Early Stage Deal Blog by Bill Payne

Debt financing is generally considered to be an inexpensive source of capital for business, especially when compared to equity, which involves giving up part of the ownership of the company.

Unfortunately, very little debt financing is available to early-stage entrepreneurs, because lenders expect loans to be paid back in a predefined and timely manner with interest. Furthermore, lenders expect borrowers to demonstrate their credit-worthiness by providing collateral, which in essence guarantees repayment. When buying a car or house, the asset itself is the collateral. Due to their inherent high risk and lack of liquidity, early-stage companies are not considered sufficient collateral for debt financing.

Loans from friends and family are often used as preseed capital for startup ventures. This debt is attractive because it often is available without interest and entrepreneur is not required to repay loans on any pre-arranged schedule. While particularly useful in the initial stages of a company, this source of funding is usually only available in small quantities, that is, less than $25,000.

HIGH GROWTH, BIG BORROWING.  Credit-card debt is available to many entrepreneurs and is collateralized by the earning capability of the borrower. This debt has the advantage of minimum repayment schedules that can be spread over months and years. This form of debt, however, is generally very expensive and is also normally available only in total volume of less than $25,000 for each individual.

Many high-growth companies require more than $100,000 of capital to achieve the positive cash flow necessary to grow on internally generated funds. For these entrepreneurs, the primary sources of capital are equity investments, which requires giving up partial ownership of the venture in exchange for the funds necessary to grow the company.

The most common sources of equity capital are angel investors and venture capitalists. (I myself am an “angel,” having invested in some 25 early-stage companies, after selling my own company, Solid State Dielectrics to E. I. DuPont Nemours in 1982).

However, we often hear about two other forms of debt financing for entrepreneurs, namely, convertible debt provided by early-stage equity investors, and bank loans to venture-backed companies. What follows is an examination of each of these sources of capital.

Convertible Debt from Equity
It is common for equity investors to structure early-stage investments as convertible debt. Since the conversion from debt to equity is almost always at the option of the lender, most entrepreneurs consider this a form of equity investment and therefore an expensive source of capital.

Convertible debt has all the rights of debt financing, requires reasonable interest payments (often deferred), and can be converted to common or preferred stock, depending on the structure of the deal, at the pleasure of investors, usually upon triggers signaled by the success of the company. The value of the company at conversion is predetermined and is often based on a modest discount to the pricing of a future round of investment. Conversion is often triggered when the company closes a substantially larger round of equity investment, usually from venture capitalists.

Investors insist upon, or agree to, convertible debt financing for a number of reasons. Debt is a lower risk investment than equity, that is, in the case of the liquidation of the company, lenders are ahead of shareholders for repayment. All debt generally must be repaid prior to any liquidation to shareholders.

Convertible debt instruments allow lender/investors to enjoy a modest return on investment as interest (often deferred) with all the upside opportunity of shareholder after conversion. Structuring a convertible debt financing is relatively easy — hence, legal fees for completing this form of investment are substantially lower than conventional equity investments. Much of the legal expense is deferred until the time of conversion, which is usually at the time of the closing of a subsequent round of equity investment.

Bridge loans are often structured as convertible debt. Bridge loans are debt usually funded by earlier investors to provide the entrepreneur with sufficient cash to “bridge” the time gap between running out of earlier raised capital and the closing of a round of new funding for the company. Since new investors prefer that all new funds be used to grow the company (and not to repay debt), bridge loans are often converted into debt at the closing of the next subsequent round of equity financing.

Compromise and Convenience
In general, convertible debt is often a compromise between entrepreneurs and investors, when they can’t agree upon a valuation for the company at the time the loan is closed. In this case, the investor believes the company is worth less than does the entrepreneur. They agree to a convertible loan, which is priced at the closing of the next subsequent round of equity investment and a discount, usually 10 percent to 30 percent of the valuation of that next round of investment.

Some angel investors prefer this form of investment, as they fear investing at too high a valuation, only to see a subsequent institutional investor price their deal at a lower valuation, resulting in very unfavorable dilution to the earlier stage investor. These can also be considered bridge loans to the next round of investment.

