Today’s column is written by Jerry Neumann, a venture capitalist with Neu Venture Capital.
We're used to using equity for startup financing – or things that are actually equity even though they're not called that, like convertible debt. Who would lend money to a startup in exchange for nothing but interest? An interest rate high enough to compensate for startup risk would mean interest payments so big they would drive the startup under.
But lenders do lend to startups. They have figured out they can make money and manage risk by taking forms of payment other than interest and by lending against specific collateral. This is great for startups because these loans are far less dear than venture capital.
The three main types of loans to startups are venture debt, receivables financing and equipment financing. I'm only going to talk about receivables financing because in many media buying models, working capital can be a significant use of cash, so financing receivables can greatly ease the pains of growth and seasonal spikes in demand.
For those of you who haven't gotten to this stage yet, here's what happens: A big ad agency client asks you to do a $2 million buy in October. You pay for the media cash on the barrelhead, or within 30 days if the publisher really likes you. After the campaign runs, you call the agency to collect your $2 million. Three months later, in January, the ad agency finally gets around to paying you. For the intervening 60 to 90 days, your company has funded their campaign, tying up $2 million of your cash. And when it's finally paid, it will probably be tied up in the next campaign.
With an average of two months between when you pay for the media and when you get paid, one-sixth of your revenue is always tied up in working capital. If you have $12 million in gross revenues, you will always need $2 million in cash on hand to be able to buy the media you will resell. You can't use that cash for anything else. And the more you grow, the more cash you will need.
This isn't just a small company problem. In Rocket Fuel's June 30 quarterly report, it had $94 million of accounts receivable, up from $68 million in September of last year. Revenue and accounts receivable grew at the same pace. Growth takes money. An early-stage startup that is losing money or is break-even often has to raise outside money for nothing else but to finance working capital.
While it may seem a bit seedy for some multibillion-dollar company to ask you to front a couple million for a few months, it's pretty certain you will eventually get paid that money. The big ad agencies might be slow to pay, but they do pay. So funding the zero-risk working capital on high-risk VC terms is a waste of good equity. A better way is to borrow.
Venture lenders like Silicon Valley Bank or City National Bank will lend money secured by receivables on decent terms. They mitigate their risk by vetting who the receivables are payable by and taking first dibs on that money. If your company can't repay the loan, the lender will take the receivables and get repaid by your clients directly.
What do they ask for in return? Several things:
1. An upfront commitment fee: $5,000 to $10,000 to cover their cost of getting the loan in place;
2. Interest: I've recently been seeing interest rates in the range of the prime rate plus 1% to 2%. Prime is currently 3.25%, but it changes periodically, and so would your interest rate;
3. Warrants: This is the right to buy some percentage of the company's common stock at the current 409a valuation. The amount of the company that they will ask for will be all over the place. In recent deals, I have seen asks from less than 0.1% to nearly 0.5%.
They will also get a security interest on all of the company's assets, not just the receivables. In return, they will lend you an amount of money equal to up to 80% of the value of your outstanding receivables, subject to certain covenants.
The covenants will give the lender a reason to refuse to lend you any more money if your financial situation gets dicey. They are often limits on things like the "adjusted quick ratio," and you should always forecast what they will be under different scenarios.
Accounts receivable financing is almost invariably a good deal as long as you're growing or profitable. It gets tricky if you're using the loan to prop up a money-losing company and your revenue shrinks, even temporarily. Then you find yourself underwater very quickly. Always know how you're going to repay the loan and always have cash forecasts for a year ahead. I know it's almost impossible to forecast revenue even a few months out in a rapidly growing ad tech business, but study various scenarios: If you miss your next quarter's revenue target by 10%, what happens to cash, do you bust your covenants and become unable to borrow? Loans can help you grow more quickly, but they can also cause you to fail more quickly. Leave yourself time to respond by paying close attention.
I always recommend to my ad tech portfolio companies that they look at borrowing against receivables once they have a CFO. And I always recommend they get a CFO if they want to borrow against receivables. Managed well, it's the cheapest growth capital a startup can get.
Follow Jerry Neumann (@ganeumann) and AdExchanger (@adexchanger) on Twitter.