Debt is Coming

Alex Danco, 2020-02-07

Debt is coming to the tech industry

  • DEF: Financial capital (FK) – equity and debt owned by investors

  • DEF: Production capital (PK) – factories, equipment, processes, etc. owned by FK

  • Statement: FK and PK have changing but predictable relationships with each other in distinct phases of tech development and deployment.

  • Peter Drucker on FK: “securities analysts believe that companies make money. They make shoes”. —> the viewpoint of FK

  • Phase 1 (Installation): FK’s and PK’s relationship is speculative, bets on the unknown. VC model. Misalignment of investors and operators (bets vs consequences).

Lots of ambiguity, high failure rate.

VCs are hyper-optimized to invest under these conditions.

For PK VC cash for equity is arguably the only way to get funded

  • Phase 2 (Deployment): Alignment. Capital is deployed more deliberately and predictably. Focus on assets, cash flow, return on capital  more like usual finance.

VC equity is not the best tool at this stage.

  • Customers get more value than the vendors, ubiquitous technology.

  • Three tech industries today: Mature, FK/PK coupled [AMZN, MSFT, GOOG], Contenders, FK/PK uncoupled [VC-backed growth companies], and Rebels, FK/PK coupled [long tail of sub-venture software businesses].

  • Putting money into Mature —> securitization, production capital.

  • Putting money into Rebels —> improving their infrastructure, production capital.

Recurring revenue

  • Everyone’s darling, even though the timing of cash flows initially is inconvenient.

  • Doesn’t always apply to SaaS, consumer services [with defined cohorts] have it too.

  • Acquiring users == accumulating assets, similar to building factors in the past.

  • VC money goes towards acquiring customers and financing service delivery.

  • Such financing creates tension between FK (portfolio approach, not all $ goes into one basket) and PK (complete commitment, need as much $ as needed), but manageable.

  • So investment into businesses with recurring revenue becomes similar to a fixed income yielding asset —> opens up to a broader investor base.

The problem with equity

  • Could equity financing be the reason for the startups’ high failure rate?

  • Dilution and high valuations are often damaging to the startup operators, kills options to grow and develop:

High valuation may destroy discipline and focus

High valuation —> less cheaper options, have to keep raising money

  • Also, suddenly the startup’s future (and failure) starts being defined not by the product, but by the way it’s funded.

  • Preferred stock is also not a solution, when liquidity preferences kick in, this becomes very unfair to the company. Also, very narrow path for exit.

  • Debt may be the solution if it’s not used for the runway [i.e. use it for expansion instead]. Use debt instead of expensive VC money to grow customer base.

Gradually, then suddenly

  • Lenders aren’t used to lending to growing companies. Most banks don’t know how to lend against predictable revenue [MK: it’s being solved, though, as we speak]

  • Debt no a balance sheet may prohibit companies from raising future equity rounds

  • Debt is higher than preferred shares in the equity stack —> investment becomes not so attractive; also signalling

  • Debt without positive cash flow is very risky. Venture debt works for VCs, not companies.

  • Founders and VCs may both start thinking in bets, redistributing the FK/PK tension into employees.

  • Start thinking about the revenue that can be grown not just using the equity finance, separate projects and revenue lines.

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