Convertible notes are also a convenience to investors, since they generally remove the risk of equity investments at valuations that prove to be too high. However, in many cases, pricing the conversion at a small discount to the next round can be unfair to the early-stage investor, when closing the next round takes much longer than anticipated, or when the valuation of the company is growing rapidly. One could conclude then that convertible debt limits both the downside risk and upside potential for these investors.

Bank Debt for Venture-Backed Companies
In the past decade, a few banks across the U.S. have been providing debt financing for companies that have secured equity capital from venture capitalists. The most well known is Silicon Valley Bank. However, other banks are also sources of such debt financing. Not surprisingly, this debt is available primarily in regions of the country where venture capitalists are particularly active, such as Silicon Valley and near Boston.

This debt is used by high-growth, later-stage companies to supplement venture capital in rapidly ramping up growth, and is often available to companies that can quickly pass the break-even point in cash flow necessary to pay back the debt. The banks that offer this debt depend on the due diligence of trusted venture capitalists to validate the quality of the management team and the business plan. The size of these loans is often proportional to the amount of venture capital raised by the company, perhaps 20 percent to 30 percent of the amount of equity capital, depending on the quality and maturity of the company. This debt financing would likely be a combination of equipment loans and a line of credit.

These banks buck the trend by lending to entrepreneurial ventures for a number of reasons. First, they are lending in concert with known and trusted venture capitalists. Second, in addition to relatively high business interest rates, these bankers usually require “warrant coverage,” that is, the opportunity for the lender to purchase stock later, once the company is successful, at very attractive pricing.

By making many such loans to venture-funded companies, they can achieve an attractive supplemental return on their investment from the equity piece (warrants) of these debt packages. It is important to add that these banks have ongoing relationships with venture capitalists and their limited partners and are developing strong banking ties with exciting companies who often become major bank customers over many years into the future.

BOTTOM LINE.  While a few banks offer debt financing to venture-backed companies, it is important to put this source of funding into perspective. While more than 500,000 companies are started each year in this country, only 1,000 solicit their first round of venture capital, and only a fraction of that 1,000 also receives bank financing from these sources. Although bank debt is a very attractive source of funding for entrepreneurs, it is available to only a very small number of entrepreneurs each year.

In summary, debt financing in amounts greater than $100,000 is not available to entrepreneurs starting and growing new ventures until the assets of the company can collateralize the loan. Some debt financing in these amounts is available to a few selected venture-backed companies. In a very few regions of the country, modest debt is available to entrepreneurs from non-bank entities, but these sources are very rare indeed. Finally, convertible debt and bridge loans are debt instruments provided by equity investors and are considered by entrepreneurs to be a variation of equity

Reprinted courtesy of EntreWorld.org

Angel investors have long been a primary source of financing for companies at the seed and start-up stages. However, in the recent past, as venture capitalists have backed away from funding enterprises at these early stages, angels have become recognized as the primary source of funding at this stage of company development. What’s more, having in the past largely operated individually and behind the scenes, they are now banding together in groups, enabling them to share information about companies worthy of funding and pool their collective resources.

These developments have significant ramifications for today’s entrepreneurs. While founders must still toil diligently to present to investors a business plan that signifies a clear competitive advantage for their product or service, the fact remains that they now have easier access to angels. A group with which I am involved as an entrepreneur-in-residence at the Ewing Marion Kauffman Foundation (which sponsors the EntreWorld Web site), called the Angel Capital Association, has even endeavored to join together some 60 angel groups in order to facilitate the sharing of information.

As a former entrepreneur and now an angel investor for many years, I have observed these trends with great interest. A look at the forces driving these trends might help entrepreneurs understand this altered financing environment — and thus more intelligently pursue the financing they need for their companies.

Financing trends

At its heart, the recognition that angels are the primary source of seed and start-up financing can be traced to recent trends in financing on the part of venture capitalists — that had once been heavily involved in funding start-up companies.

