Understanding Debt

The Kauffman Foundation conducted a survey of businesses that were launched in 2004. They then
followed these firms over time to see how they grew or how they failed and, what happened to
them. The survey was comprehensive, but in particular, it looked at how the businesses were
financed. I've put together some graphs here to show you some of the main lessons from that
survey. You can see on the graph the orange bars at the top, that represents the amount of the total
capital being put into the business, that comes from outside debt. That's debt coming from banks
through a variety of channels. What you can see is that, that about 40 percent of the total capital
being used to launch a business is bank debt. The bottom piece, the blue bar, the light blue bar at
the bottom, that's money that the owner herself is putting into the business, and you can see that's
about a similar magnitude, about 35-40 percent. So about 80 percent of the total capital that is
going to start most new businesses is pf equal parts; owner financing and bank financing, and the
rest is everything else. So you might think "Well, okay, what if the founders of the businesses have
really good credit versus really bad credit? You don't see a very big difference there." In both cases,
it's about 40 percent outside debt, about 40 percent owner financing.
The difference is the size of the business.

Businesses that are high credit, worthy businesses are just bigger businesses. Their capital structure
is the same.
You can look at businesses across a variety of stages of life, from businesses that are being operated
out of the homes of the founders, to businesses that don't have any employees, to businesses that
don't yet have any revenues and the bottom line is the same. It's about 40 percent debt, about 40
percent owner financing, and the rest comes from all other sources. The difference is simply the size
of the business.
You can even go and look at businesses that get outside equity funding. So the the large bar in the
middle there is businesses that are venture capital financed. The average firm in the Kauffman firm
survey, that received venture capital financing had something like more than a half million dollars of
bank financing also. So again, as we said before, you want to think about sources of capital as
compliments not substitutes. Surely, the fact that these firms had been able to raise venture capital
financing, probably made it easier for them to also raise bank financing.
Let's take a closer look at the debt that goes into financing most new businesses. I've put together
this pie chart to show you how it's mostly broken out. As you can see, there's two big sources of
debt financing. One is business bank loans, that's about 30 percent of the total debt that goes into
new businesses. Those are loans that the bank makes directly to the business itself. An even bigger
portion, though comes from personal loans to the founder, not the business. So in other words, an
entrepreneur walks into a bank, gets a personal loan, the purpose of which is to start the business.
Together, this makes up basically, 70 percent of the total amount of debt financing that the average
firm receives. Credit cards, credit lines, other things like that make up the remainder, but the bulk of
debt financing is coming either through personal loans to the business or business loans, bank loans
made to the business. So how does that work? Well, it's pretty simple. You're probably familiar with
this already.

How debt works

You borrow money, you receive cash, and you enter into a legal agreement to repay the amount of
money that you borrowed plus interest on top of that. However, this interest is fixed. It's a fixed
number. It does not vary with the performance of the business. Your business does well, you have a
lot of money left over after paying the interest.

If your business does poorly, you might struggle to make those interest payments. This means that
the entrepreneur gets to keep the upside of the business all to herself.

An important thing to remember though, is that most bank debt has covenants associated with it.
These are guidelines, rules that the business must follow if the debt is considered to be in good
standing. So for example, the bank might require you to maintain a certain amount of cash on hand
in order to make interest payments. I might put in special rules that prevent you from taking on
additional borrowing. These rules are called covenants. If a covenant violation occurs, then the debt
technically speaking can be considered to be in default, and the debt-holder could potentially seize
the firm's assets and liquidate the firm. So this is what people sometimes call contingent ownership.
As long as the debt is in good standing, the entrepreneur owns the business. But if the debt fails to
be in good standing, then the bank or whoever is supplying the debt has the right to seize the
business and take it away from the entrepreneur, and find another operator or just liquidate it
entirely. A major component of most debt is what's called collateral. If you go to a bank, a bank will
typically ask for collateral to provide a loan. Oftentimes, the collateral being used to launch a new
business comes from the entrepreneur's personal assets. What we saw on that pie chart on the
previous slide, that the largest source of debt was personal loans used to start a business. We're
envisioning a world in which the entrepreneur is taking their personal assets, using them as
collateral in order to get a loan, and then taking those proceeds and putting them into a new
business. So that's how debt works. It's important to remember that debt is an incredibly important
source of capital for almost all start-ups
 VENTURE CAPITAL

