to model it, and undoing it is not fun. That’s why I found the NVP post quite useful to share and expand on in this article.
NVP wrote their article following a round table with two experts from Accenture – Kevin Dobbs, Everything-as-a-Service Practice Lead, and Mark Wachter, Managing Director of Sales Strategy. Below is what they learned.
Sounds straightforward, right? You would be surprised how many times this obvious action is ignored. I think the culprit is speed: your time as a CEO in a young company is spent on product and actual selling, so thinking strategically about compensation seems like a luxury you have no time for. Terri writes that “the complexity comes from defining your key success metrics, how they are tracked, setting goals, what success looks like and then how do you want to pay for these results.” This is exactly where you can use cover from a part-time CFO – all the points their article refers to are part of financial planning and support to tie your incentives and strategies to the fabric of your business model, and keep a close eye as they progress.
For most SaaS companies, hunters are their sales people and farmers are their customer success people. Even if they start out the same, eventually, you need to separate these two groups in your financials and then operationally. How can a part-time CFO help you here? Hunters and farmers need completely different incentives. Hunters go for the big fish; farmers nurture that catch and make sure they reproduce (think renewals). A CFO can help you model compensation to reward both groups differently, according to their incentives, and evolve that model over time as your business grows and your customer success people become more specialized. In practice, the process of designing incentives for different sales behaviors is one of trial and error, so that it can be evolved as these roles change. At certain stages in your trajectory, hunters farm and farmers hunt, and you have to track and evolve incentives around this dynamic with cover from a seasoned CFO that can see the world from the eyes of your sales team.
You don’t need to go to a round table to know that. However, our experience helping CEOs with strategic finance actually coincides with what the Accenture experts told NVP: “When it comes to setting quotas, most organizations don’t set sales quotas correctly.” Correctly is the key term here. All companies set sales quotas, but setting them in a way that works – and keeps working over time – is actually tricky. Low base/high commission? The reverse? On total ARR? New ARR? What level of quota? When to change them? Well thought-out quotas reflect key elements of actual performance such as the length of your sales cycle, how much control do your reps have on the sale, whether you price low to go in, the importance of renewals, etc. To add complexity to this, all these elements evolve over time, so they need to be fine-tuned to keep sales quotas effective at driving sales. A part-time CFO with experience working with sales teams can ensure you keep your eye on the ball regarding setting up and fine-tuning sales quotas for your team.
Thinking strategically regarding your sales machine from day one will result in more confident growth and will attract the best people to your team. Terri at NVP puts it well when she writes that, “If you want your own recurring revenue business to drive a smooth path to success, you must set up a sales and commission plan that works in synchromesh with your strategy and goals.” I would only add that a CEO and a VP of Sales can do it with less pain and more effectiveness with the help of a CFO who thinks about the long-term implications of sales compensation and helps them model incentives, compensation and quotas to grow with confidence.