Espresso Capital, Making a Case for Debt and Equity in Tech Startups
Charlie Munger, the renowned value investor and vice chairman of Berkshire Hathaway, used to have a tricky test for aspiring analysts that wanted to join his firm: Find the intrinsic value of an internet startup. The trick was that if the analyst came up with any value at all, they would fail the test. Charlie’s point: There is no reasonable way to determine the intrinsic value of an internet startup.
Fast forward almost two decades, an internet bubble, and a lot of evolution in the tech market place, and you have Berkshire Hathaway actively investing in tech companies. Now, to be clear, in order to attract Berkshire’s interest, you have to be an elephant, tech or not tech. It’s not surprising then, that the two tech stocks owned by Berkshire are IBM and Apple. To be fair, the basic tenet of value investing is still being followed since IBM and Apple are both companies with a demonstrated ability to generate cash in the long term, but there has definitely been a shift in how even the most conservative value investor approaches tech companies.
Banks face similar challenges. They think of companies as a set of long term assets (property, plants, and equipment), short term assets (receivables and inventory), and positive cash flows that can justify loans at low interest rates. Viewed through this lens, it’s difficult for a risk analyst at a major bank to evaluate the risk of lending money to a tech startup - companies that often have little in the way of tangible assets and are consuming, not generating, cash. The problem is not just that the risk is high, it’s that it’s also really hard to measure.
This poses an immense challenge to tech startups. Much like pharmaceutical companies, tech companies need to invest a significant amount of money in research and development and can go years with negative cash flows before making a significant profit. During this time, they need to raise capital, which, given the level of risk, comes at a great cost.
If you talk to an aspiring tech entrepreneur, they might talk about raising series A or series B venture capital, and headlines are made when the amounts raised are significant. One detail that is often missed however, is that each of these rounds of equity financing can significantly reduce both the value of the founders’ equity (dilution) as well as their ability to control the company.
Just to put things in perspective: I work for a privately held 25-year-old food manufacturing company. Our cost of equity is somewhere around 15% and our cost of debt capital is very low, comparable to an A or BBB+ corporate bond. A tech startup faces equity costs of upwards of 40% and in most instances won’t have have access to any traditional sources of debt - eg, bank debt.
This begs the question: What would happen if you could significantly lower the cost of capital for a tech startup?
I recently explored this question at a dinner with Espresso Capital a few weeks ago, where I was able to hear from Espresso’s management team as well as some Espresso clients. What I came away with was a new understanding of how growing tech companies can raise debt capital and significantly lower their cost of capital, especially during those tough early years when a company needs to invest heavily to drive growth.
Espresso Capital is a lender to tech companies. Their corporate mission is to “keep founders in control”, but practically speaking, they can lend money to revenue generating tech startups to help fund growth while decreasing their cost of capital, limiting equity dilution, and helping founders retain corporate control.
More specifically, Espresso has found a way to lend money to Software-as-a-service (Saas) companies that have stable and recurring revenues. Saas companies, instead of selling software licenses and support contracts, sell hosted software that requires monthly or annual fees instead. Think of Dropbox, Smartsheet, Shopify, Salesforce, or Hootsuite, to name a few.
While this was all an interesting concept, I tend to understand better when I see the numbers, so I decided to model two scenarios where a fictitious tech startup goes through a 5 year period with negative cash flows as it grows dramatically, followed by 5 years of positive cash flows. In one scenario, the startup has to raise all its cash shortfalls for the first five years through equity capital. In the second scenario, that same firm raises 50% of their capital through debt, and the other 50% through equity.
In each scenario, the firm had to raise similar amounts of capital and had the same cash from operations. During the first 5 years, the firm is cash flow negative, and for the subsequent 5 years, it is cash flow positive. In both scenarios, the founder injects the first $500,000 of capital. In both scenarios, the company is valued at $112 million at year 10. I assumed a 40% cost of VC equity capital and a 15% cost of debt capital. These numbers are for illustration purposes only, as both venture investors and lenders will set their own rates.
The results are striking, but not surprising. In the first scenario, the firm has equity valued at $112 million, but the founder(s) only owns $27 million, or roughly 24% of the equity. Note that this also means that the founder(s) control roughly 24% of the votes on the board. In the second scenario, the founder(s) owns 45% of the equity, or roughly $50 million. In the second scenario, I assumed that one of the positive cash flow years was used to pay off the debt. This temporarily lowered the value of the firm. A case could be made for establishing an optimal and ongoing debt to equity ratio.
This all makes for an interesting shift in how we view debt with tech startups. As with Charlie Munger and Berkshire Hathaway, banks are used to determining value (and risk) based on tried and true historical data such as revenues, earnings, and short and long term assets. Tech startups make this job notoriously difficult due to negative cash flows early on, untested revenue and earnings histories, and no long term assets. Software-as-a-service companies are helping to bridge this gap by providing steady recurring revenue streams that can serve as both collateral and forecasting tools. Lenders like Espresso are able to model risk in innovative ways and significantly lower the cost of capital for these firms. In turn, entrepreneurs have access to more financing options, can reduce their overall cost of capital, benefit from improved negotiating power with equity investors, retain greater control of their firms, and achieve higher value of equity upon exit.
The real question for me is if this model can work in the long term. There is a lot of potential, but in the past 8 years we have not experienced a shock to financial markets like we saw in 2008, or the tech bubble that popped back in 2000. On the contrary, we are currently enjoying the benefits of a sustained bull market which has helped the tech sector attract significant amounts of capital. I would be interested to see what would happen when capital for startups becomes more scarce. If it does work however, it has the potential to create a whole new face of early stage investing.
It’s an exciting market, and I can’t wait to see what’s next.
