Drawing the Line – Seeking Credit Lines for your Venture backed Business

Over the past 3 years, we have raised and deployed some $10 million in venture capital to build out our products and infrastructure and expand our marketing reach at Practice Technologies (www.practicetechnologies.com).  As we approach operating profitability, we have a series of important questions to answer as we continue to pursue great market opportunities:

1. When should we supplement our ability to internally fund growth with additional capital infusions?  Considerations include business focus, valuation issues, and the availability of various capital sources.
2. What are the implications of the various funding alternatives to important constituents (investors, management and our customers)?  For example, debt takes a senior position in the capital structure to equity holders, and you will have various loan covenants and triggers relative to financial plans and balance sheet ratios.  Make sure these are well understood as you are aggressively chasing market growth.
3. How do you balance the competing interests of your stakeholders? 
4. What is the true cost of each potential source of capital?

Given our stage of development (post revenue, several successful products, positive cash flow), we’re able to consider securing a somewhat traditional bank line of credit.  I say “somewhat” because, being a technology and content provider, we don’t have a lot of traditional assets to collateralize, and until recently, we haven’t had the cash flow to justify a bank line from commercial banks.  Fortunately, there are some great lenders for companies like us, including Silicon Valley Bank, Comerica, and a relatively new entrant that we’re quite impressed with, Square One.  These banks are looking to make a premium over traditional lenders through warrants and fees, and in establishing a long term banking relationship with a hopefully growing new company.  In return, they are providing lower cost capital in the $500k-$2mm range to allow you to stretch into better valuation milestones.  They are not a substitute for larger venture financing or in situations where current cash flow can’t meet line repayment obligations.

In the “fixing to get ready” category, the banks will suggest putting together the following materials for your initial discussions:

• 2 years historical and YTD Financial Statements
• 2 Year (Current plus Next Year) Forecast Financials (Income statement, Balance Sheet, and Cash Flow Statement)
• Aged listings of A/R and A/P
• Current Capitalization Table
• Most recent Power Point Deck used in connection with fund-raising or Board communication (to gather a sense for the market opportunity, the competitive landscape, the technological differentiator(s), the Management Team, etc.)

In addition to these, I’d add a few more (some obvious, some not so much):

• In the obvious category, take care of the general housekeeping.  Make sure you’re all caught up with tax and corporate compliance issues.  These deals are all about credibility, and potentially they can be time sensitive. 
• As much as it can seem like it’s all about the numbers, the good ones in the venture-backed technology lending space are looking to the following in evaluating the application (in some order):
  • Your venture partners.  Are they excited about your growth prospects, or are they getting tired?  And why do they feel that a line is more appropriate at this time than another venture round?
  • The management team.  Is it seasoned, well grounded and reasonable?  Do the financial projections make sense, or do they look like an enormous hockey stick?  (See my previous post on financial projections for further comments.)
  • Understanding the business opportunity.  Your venture backers got in, but is it something the bankers can get excited about?  And how much of a banking opportunity is it?
• As an entrepreneur, you need to be able to succinctly talk about your business, and you’re always selling.  This is no exception.  Again, with your feet firmly planted on the ground, be able to present this as an exciting opportunity.
• Start building those relationships early.  The longer they have to get to know you and watch the business, the more comfortable they will be.

One of our challenges is to value the true price of the line relative to other potential sources of credit.  In addition to the hard costs (application fees, interest expense, etc.), the line has a finite life and must be repaid.  Assuming it is not refinanced, against a $500k line that is fully drawn down in the first year, you might have about $150-200k in costs over the 4 year period (the draw down, plus say a 3 year repayment) for temporary access to $500k in Yrs 1-2, $300k in Year 3, and $150k in Year 4.

Surprising?  Look at the breakdown:

• Application fee – $15-25k (including legal)
• Warrants – 3% of line ($45k in exercise price – value is up to you)
• Interest costs – 12-14%/yr, or $60-75k in years 1-2, $40-50k in year 3, and $25k in year 4.

True, you’re ideally providing your venture investors with a 35-40% ROI over that period, which compounds very quickly, and there are plenty of other strings attached.  But at least you’re not repaying that money over what might be a cash-constrained period, and your venture investors are all about value creation, not loan repayments.  Oh, and if you secure a new venture round, new money is generally not fond of paying off prior obligations. 

I’ll keep you posted as the discussions unfold over the next 3 months.

Financial Modeling: Murder by numbers…

To borrow a line from the Police, it might seem as easy as your a-b-c’s, but there’s a lot that goes into effective financial modeling.  For the past 8 years with Practice Technologies (www.practicetechnologies.com), and going back some 10 years before that, financial modelling has always been central to the analysis I’ve relied upon to evaluate a business’ health or justify an investment in its growth. 

