To amortize or not to amortize
17 November 2006“… Venture loans extend the runaway by only 2.5 months. Why bother? ” Ron Dizy from Celtic House at a 2005 CVCA professional development series.
Two CFOs that I met at the recent Financing Forum in Vancouver told me that they had turned down such amortizing venture loan deals recently. Needless to say, a Company paying a lender back (principal) right away at an accelerated rate with the lender’s own money or from existing cash balances wasn’t all too appealing to the CFOs who did the math.
They needed capital to fund future growth (whether working capital or cash burn), not principal payments every month after closing.
From a lenders perspective, a 3 year amortizing term loans make a lot of sense. It is relatively easy to do as credit risk is significantly reduced (principal being paid back every month is the best covenant / monitoring to have). Plus assuming cash burn of the Company is minimal down the road, the lender is getting paid back the following way: 1) from its own money; 2) existing cash balance of the Company, presumably after an equity round and 3) a small operating line. Between these three sources of cash, more than 50% of the original capital will come back within 16 months, and hopefully the operating line will cover the rest in the third year if all goes well and the line can be drawn. The credit risk is significantly minimized.
Though many venture debt players across North America do offer an amortizing structure as above, CFOs are increasingly seeing right through the elusive “added runway”. To alleviate the concern that th eloan provide true runway extension, we have always offered a bullet term loans (2 to 3 years).
So, no principal payments in the interim period, just one balloon principal payment at the end. This does increase our credit risk quite significantly but it does provide true growth capital for the business that can actually use it to fund working capital / cash burn.
From a cash flow perspective, a bullet payment significantly helps the CFO. How much? Let’s compare a $3 million 3 year loan – one amortizing and the other a bullet term (principal paid at maturity). All else being equal (cash burn is same, assumed minimal), if you compare the net cumulative cash flows going out of the Company to the lender, the difference is quite stark.
After 18 months, the Company would have paid out almost $1.8 million (in principal, interest and fees) from its cash balance under amortizing structure versus less than $0.6 million under a bullet structure (in interest and fees), almost 3x as much!
In order words, if you start with cash balance of $3 million (gross proceeds), the Company would have $1.2 million in cash left ($1.8 million was paid back to lender – principal, interest and fees) under an amortizing structure, versus $2.4 million in cash left on hand ($0.6 million was paid to lender – interest and fees) under the bullet structure after 18 months. So, the CFO would need to overfund the business plan by $1.2 million ($1.8 million less $0.6 million) or roughly 40% of the gross proceeds under amortizing structure in order to have the cash to pay back the amortizing lender in the first eighteen months (see cumulative cash flows going out of the business shown in the graph below).
Now, we will offer an amortizing structure when requested; but this has generally been for cases where the company is cash flow positive (i.e. in a traditional sector, not technology) and we are financing long-term fixed / tangible assets that are being depreciated at the same time. But for all venture debt deals where IP / intangibles are the most material assets, we have always offered a bullet term loans as we expect (as do the borrower’s shareholders) that the intangible value of the business to actually go up with our funding, not down.
Now there are risks associated with any financing, equity or debt: what if the business plan doesn’t meet expectations? what if none of the crucial milestones will have been hit? what if the expected next round doesn’t show up to provide the next couple of years of runway? what if a key senior manager leaves for a new opportunity? what if there are bugs in the software?
An amortizing lender will say that a term loan is a riskier deal: what if you can’t pay them back? Well, occassionally things don’t go as planned. Sometimes the equity doesn’t come, or the customers don’t bite, or the product gets stuck in QA. How is that not the case with an amortizing loan? The only difference is that you’ve paid the loan back earlier, and run out of cash earlier.
None of these issues have anything to do with debt structure. If you’d gone with an amortizing loan, a large percentage of the capital you would have used to promote your product, or market it more broadly, wouldn’t have been possible as that capital wouldn’t have been around to execute in any event…it would have gone towards principal payments.
If business plans don’t live up to their billing, it isn’t a function of the term loan bullet payment coming due 2 or 3 years from now.
However, if a tech firm is burning cash, and the CFO still insists on an amortizing debt structure despite above, we can go that route; it is a much easier credit for us as so much of the capital is off the table in the first few quarters. That’s why some venture debt funds will do amortizing deals for a company that doesn’t even have any customers or revenue yet.
As for the two CFOs that I spoke to in Vancouver, they are probably looking for us to provide a bullet debt termsheet as a true growth capital alternative in the coming days. Given the increased credit-risk of bullet versus amortizing structure to the lender, the pricing will understandbly be slightly higher, but generally less than 50 basis points all-in. Not enough to matter when you think about the benefits of the structure.
Watch, in particular for amortizing warrants being priced off the last round, rather than the next (higher) round. More importantly, figure out the early day cash flows, even with a 6 month principal holiday. You still have to borrow less under a term loan to have the same amount of capital available to you as under an amortizing structure, so the true dilution and all-in cost is substantially less under a term loan structure.
And then there’s that devilish “material adverse change” covenant clause to keep an eye out for as well. That’s part of the reason why certain lenders say: “no covenants”. Just as Xillix found out to their horror, a MAC clause is all a lender really needs. That, and getting half of your principal off the table in the first few months!
KM
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