Most of us are familiar with the fundamental difference between debt and equity. In both cases, you get some cash that you can use to fund your business goals. In exchange, you share some of the upside with the other party. With debt, the upside you share is a constant regardless of your outcome. In equity, the other party gets to participate in the risk with you. When exchanging equity, you share a more significant portion of the upside but are protected from the downside. In this article, we want to discuss how the basic logic between debt and equity plays out between founders of tech services companies.
Years ago, I saw this clip from the TV show Shark Tank. The exchange towards the end is a great example of understanding debt and its implications. The deal offered by Kevin O'Leary is 2.5M at 7%, with 2.5% of the company. This is a mixed debt and equity deal. Everyone agrees that it is a good deal. O'Leary calls it venture debt. But Miles Penn pushes back about not wanting to have a balloon payment and looking for equity partners. Immediately, all the sharks turn hostile towards him, saying that he doesn't have faith in his company.
So what happened?
Let's break down the offer, some alternatives, and possible scenarios for $2.5M in funding:
Pure Debt at a 12% interest rate.
Pure Equity at $20M pre-money valuation for 8.9% of the company
The O'Leary Offer which is both a debt at 7% interest rate but 2.5% equity.
Let's assume a good increase in the company's valuation. We aren't talking about the excellent scenario, so we're aiming for a relatively modest 50% increase rather than a mind-blowing 100% year-on-year increase. This translates into a final valuation of $67.5M minus debts with interest.
Now let’s look at how you’d fare under each of the financing paths.
Pure Debt: you have a 40% return for net $1M.
Pure Equity: your 8.9% is now worth $6M so it netted $3.5M and gave roughly a 140% return over three years. As we can see, there is a vast difference between the two numbers.
The O'Leary Offer: this requires $563k in interest payments and $1.61M in equity for an 87% return with a net of $2.2M.
In each case, the amount netted by the investor represents the amount that the founder did not get. So, you can see how the increased risk of equity investment gives the investor a bigger share.
As you can see, the deal O'Leary offered was not bad for the successful case. Miles Penn wouldn’t have had to share as much of the upside. Consequently, he would have done better with the O’Leary than with the pure equity scenario.
In the bad scenario, the company has a valuation of $22.5M minus debts three years later. This $22.5M corresponds to the post-money valuation at the beginning. This valuation will likely be based on an increase in sales but a slowed-down growth rate because of which nobody is willing to pay a premium.
What does the situation look like now?
Pure Debt: This financing stays the same with a 40% return for net 1M.
Pure Equity: you own the same $2.5M stake for a return of 0%.
The O'Leary Offer: this gives a 42% return for net $1.05M, so it is very comparable to the Debt financing option.
As you can see in the bad scenario, Pure Equity is the best outcome for the owner. That’s why when the sharks said he doesn't have faith in his own company, they implied that he’s expecting the bad scenario to be more likely.
In our calculations, we didn't assume the debt was paid off over the three years. Instead, we had debt till the end. The expectation would be that an equity fundraising round pays the debt. Debt that gets paid from investment rather than from cash flow is called venture debt.
If you're raising venture debt, you need to have high confidence that you'll be able to raise money in the future. Otherwise, you need to account for it in cash flow projections. He’d have to burn his entire war chest to get the growth Penn wanted.
This means he would not have been able to pay off the balance without getting additional funding. So his performance would need to not only be good enough to make the 2.5% stake and 7% interest worth it, it would have to be good enough to ensure future funding rounds.
So far, we've called debt a safe investment for investors. But the truth is, startup debt isn't that safe. If the company goes bankrupt, the lender will only get assets as part of liquidation. The lenders have priority over all other stakeholders but, for a tech services company, there are very few tangible assets. Because of the lack of collateral and the risk of a young business, it is difficult to get debt large enough to provide growth capital.
The dynamics in this episode are brilliant for understanding debt vs. equity. Two minutes of conversations by experienced entrepreneurs showcase the risks and rewards to the investors and their implications for the owners.
Debt is about controlled returns, and equity is about participating in the upside. Unfortunately, it is challenging for founders of tech services to get debt because they have minimal assets. We'll discuss more about tech services founders' options for debt in our next post.
We also encourage you to look into the Vixul Continuity Fund, a special fund set up to provide capital to emerging tech services companies.