Let's take a closer look at venture capital. We want to dive into the term sheets that venture capital
investors use when they invest in new businesses and we want to understand the types of financial
securities that they use when they invest. But before we do, we need to get a couple of key concepts
on the table. Suppose an entrepreneur takes $10 million for five percent of our company. What does
this imply about the value of the business? Well, there's two key valuation terms that come up all
the time in venture capital and so it's probably best that we start here. One is called the post-money
valuation. The definition is simple, it's the value of the business after the venture capital investor has
invested the money. So in this case, if the venture capital investor put in $10 million and received
five percent of the company, the company would be worth $200 million. We simply take the amount
invested and divide by the ownership share. So in this example, we'd be taking 10 and dividing by
0.05. That's 10 times 20 or 200. The post-money valuation describes the value of the business after
the venture capital has been injected into the company. What about before that money comes in?
Well, we refer to that as the pre-money valuation. If a venture capital investor puts in $10 million for
five percent of a company, that implies the post-money valuation is 200 million. Well, the Venture
Capital Investor has put in $10 million. That means that the pre-money valuation is a 190 because
the a 190, plus the 10 million invested, adds up to the $200 million post-money valuation. So an easy
way to think of that is the pre-money valuation is simply the post-money valuation, minus the
amount of capital that's being put in. In this example, the pre-money is a 190 million and the post-
money is 200 million.
So let's stick with this example. Suppose an entrepreneur accepts $10 million for five percent of her
company. What's really happening? What's going to happen is, the venture capital investor and the
entrepreneur are going to agree to what's called a term sheet. This term sheet is a legal document
that specifies all of the rights and privileges that the VC investor has in exchange for providing that
capital. It's going to talk about special corporate governance rights that the VC has. Its going to talk
about special control rights over business decisions that the venture capital has and it's also going to
spell on a very careful detail, the amount of equity that the venture capital investor receives for the
amount of money that's being provided. All of these terms are going to be laid out in this term sheet
and this term sheet as you can imagine can be quite a lengthy, detailed, complicated, legal
document. The VC and the entrepreneur are going to sign this term sheet and then that will allow
the venture capital investor to inject capital into the firm. The venture capital investor will provide
cash to the firm and then receive a special type of security called Convertible preferred equity. It's a
special type of equity that has special rights and privileges attached to it. In particular, it's kind of a
weird hybrid between a debt instrument and a standard equity instrument. The convertible
preferred equity will receive interest payments like a loan. These interest payments will typically
accrue unpaid, just increasing the amount of principal balance that's outstanding. The VC investor
will have an option to either keep the instrument as preferred equity or convert it to common equity
at a conversion price that we can talk about. This balance between converting to common equity or
maintaining the security as convertible preferred equity, gives the venture capital investor downside
protection when things go wrong and at the same time allows the venture capital investor to share
in the upside of the business. So in particular, this convertible preferred security is going to look like
debt when times are bad and it's going to look like equity when times are good and that balance is
what gives the venture capital investor downside protection while still giving them a slice of the
upside.
Some convertible preferred securities are structured as participating preferred shares instead of
convertible preferred shares and in a few lessons, we'll go into great detail in understanding how
participation versus conversion works. But essentially, if it's a participating preferred security, then
first we will pay the liquidation rights and then convert to equity. So it's no longer an either or
situation. It's an and situation. The important thing here is to understand how this creates incentives
for management and it provides downside protection to the VC. Notice that in this example I've
given you where the 20 convertible preferred shares are 31 percent of the company's common
equity, if we convert or $200, if we don't convert, then what we're going to see is that, if the
company ends up not being worth very much, we're better off being a debt holder and getting back
as much of that $200 as possible. That's where the downside protection is coming in. Imagine that
the company is liquidated and it's only worth $50. If you had converted to common, you'd have 31
percent of the $50 as a venture investor. Instead, if you held the convertible preferred security and
did not convert it, all $50 would go to you because you would have liquidation rights all the way up
to $200. This encourages management to work hard because management is only going to get paid
for large exits.
What is a VC Investor? VC Funds

