Understanding the optimal amount of debt in negative Cash-Flow generating companies with a quick benchmark.
Author: Lucas de la Vega for Medium.
After some years working as a credit investor (including Venture debt) I am afraid to tell you that there is no golden rule for the optimal leverage.
By signing a Venture debt you’re making a commitment with the lender to pay back the amount received in the agreed terms and conditions (interest and principal repayment).
The best proxy to understand the repayment capacity is the probability of default.
However, small Tech companies’ prediction of default has found important limitations as some of the critical inputs correspond to qualitative variables. Likert-type, intervals, scales and many other analyses were proven unfruitful predicting default rates in Venture debt portfolios.
Therefore, the simplest way to determine the optimal leverage in negative Cash Flow companies is common sense and a thorough bottom-up analysis of the company.
The classic approach to evaluate the credit profile of a company is to benchmark your company metrics to the most relevant indebtedness ratios:
Again, the problem for many of these companies is that these ratios are not applicable within the Negative Op. Cash Flow generation spectrum.
Consequently, the analysis should be focused in challenging the strength of the company business plan and probability to determine whether a company will be able normalize these ratios in the mid-long term.
As a quick reminder, it is always too much debt when there is no positive Cash Flow generation. Maximum leverage of your company should be set at some point were your financial ratios start making sense in the mid-term (18–24 months) with mild growth expectations (10–15% top line growth YoY).
Classic credit ratios should be used as guidance in the long run. However, there are some significant metrics that are frequently used by Venture debt investors to determine the present credit worthiness of a business.
The AGroS Rule
I tried to put down some of these relevant metrics to create an easy application matrix for negative Cash-Flow companies. This will help us to understand the optimal leverage.
First part of the matrix is composed by a Credit Scoring (see left) over some qualitative items. These are some of the most common metrics to determine the resiliency of a business (namely the probability of default) and its ability to generate substantial returns (turn-around the negative Cash-flow situation).
- Cash in hand and runway. The lesser you need the money the easiest you will be able to find it. Aside the historical probability of default (see Demystifying Venture Debt)
Runway = Cash in hand ÷ Monthly Net Cash Burn)
The major indicator for probability of default is runway. For this reason, the classic situation of a Venture debt is to top up an investment round which may enlarge the runway to sustainability.
2. Visibility to breakeven. The most important metric for Debt providers. Breakeven should be visible in the upcoming 12–18months. Endless negative cash flow business should not be financed through debt unless the company has a strong roadmap of equity financing with current investors.
Diminishing monthly negative Cash burn and Ebitda Margins are a good metric to understand future trends of a company. This is often a discussion point among Venture Capital (chasing growth) and Venture Debt (looking after profitability).
3. Powerful Structural Margins. Contrarian to Venture Capital, Venture debt needs the loan to be amortized in the mid-term (12/36months) and therefore would prefer powerful unit economics (i.e. Software) rather than business where revenues are driven by volume (i.e. Marketplaces)
Software business (80% Gross Margin) with €1m revenues and 80% growth (YoY) obtains a €0,45m (3y bullet loan). By the third year we can see a normalization of ratios flowing the standard credit metrics (see above)
All else equal, a Marketplace business with a 150% growth (YoY) will struggle to refinance its position in the third year due to a still negative leverage.
4. Residual Value. Lenders differentiate from equity capital providers in their risk appetite. Understanding the residual value of you company will enable you to repay debtors in case the cash flow of the business is not enough.
Try to understand the residual value as a percentage of the loan granted to the company. Bear in mind that residual value is often triggered after insolvency.
Residual value on pure tech companies is often close to zero as their assets are mainly intangibles and other non-marketable items. However, some PropTech, Fintech or Hardware companies may have an increased residual value given the nature of their assets in balance sheet (i.e. Real Estate, Pool of credits).
The Growth Nemesis
The only reason to finance Negative Cash Flow companies is growth. It’s the lever to future profit and will enable the company to pay-back debt and equity capital appreciation. Unfortunately, growth in companies is meant to follow a logarithmic function and is expected to flatten over time.
There is a well-known rule for healthy growth in Tech companies (mostly used in SaaS), Brad Feld stated that:
Adjusted Growth =Net Revenues growth (%) + Ebitda Margin (%) > 40%
Based on this Adjusted Growth metric and the prior qualitative scheme I set up the following matrix (AGroS-Adjusted Growht to Sales) to determine optimal leverage through the level of net sales of your company (not GMV).
As mentioned before, Venture debt lenders are at ease in the negative profit companies spectrum. This determines that Venture debt requires a top line growth of at least c.40–50% (lower than traditional Venture Capital) in order to find appealing companies looking after financing.
To comply with the 40% Adj. Growth with the minimum Negative Ebitda Margin (i.e. -5%) growth should be at least c.45% (YoY)
Matrix is presented as a percentage of sales of the company; it is intended to be used on a LTM basis. Growth is already accounted in the upper side of the table.
This formula would not enable any leverage to pre-revenue companies. Tech companies should validate product-market fit and have recurrent sources of revenue before incurring into Venture debt financing.
We will take the prior Software company as an example. The qualitative scoring is set at 11 points (see Notes) while adjusted growth is at 40%. Final number within the AGroS matrix is 45%
45% x €1m (LTM Sales) = €450k of Total debt capacity
Leverage (at 0.7x) and other credit ratios will become sustainable over time (3y) and the company would probably not have problems with refinancing or repaying its debt (see above).
This is a just a quick proxy to leverage. Optimal leverage in your company which should be at ±30% the calculated amount but every company should make its own assessment.
Besides, I strongly encourage all companies to have a back-up plan in order to face its obligations. The same way poker players crunch their numbers in order to succeed companies should make their own risk assessment.
Being able to fold back in a certain number of geographies, limiting your growth expenses or selling away different business units could eventually save your company in case you do not meet your growth expectations.
Concentration of default
As long as music keeps playing and there is liquidity in the markets (equity-rounds, bank financing and public funds) you should be able to refinance your debt commitments and continuously expand the business.
However, the resilience of your business and the correct capital structure will be tested under difficult circumstances, see below the Dot.com crash (2001) or Subprime Crisis(2008–09). Growing a business from scratch takes time and you’ll definitely go through very hard times along the way, hope for the best but expect the worst.
To sum up, Venture debt should not be seen as cheaper equity but as a complement to balance the equity capital at a lower cost. Neither should it be used as a rescue financing or as a last resort.
Venture debt is a handy financial instrument to be used carefully in order to boost growth and smooth the bumpy road of entrepreneurship. It is ideally designed for expanding businesses grounded in strong fundamentals and relevant track-record.
The analysis is limited to 10 to 70% adjusted growth ratio as a simplification as the vast majority of fast-growing companies with negative Cash-flows would fall into this spectrum.
Implicit limitations to the AGroS matrix are: (i) companies seeking breakeven in a longer period than 18 months may not apply unless further capitalization is expected to take place.
Score (Software Co.): (a) We assume that the runway is in between 6m and 12months. The negative Ebitda is €-0,5m and the Net debt is at -€0,2m. Three points (b) We can see from the Ebitda that company is 12months from breakeven. Four points (c) Strong unit economics as a Software company. Three points (d) Low residual Value on the transaction. One Point