•Venture capitalists invest at later stages

In the past eight years, from 1995 to 2003, venture capitalists have been making more investments in companies at the expansion and later stage and far fewer in those at the seed and start-up stages. In fact, VC funding for fledglings has dropped precipitously since the mid 1990s, with fewer than 200 companies a year receiving VC funding during the past three years.

Let’s look at the numbers that underlie this development. Today, nearly half of all venture capital is invested in funds with at least $1 billion in assets under management, whereas, in 1995, no venture capitalists were managing assets of that amount, according to Venture One, a research group that tracks the industry. During this period, the total amount of venture capital has increased tenfold, while the number of principals managing such funds has not increased proportionately. With more money to invest and fewer venture capitalists for each dollar under management, the average round of venture investment has more than doubled to $7 million in 2003 from $3 million in 1995.

With venture capitalists committing more money to each investment, they have tended to invest in more mature enterprises, those that have demonstrated the value of their products or services and seek additional funding for expansion. Indeed, whereas the average VC investment in a seed or start-up company is now $2 million to $3 million, later investments in these same companies are substantially larger. Specifically, in 2003, the average early stage investment was $4.5 million compared with $7.3 million at the expansion stage. For entrepreneurs launching new companies, the numbers make an undeniable point: VCs aren’t the investors to be approaching in the seed and start-up stages.

•Angel investors solidify their hold on seed and start-up stage investments

While the data for angel investing isn’t as definitive, these individual investors have put $15 million to $30 million a year into new companies in the past decade, with rounds averaging $250,000 to $750,000, according to the Center for Venture Research (CVR) at the University of New Hampshire. Some 30,000 to 50,000 companies a year have been recipients of funding from angels during this period.

Significantly, more than half of all angel dollars have been invested in seed and start-up companies, with the bulk of the balance going to existing portfolio companies at later stages of development. In 2003 alone, angels invested $18 billion in 35,000 companies, according to CVR. Of that total, they put 60%, or $11 billion, into an estimated 20,000 companies at the seed or start-up stage. That compares with VCs’ investments of only $400 million into 181 fledglings during the same period. The comparison is as startling as the message is clear: angels continue to solidify their hold on the funding of start-up companies.

Group dynamics

Some angel investors have created a new model, banding together in groups, or networks, in an effort to seek out and adopt best practices, improve due diligence, and utilize standardized term sheets. In 2003, some 200 such groups were in operation, compared with less than 20 in 1996, according to estimates by the Kauffman Foundation and also by CVR. Indeed, Kauffman’s latest effort to consolidate the groups into the Angel Capital Association represents an acknowledgement of the value of refining investing techniques, adopting robust processes, and sharing information about deals among fellow investors.

In addition to joining networks, angels and networks of angels have become willing to syndicate deals among themselves and also in collaboration with venture capitalists. Indeed, the sophistication of mature angel groups hasn’t gone unnoticed by venture capitalists, especially those that still consider investments in early-stage companies. In the case of Tech Coast Angels, a network of angel investors in Southern California, for example, more than 20 venture associates routinely scrub deals and invest alongside the group’s members. Venture capitalists appreciate the robust process adopted by angel organizations and recognize that angels serve as critical mentors and board members for start-up companies. In addition, by investing alongside angels, the venture capitalists set the stage for leading subsequent larger investment rounds.

Benefits for entrepreneurs

For the entrepreneur, these recent trends in the funding environment contain enormous advantages. Angel groups tend to publicize their application processes, making access easy for entrepreneurs who no longer need to find angel investors one at a time. For those that survive the rigorous screening process adopted by the Tech Coast Angels, to take one example, entrepreneurs are able to make their case to upwards of 200 potential investors.

Finally, given the cooperation between angel groups and seed VCs, and also among the angel groups, including the willingness to syndicate, that netherworld of the $2 million to $5 million investment is finally being addressed. Entrepreneurs will be increasingly able to secure funding for these amounts.

In sum, the news is good on the financing front for entrepreneurs seeking dollars for seed and start-up enterprises. The challenge for these founders will be to thoroughly understand today’s angel investing environment and to position their companies to take full advantage of these exciting developments.