Okay, soon we're going to dive into the details of how venture capital investments are structured
and how the equity proportions are determined. But before we do, it's a useful place to start to first
ask what actually is a venture capital investor, and so once we understand a little bit more about
who venture capital investors are, we'll have a much better sense of why the investments are
structured in the way that they are. So let's start there. What is a VC investor? If you're an
entrepreneur and you think about getting money from a VC, it's important to understand that you're
really getting an investment from a venture capital fund. The "fund" is distinct from the venture
capital firm. A venture capital firm is a collection of partners who raise capital in funds, they raise
capital from what are called "limited partners." Limited partners might be big pension systems like
the state of California pension system, might be universities like Duke University's endowment,
might be family offices, in other words, wealthy families who've set up investment offices to manage
the family's assets. These institutional investors enter into partnership agreements with the venture
capital firm to create a venture capital fund. The fund is the investment vehicle that makes the
investments in the portfolio companies that the fund invests in. So this partnership is a partnership
between the limited partners, these are the pension funds, universities, family offices, and what's
called the general partner. The general partner of the fund are the employees of the venture capital
firm itself. Now, it's very important to understand how this fund is structured. The general partner is
the person or the set of individuals who were making investment decisions. They're determining
which companies are going to get investment capital, which companies are not. But they're really
using money that comes from their limited partners. A typical partnership would have about 99
percent of the capital provided by limited partners and about one percent of the capital provided by
the general partner itself. Then the general partner would be engaged in the job of searching for
investments to make and structuring those investments.

These partnership agreements are typically designed to have a 10-year lifespan, but the initial
partnership agreement will often include provisions that allow the fund to extend beyond 10 years if
it's necessary. That 10-year period is kind of broken into three chunks. Usually, new investments can
only be made during the first five years of a fund's life. Of a typical venture capital fund might make
somewhere between 10 and 15 investments, many of those investments will fail. We'll see when we
start to talk about how to value companies accounting for that failure is critically important for
understanding why venture capital funds use such higher hurdle rates relative to the discount rates
you've seen with men well. After a VC makes new investments, a small number of those new
investments will require follow on capital, and then ultimately, hopefully, a few of those investments
will be exited. Exits will occur in the form of an IPO, or an acquisition by a strategic partner, or
possibly by a sale to another private equity investor.
Now, this partnership agreement that ties the limited partner in the general partner together
specifies the rules that determine how the general partner is paid, how the venture investor is paid.
Their money comes from two main sources. First of all, they charge management fees to the limited
partners. Those management fees typically run in the neighborhood of two to two-and-a-half
percent of the capital that's been committed to the partnership. It's not uncommon at all to see
these fees be reduced as the fund gets older. So a fund might start with $100 million, let's say, of
committed capital, that's capital that the limited partners have promised to provide when the VC
identifies investments to make. That two percent of committed capital is $2 million a year. The
venture firm would take $2 million a year in management fees from the set of limited partners that
were invested in the fund. But then as the fund aged, $2 million a year might drop to some lower
number depending on how the limited partner agreement was structured. Management fees are
one source of compensation for VCs. The second source of compensation for VCs is carried interest.
Carried interests basically is a slice of the net return that a venture capital investor generates. This
number is typically between 20 percent and 30 percent. So let's take an example and say that a
venture capital investor who has a 20 percent carried interest stake. What does that mean? Suppose
we have $100 million fund, we've identified an investment in a portfolio company that requires $10
million of invested capital. I invest $10 million into the company, and then five years later that
company is sold and my $10 million investment is worth $20 million. The VC would typically get 20
percent of the net return; $20 million returns $10 million of invested capital leaving $10 million of
net return, the VC would get 20 percent of that or $2 million. Now, limited partner agreements are
quite complicated and they often have very specific rules about when and how the venture capital
investor can earn this carried interest. For example, it's common place that the funds entire invested
capital be returned back to limited partners before the general partner can earn carried interest. But
those are the basics, that's the basics behind what a venture capital fund is, and it's important to
recognize that a venture capital investor is really investing other people's money. You're going to get
a slice of the return when they generate the return, but it's going to be important for them to be
able to deliver a solid return to their investors in order for them to be able to generate returns for
themselves.
How VCs Value Businesses

Okay. In this lesson, we want to jump into the details of how venture capital investors value the
businesses that they invest in. You might have heard that venture capital is a really expensive form
of investing that can be stated in a number of different ways. Sometimes we talk about VC investors
having really high hurdle rates, discount rates that seem way too high relative to the numbers that
you might have used in forming your own cash-flow projections. Another way of thinking about it is
you might receive a term sheet and the term sheet calls for the venture capital investor to take a
much larger piece of your company's equity then seems fair given how much capital they're
providing. So we want to dive into the details of understanding how VCs value the business that
they're investing in. We want to understand why these hurdle rates, why these equity ownership
stakes seem so high. The first step in understanding that though is to go back to what we talked
about in a previous lesson and think about how venture capital partnerships are structured.
Remember, VCs are investing other people's capital. These limited partners are expecting to earn a
return. Also bear in mind that a venture capital investor is only going to make maybe 10 or 12
investments in any given partnership. Many of those investments will fail. So let's just take those
two basic facts and see how that plays out in understanding why venture capital hurdle rates are so
high. Let's look at the cruel math of venture investing. So the equation at the top of the slide relates
the amount of cash that we're putting into the business to the amount of cash that we hope to get
out of the business at a later point in time.