There are several important steps to follow in developing a financial model which will serve your objectives as an entrepreneur, whether you’re trying to manage what you have or raise capital for what you could.  This is particularly true for newer enterprises, as the discipline associated with identifying and thinking through the key business drivers is invaluable to the early planning process.

1.  Figure out what you’re trying to accomplish. 

As an entrepreneur, you have a number of competing objectives.  Depending on how established you are, you may have a business to run on a day-to-day basis, and it’s hard to find the time to plan, build and manage against a set of financial models.  You may be tempted to build a simple income statement-type spreadsheet that lays out revenue assumptions and backs out costs.  But effective financial models can and should be used for so much more.  Using them, you can look six to sixty months down the road to plan for organic growth, evaluate opportunities to enter new markets or take on new sources of capital, or anticipate liquidity problems.  I highly recommend taking the time to build a model which will generate a consolidated set of financial statements that will provide a more comprehensive picture of your business.  And the sooner you identify the range of scenarios, the easier it is to plan and build your model to accommodate them.

2.  Plan, and then plan some more

A rule of thumb in traditional software design and development is that for more complex projects your engineering team may spend half of the overall project timeline in planning and design.  In my view, that’s overdoing it for financial modelling, but not by much.  Key planning considerations include:

• Breaking down the key business drivers and assumptions, and how they are all related (more on this below)
• Determining the level of detail / drill-down capabilities
• Building a simple map of how your supporting sheets will roll up to your consolidated financial statements
• Determining what type of sensitivity analysis you want to model and present

3.  Identify the key business drivers and assumptions 

Particularly if you’re looking to raise capital, breaking down and modelling your key assumptions and drivers is the most important aspect of building your projections, and one of the most important elements in presenting your business.  It will reflect your understanding of your market(s), growth opportunities and drivers, operating requirements, and what it takes to pull it all together.  It is also an opportunity to demonstrate that your aspirations are firmly grounded in the reality of reasonable expectations about time to market, delays, cost overruns, etc.

So if you’re modelling a new product roll-out, it’s not sufficient to say you’ll sell X Widgets each month for $Y per and multiply the two numbers.  Instead, you need to model out what drives unit sales, what are the elements of pricing (including discounting, upsells, bundling, etc.), how each of these elements might change over time, and then pull it all together.  As you gain more information and market experience, or if you simply want to run some scenario analysis, you’ll be able to tweak each of these variables and watch it flow through the analysis.  This holds true for almost every revenue and cost driver – wherever possible, use formulas to do the work on clearly identified sets of assumptions that can be easily updated without needing to reformat the sheets manually.

4.  Do the Sanity Check

Far too often, reasonable assumptions accumulate to generate unreasonable outcomes, particularly when the financial model is extremely sensitive to changes in key variables or if compounding effects occur in the revenue streams.  For example, in modelling an e-commerce business line recently, seemingly minor changes in the conversion rate of site visitors to paid subscription accounts (from, say, 0.75% to 1%) had a dramatic effect on the cumulative revenue stream over the 36 month forecast period.  So it’s essential that the model pass the smell test.  If the compounded growth rates are not credible, it is frequently a reflection on your judgment as an entrepreneur, and it can negatively affect your access to capital.  Putting “dampers” on your model, such as by decreasing growth rates once you achieve a certain market penetration, or simply adjusting your assumptions downward at various stages can help present more reasonable outcomes.

5.  Put together a range of scenarios

You’ll want to generate downside and upside scenarios to complement your base case view of the business.  Again, this requires judgment to put the pieces together and determine which scenarios make sense and which ones are a perfect recipe for disaster by showing a complete business collapse or a path to unlimited growth.

6.  Take a step back and figure out what it all means 

Frequently, someone will present a set of numbers who hasn’t taken the time to figure out what they really say or how they stack up to comparable companies.  Understand and communicate, in plain language, what your margins are, where your forecast business is most sensitive to breakout opportunities or potential setbacks, and what your overall level of comfort is with the forecast.

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Of course, the sad fact of model building is that no matter how careful you’ve been to lay everything out, you’re going to be, well, dead wrong.  It’s simply not possible, particularly in a newer (or even pre-revenue) business, to predict what’s going to happen with any level of precision.  But the process of building out the model will not only test, and then shore up, your understanding of your business, it will give you a sound foundation to measure your results, analyze them relative to your expectations, refine them, and continually improve your ability to plan for your business’ growth.