VC#10: Debt and Securitization in Tech Cos.
The best plan would be to just deal with it. Or securitize. Yes, really.
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Since I last wrote, world effectively went to shit overnight in the battle of the Vladimirs. What caught my eye was the unknown Mig 29 flying Ace who has been nicknamed the “Ghost of Kyiv”. Apparently he shot down 2 two Su-35s, two Su-25s, a Su-27 and a МіG-29. This is no mean achievement. Folks like me who are trying to fly a Mirage 2000 in DCS quickly come to realize this shit is harder than 3D chess1. I have been trying to defeat an F-18 but the damned thing sticks on my tail and I keep getting missiles to my face. All of a sudden you are thinking about stuff like one-circle, two-circle and rate fights and while it is not important, the only point is that this is really an insane achievement. If it’s real.
Now, my brain screams bullshit (this is most likely some really effective propaganda) but an unreasonably large part of me hopes this guy is real. Imagine the stories he would have to tell. Balls of titanium….
Ten years from now, we will look at this moment as a key, seismic shift and come to this conclusion - “well, that was pretty fucking obvious…. what else could have happened.”
And while I will not go into the specific reasons for why this is happening - this is the moment where some of the more baffling economic and monetary decisions made by Russia over the last 7-10 years come into relief. Putin was planning this for 10 years - creating energy dependence, insulating and fortifying his economy against economic sanctions, lulling everyone into a very false sense of security.
This will shape the world to come in many, not so good ways. Shit has only just started flying.
Speaking of flying shit, what is your view about Debt as a tool to fund startups? Or, to be more generalized - Debt in tech companies?
In the last post, I wrote about a very different approach being adopted by Hedge Funds in the VC/Growth stage. This article is a continuation of that conversation and today we will talk about another trend - the emergence of Debt as a viable option to equity in the tech world.
Sure, we can hate it, criticize it, call it the beginning of the end, the thin end of the wedge, a bennite solution2. But it’s here. And the reason why it is here has to do a lot with some of the more fundamental, underlying changes in the tech world itself.
Before we go further, I would suggest you read this post about the app-infra cycle if you have the time. It’s not necessary but will help put what I will say next in context.
1. Production Capital, Financial Capital and Deployment Phases
4 Definitions to start:
Production Capital (PC) - Factories, machines, processes, IP - basically everything on the asset side of a company’s balance sheet.
Financial Capital (FC) - Equity and Debt. Basically money coming into a Company that is owed by the liabilities side of its balance sheet.
Installation Phase - early stages of a tech revolution. Tech is exciting, market opportunities are uncertain but large on the spreadsheet, expectation of financial returns can be reasonably summed up as multiple large sacks of gold bullion being carried out of Alibaba’s cave.
Deployment Phase - matured markets. Lower speculation, much higher deliberation in where capital gets deployed. Investors have a good understanding of underlying cash flows and business dynamics and the Management of the Company has (reasonable) expectations around cost of capital and a credible deployment plan.
Now, PC and FC have a predictably changing relationship that morphs depending upon the maturity level of the technological curve (yes, there is a hand drawn chart, later). PC and FC perceive and work with one another with a sense of disdain - quite often.
FC views the business as a source of making money. PC views money as an inputs for making widgets (insert whatever service / good you can think of here). The sarchasm3 here is best addressed by Peter Drucker:
“Securities analysts believe that companies make money. Companies make shoes.”
2. Coupling - Decoupling -Coupling…. Ad Infinitum Nauseum.
The Installation Phase is the initial phase of a tech revolution, the Deployment Phase is what comes after what we can define as a turning point - once the battle for standardization or dominance has been fought and mature winners are evident. See chart below.
This take on the S-curve is inspired by one of the chapters from Carlota Perez’s book (more in suggested reads). OK, let’s examine this now.
Discovery: The first step in any Tech’s mainstreaming is its birth and discovery by FC. The relationship between FC and PC here is purely speculative but in lockstep. The new tech is seductive, the market uncertain (and hence potentially immensely attractive). However, there is a fundamental gap between the Investors and the Management at this phase. The Investor is thinking in terms of bets, the Management is thinking in terms of outcomes. This is a tense but can be a very productive relationship4. Now, in so many ways, the VC model can be seen to be a logical outcome of this tension. Valuations (FC proxy) are low, and asset bases (IP, market share, wha have you; PC proxy) is created using the money raised.
Bubble: As early successes become apparent, the FC chases any and all opportunity. Smart money behaves like the stupidest money on the planet and real vs paper values of assets diverge wildly. This is where FC and PC have decoupled (think of Zomato and its IPO valuation vs where it is today). This is the typical hunting ground for highly speculative strategies (e.g. hedge funds).
This completes the installation phase. Tech has been discovered, it has been funded. Capabilities have been built. Now these go out in the arena and then fight it out.
Of course, much like the gladiators of Rome, fighting is intense. Market share, capital, tech stacks, people, everything is fought over. And this is followed by an inevitable crash. Inefficiencies are weeded out. A few survivors remain.
As I write this, we are already somewhere just before an impending crash (in my decidedly uninformed opinion) as far as the larger tech universe is concerned.
So, what happens next? We go into the Deployment Phase.
Synergy: After the survivors have been identified and FC has taken it’s licks, a period of consolidation, of institutionalized recomposition begins. FC and PC recouple. We move away from speculation and capita is put to work more deliberately. Exuberance died with winnowing of the field in the crash. Investors want cash flow visibility, Management teams understand the underlying dynamics and can offer them very well. Expectations around cost of capital and returns are reasonable. This is the domain of mainstream PE.