Play video starting at 2 minutes 4 seconds and follow transcript2:04

Remember, we're going to take cash from our limited partners and we're going to invest in this
company. It's going to be locked up for T periods of time. Our limited partners are going to have
some required return. So the left side of the equation says that the cash that I'm putting into the
business needs to compound at this rate of return for T periods to be some future value. How are we
going to generate that future value? Well, we're hopefully going to be able to exit this investment by
either taking the company public, by selling it to another company or by selling it to another
investor. When that occurs, we're going to get cash out. But remember, we don't know if that's
going to occur. Most venture investments fail. So let's let P represent the probability that this
investment is a successful investment. Now remember from our previous discussion, a VC might
make 10 investments and only one or two succeed. So P is a number like 10 percent or 20 percent.
There's maybe a 10 percent chance that this investment is the investment that succeeds and
generates the cash out that we use to pay our limited partners. So that's what that equation at the
top says. It says that the cash that we're taking from our limited partners to invest in this business is
going to grow at this rate R for T periods, and how are we going to return that capital to limited
partners? Well, with some probability P, we're going to have an exit event that's going to generate
cash out back to us.

Play video starting at 3 minutes 55 seconds and follow transcript3:55

We can take that equation and we can rearrange it and we can see a couple of concepts really
simply. I can just put the cash on one side and put all of the discounting terms on the other side and
you we can develop an expression for what's called the cash on cash return. So to do that, I'm just
going to divide both sides by cash-in and I'm going to divide both sides by P. That's going to give us a
different form of the same equation: cash-out divided by cash in equals one plus R to the T divided
by P. So what's on the left? Cash-out over cash in. That's basically the cash on cash return. How
much cash do I get out for every dollar of cash that I put in? How do I know what that number needs
to be on average? Well, I need to think about the fact that I need to pay an expected return to the
limited partner but I'm bearing a lot of idiosyncratic risk by only making these 10 or 12 investments
of which may be one or two will succeed. So I'm going to take what would otherwise just be the
standard discount factor that you learn from Manuel in the earlier part of the course, that one plus R
to the T, and I'm going to be dividing by the success probability. So think about what that does. If
you have a discount rate like maybe 10 percent, that would be an R of 0.1. That will give you the
term inside the parentheses would be 1.1. We'd raise that to some power T to represent the number
of years that we would be earning interest. You might have a number like 1.3 or 1.5 for example
depending on how long it compounded. That would be saying that if we were just paying an
expected return to investors, we would need to get say 1.5 dollars out for every dollar we put in. But
instead, we're going to take that 1.5, the 1 plus R to the T power, and we're going to divide by the
success probability which might be 10 percent, might be 20 percent. So we're going to take 1.5
dividing by 0.1 is like multiplying by 10. So we're going to take 1.5 and turn it into 15. That's going to
say that we're going to need to get $15 out for every dollar we put into the company. Why is that
happening? That's happening because when we make the initial investment when we put the cash
into the company, we don't know if this is going to be one of the ones that succeeds and one of the
ones that fails. So we're going to have to write this term sheet in a way. It gives us enough cash
coming out of the business if it's successful to compensate for all the failures that we're going to
encounter along the way. That means that we're going to require a very high cash on cash return
relative to the return you'd be expected if you were a diversified investor. You can take that middle
equation that gives you the cash on cash return and we can work with it a little bit to get what the
hurdle rate is. If I basically just take that number 1 plus R to the T power divided by P, the probability
of success. If I take the T root of that and subtract 1, I get the hurdle rate. We can go through some
exercises you'll see that that hurdle rate is many times higher than the discount rate are that an
investor would require if he or she were diversified.
The VC Method

Now that we've seen how hurdle rates are computed, let's use that hurdle rate to do what's called
the VC method. It's an alternative to the standard NPV calculation that Manuel showed you earlier in
the course. It helps you understand how VCs think about how much equity to take in the
investments that they make.

