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, while 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.
An Example From TV
Many 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. So let's look at a few of the things that are said. 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. 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.
Good Scenario
In the good scenario 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 in valuation. This translates into a final valuation of 67.5 minus debts with interest.
The 8.9% equity investment is now worth 6M, so it netted 3.5M and gave a roughly 140% return over the three years. In the pure debt scenario, you have a 40% return for net 1M. As we can see, there is a vast difference between the two numbers. The O'Leary option instead requires 563k in interest payments and 1.61M in equity for an 87% return with net of 2.2M. In each of these cases, the amount of money 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 increased returns.
As you can see, the deal O'Leary offered was not bad for the successful case. Miles Penn would have done better than with the pure equity scenario.
Bad Scenario
The bad scenario is that 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.
The pure debt stays the same with a 40% return for net 1M. Pure equity means you own the same 2.5M stake for a return of 0%. The O'Leary mix gives a 42% return for net 1.05M, so it is very comparable to the debt. As you can see in the bad scenario, the equity is the best outcome for the owner. And 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.
There is mention of venture debt and balloon payments. In our calculations, we didn't assume the debt is paid off at over the three years. Instead, we had debt till the end. The expectation would be that an equity fundraising round pays the debt. This kind of debt, which gets paid from investment rathen than from cashflow, is called venture debt . If you're raising venture debt, you need to have a high confidence that you'll be able to raise money in the future. Otherwise, you need to account for it in cashflow 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'd have to be good enough to ensure future funding rounds.
Bankruptcy Scenario
So far, we've called debt a safe investment for the investors. But the truth is, startup debt isn't that safe. If the company goes bankrupt, the lender will only get assets as a 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.
Wrapping Up
The dynamics in this episode are brilliant in understanding debt vs equity. The risks, and rewards to the investors and their implications to the owners are showcased in two minutes of conversations by experienced entrepreneurs. 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. Please enter your email to ensure you don't miss our next post.