Why Venture Debt, and Why Now?

Interview with Alkarim Jivraj, Espresso CEO featured in the TakeOver Magazine. Republished with edits.

The technology sector continues to be one of the main drivers of economic growth – globally, and certainly within Canada. Indeed, tech companies, specifically those focused on the SaaS market, continue to churn out amazing new products and services that are changing the world as we know it.

That effort requires money, and lots of it. Traditionally, that funding has come from venture capital and other private equity sources, who see promise in a technology or product and invest in it – in exchange for equity. This gives the founders cash, but it also gives them less control, as it dilutes their ownership.

If founders lose control too early, before they have enshrined their vision, set the future direction of the company, and instilled the right corporate culture, the result can be a loss of entrepreneurial energy and a sub-optimal exit.

Venture debt is a less-known and less-utilized way to raise cash. Popular in the U.S. but still catching on here in Canada, venture debt has proven to be one of the key tools to support the growth of tech companies – by providing financing that not only allows founders to retain control longer, but also creates greater net worth for themselves, their employees and their early investors including VCs.

TakeOver Magazine asked Espresso Capital Founder and CEO Alkarim Jivraj about some of the questions – and misperceptions – he and his team encounter when talking to tech companies and their founders about choosing the venture debt path.

What exactly is venture debt?

Venture debt is what it sounds like: a term loan or line of credit used by technology companies to fund growth investments. “Unlike traditional bank lending, venture debt is available to start-up companies that do not have positive cash flow or significant assets to use as collateral.” (Erhart et al., Smart Financing: The Value of Venture Debt Explained. (Trinity Capital Investment, 2016) 2.)

Why is it a good capital-raising option?

Venture debt allows founders to retain both economic and strategic control over their company longer than if they were to fund with equity alone. Using the most recent data from Pitchbook, we estimate that if a company funded each of its seed, A and B rounds using one-third debt and two-thirds equity, the pre-seed would retain 52% ownership versus 40% if the funding was comprised of equity alone.

Founders and pre-seed investors are not the only beneficiaries of using venture debt. The equity investors in the seed and A rounds also benefit from preserving greater dry powder to maintain their pro-rata ownership in later rounds. Additionally, venture debt can improve the prior round investors’ IRR if they can use the investment to create greater company value in advance of the next round.

What are the other benefits?

For one, it’s efficient. There is a lot less paperwork than equity financing, and founders usually get money much faster, sometimes in as little as a couple of weeks. An additional benefit specific to Espresso is our understanding of the “founder’s mentality” – we are entrepreneurs, so we understand entrepreneurs. When founders have the ability to shape and control their destiny, they generally do better. We allow entrepreneurs to retain this control and to grow their businesses without dilution, board seats or personal guarantees.

How is the capital used?

When companies think of debt financing it is often in the context of needing a bridge or funding extension. Obviously, this is a very good use for debt, but its impact can be much more profound if incorporated into a long-term funding strategy. A long-term venture debt partner can be a very valuable ally in helping to ensure the business has access to quick and timely funding to take advantage of growth opportunities as they arise. For companies growing very rapidly, deferring an equity round for 12 or 18 months can have a huge wealth impact for the founders and their existing investors. When equity markets slow or shut down, venture debt can help companies continue to make hay while their competitors are in hold-mode. And for companies going through growing pains, venture debt can help provide the extra runway to get things back on track.

What are the common misperceptions associated with venture debt?

Many first-time entrepreneurs’ perceptions of venture debt are informed by views about personal debt generally. They look at interest rates on credit card debt and equate venture debt as the equivalent to credit card debt – essentially living beyond your means. The same entrepreneurs happily use mortgage debt to finance their home purchases because they realize that homeownership is one of the core strategies for building long term personal wealth. The important nuance that is missed is that cost of capital for a given type of financing is related to underlying risk of the asset being financed. Clearly debt financing for a fast-growing technology company inherently exposes the investor to greater risk than mortgage financing for residential real estate. Venture debt priced in the mid-teens, or if combined with senior debt with a blended cost in high single digits, is essentially a replacement for equity which typically costs two or three times as much. Using venture debt to reduce equity dilution and total weighted average cost of capital for growing companies is not the same as living beyond your means by racking up personal credit card debt. Certainly, the track record of companies in Espresso’s portfolio proves this critical point.

Tell us more about Espresso’s track record.

Espresso has been providing venture debt financing for over eight years – during this period we have funded over 225 companies and 700 loan advances. We’re exceptionally good at what we do, mainly because we have deep expertise in tech investing and have also invested in applying data science to help our team objectively and consistently measure the risk inherent in each new loan. Our team includes former VCs, bankers, CFOs and technology company executives. Our track record of success speaks for itself, and should provide comfort to our borrowers knowing that they have an expert funding partner that understands the ups and down of the growth journey.

How does Espresso size up risk?

Understanding and predicting risk in every deal is critical to venture debt underwriting. To size up the risk of a potential borrower, we have developed the Espresso Credit Score, which is an Artificial Intelligence-powered risk-scoring model that helps us objectively measure the risk inherent in every loan relative to our database of 700-plus loan outcomes.

We have also built a software platform that enables us to ingest lots of financial, operational and market data to make better predictions regarding a borrower’s future performance, helping us make smarter lending decisions. Ultimately, we plan to push all of these insights back to our customers to help them optimize their financial planning and analysis, and help inform their investment decisions.

A Real-Life Example:

Toronto-based Strongpoint, founded in 2013, bootstrapped its growth until Nov. 2016 when it secured sales expansion financing from Espresso, now totaling $5 million. Strongpoint used the funding to triple headcount and quintuple revenues in the 18-month period following funding. According to Mark Walker, Strongpoint founder, “Espresso’s non-dilutive funding was the right solution for the company. We explored venture capital but ultimately decided to partner with Espresso at this stage of our growth because it represented the most compelling economic outcome for our founding team.”