Let's just walk through a simple example. We want to ask ourselves we need a couple of inputs for
this. First of all, what's the required investment that the VC needs to make into the company today?
Let's call that $100. The second critical piece is going to be what is the exit valuation for this
company? Now, to keep things simple. Let's assume that the exit valuation will be 20,000. So let's
pause for a minute though and ask how are we going to estimate this number? Well, typically, what
we would do is we would go back to the very tools that Manuel taught us in the beginning of the
course and we would think about cashflow projections, and we would imagine what the cashflows of
the company would be like, let's say 5, 7, 10 years down the road. At some point, when the company
was mature enough to be sold to another investor or taken public. So we would use those cashflow
forecasts that we had developed and we would think about what prevailing market conditions might
be based on those cashflows, how much would we get for the company if we sold it at that time.
That's going to give us this number that I'm using $20,000 as an example. So we've got the first two
inputs are how much money do we need to put in today? How much are we going to exit this
investment for the future? The third key input is what is the cash multiple that we have to earn? So
going back to our previous lesson, if the discount rate that limited partners require is 15 percent, if
it's going to be locked up for five years, and if the success probability is 10 percent, then the hurdle
rate is going to be about 82 percent and the cash on cash multiple that we'll need is about 20. So just
think about that for a second. Our limited partner is going to get a 15 percent return on average. In
order to develop that 15 percent return accounting for all the failures that I'm going to experience
along the way, I'm going to use an 82 percent hurdle rate. I'm going to take these three pieces and
I'm going to put them together and that's going to give me a net present value. So I'm going to take
the exit valuation, $20,000 and I'm going to divide it by the cash on cash multiple and that's going to
give me the today's net present value of the entire company. In our example, that would be 1,000.
So it's taking the $20,000 exit valuation and dividing by the cash on cash multiple of 20. That NPV of
$1,000 that's today's value of that future exit. Now, I can compare apples to apples because you're
asking me to make $100 investment in the company today and I've determined that today's present
value of a future exit is worth $1,000. So now, I can think about how much equity I need to own in
order to break even? You're asking me to put in $100, the company is worth $1,000, therefore, I
need to get about 10 percent of the firm's equity in order to break even on this $100 investment
you're asking me to make. So let's just pause for a second and think about this. If you're the
entrepreneur, you think about that $20,000 exit and you think that's what your company is worth.
You know this is going to be a success and when it's successful, this company is going to be worth
$20,000. You're asking a venture capital investor for $100 and you're thinking you're going to give
them a piece of equity that represents their fair share of that $20,000 stake. At least, he's going to
look at you and say, "I'd like 10 percent", and you say to yourself, "10 percent? That's crazy." Well,
bear in mind that what the venture capital investor is doing is the venture capital investor is folding
in the fact, that your success is not guaranteed. So we need to account for the very high probability
of failure and take a much larger equity stake than we would take if we knew it was successful, we
don't know it's successful. We'll take a large equity stake and that's going to compensate the venture
capital investor on average for all of the failures that they've experienced along the way. What that
really means is that who is responsible for compensating limited partners for the high probability of
failure in venture investment? Well, it's ultimately the entrepreneur. That's why venture capital can
be such an expensive source of capital because the failure rates in venture investing are so high and
ultimately, the cost of failure are borne by the startups themselves.
Now, let's use the venture capital method and use it in a couple of different ways. I've got two
examples here. You'll see when we read these examples, that you need to make some assumptions
on your own in order to get a concrete answer. The first one ask, how large does an exit have to be
to justify investing $10 million for a 28 percent ownership stake if we expect to wait 5-7 years for an
exit and our current ownership will be diluted 50 percent before and exit occurs? So what that
means, let's just pick that apart for a second before you start the exercise. A 28 percent ownership
stake today, we're expecting investors to come in behind us and dilute our investments so that our
28 percent ownership stake today is going to be 14 percent of the exit when it occurs. We're asking,
how large does that exit have to be for our $10 million investment to be worth 14 percent
ownership of that company? So think about what additional inputs you need in order to solve that
problem. We're going to have to be able to compute that cash on cash multiple in order to answer
this exercise. The second exercise says, how much equity should we negotiate for a $10 million
investment if we expect to wait 3-5 years for an exit to occur and that exit will be priced at 11 times
earnings on a company that's earning $100 million in earnings? So in other words, we're imagining
that in 3-5 years from now, this company is going to have $100 million EBITDA, Earnings Before
Interest Tax Depreciation and Amortization. When we sell this company, we expect to be able to sell
it at 11 times EBITDA. That's going to generate an exit value of 11 times 100 million. Then we need to
ask, how large of an equity stake do we need to negotiate for a $10 million investment in that? So
ask yourself what factors does that depend on? Go back to the equations, try to write down
numbers that express what those factors are, and then use those numbers to determine the equity
stake.