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.
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.