Maturity: The tech has now matured to a point where it is being deployed everywhere. Early mover advantages have been removed. Small players have access to same tools and firepower as fortune 500 companies (as an example AWS). The Technology now creates far more value for its customers than for its vendors. New investment opportunities dwindle, incremental returns falls. Deliberate underwriting is the new game (public markets). PC keeps working on consistently but this is where FC is looking for the next big thing. Idle capital is deployed in newly discovered Tech.
And thus the cycle repeats itself again and again. Earlier, I asked you to read an older post on the app-infra cycle. See the point? Here’s a quote from Jerry Neumann’s blog on this:
The past 240 years have seen four of these great surges and the first half of a fifth.
We’re all familiar with the industrial revolution, with its mechanization of textile mills, the spread of water power and canals, and the massive increase in productivity. This was followed by the spread of the railways and steam power, the age of steel, and the Age of Oil, Autos, and Mass Production (from the beginning of the 20th century to the 1970s.) The wave that we are currently in, the Information and Communications Technology Revolution, started around 1971.
These cycles have eerie similarities. Each is characterized by
some critical factor of production suddenly becoming very cheap,
some new infrastructure being built,
a laissez-faire period of wrenching innovation followed by a bubble,
a post-bubble recession,
a re-assertion of institutional authority, and then
a period of consolidation and wide spread of the gains in productivity from using the new technology.
The repeated pattern in otherwise dissimilar eras seems like it has to be more than coincidence. What dynamic could cause it?
3. So where are we on this chart?
Somewhere between Bubble and Synergy, depending upon which sector/segment you are competing in.
See, “tech” is not a monolith. Sure, Food Delivery has had its crash and is well into synergy mode. Fintech is still in the bubble phase. SaaS is about to cross over into maturity. The point is that various players that fit each of the 4 stages have various opportunities available to them.
VCs still live out in the speculative future, funding wild bets (basically, out of the money call options). At the same time, tech giants can put capital to work at scale, with little guessing involved. A new generation of small businesses has learned to take full advantage of software and the internet, understands their customers, and knows how to put capital to work serving them.
Startups used to build or buy their technology stacks. Now they rent them. The “peace dividend” of the fight between AWS, Azure and Google CLoud, means that startups can increasingly choose to move most of their technology off their balance sheet forever. The AWS bill has become the new electricity bill. That’s the new production capital in action. Think of what companies like Shopify and Shiprocket have done. The small player making 10 units a month has access to the same tech as the behemoth making 10 million units a month (of anything, doesn’t matter here). There’s no speculation involved. Everyone knows exactly where the money’s going, and what’s expected of them.
I would posit here that certain parts of the tech universe (e-commerce, infra, SaaS) have passed well into the Synergy Phase. Let’s take a minute discussing the matured model’s dynamics before addressing Debt in tech cos.
4. Mature Business Models
Perhaps the most important development of the last 15 odd years is the mainstreaming of the recurring revenue or pay-as-you-go model. It feels mature to us today. Right?
I think we haven’t even begun seeing it’s second order and third order effects. Sure, as of 2022, the dot-com crash feels like ancient history. Recurring revenue model - looking back today - feels logically inevitable. Mr. William Janeway explains:
“While the SaaS model made it radically easier to sell software and to forecast reported revenues as contractual payments were made over time, it came with a cost. Salesforce.com was the first enterprise software company characterized by sound operating execution to consume more than $100 million of funding to reach positive cash flow. Now the poor start-up was in the role of financing the rich customer. Funding from launch to positive cash flow for a SaaS enterprise software company runs from that $100 million to twice as much or more, some five times the $20–30 million of risk equity once required to get a perpetual license enterprise software company to positive cash flow.”
Effectively, lending out you balance sheet funded by equity to other large customers with far lower cost of capital. Ouch!! It’s bad arbitrage.
However, this has been a great things for folks like me. VCs have happily stepped into this breach with huge piles of cash. SaaS models are a brilliant way of deploying capital - these new businesses spend an insane amount in marketing expense to acquire users, and then harvest a fairly predictable cash flow stream from that customer. These cohorts of customers can be modelled, forecasted and understood quite well. And this VC model adapts itself well to things like marketplaces, shared value transactions and so on.
The only limiter is really the imagination. If you survive, that is…
Now, the most important form of PC in this scenario is the “User”. Have you ever wondered why these cash burning unicorn types tomtom their user counts so much? It’s a signalling mechanism. They are accumulating assets. The USERS. Their use is what we’re out to monetize. Whatever the business model is, acquiring users is the new building factories. What that also means is that while most bets may overall be speculative, the median VC dollar isn’t anymore. It is effectively buying customer acquisition and financing service delivery while hoping to be repaid via cash flows. Another key learning for VCs seems to have been this - the best way to make money isn’t goods and services, it’s financing them. Same as GM and Ford learned many, many decades ago.
The issue is - as long as the recurring revenue is financed by FC (VC money), PC (founders and management time, effort and commitment) is at odds with it. PC works hard to squeeze, FC takes away all the juice. To quote Office Space:
However, these conflicting interests could be aligned. The relative maturing of the recurring revenue model suggests that an alternative way of financing may make sense. Whatever could it be?
Jonathan Hsu of Tribe Capital in an interview says:
“When you acquire some customers and they start yielding revenue that behavior sounds an awful lot like buying a fixed income instrument and there is a lot of sophistication around how to value those cash flows. In some sense, what we’ve seen over the last decade is that software enables a whole new business model – recurring revenue – which is both good for customers and is good for investors. It’s good for investors because it becomes more “predictable” in the sense that it starts to look more like a fixed income yielding asset and thus more amenable to traditional financial techniques and thus potentially “in scope” for a wider set of investors.”
What is the net takeaway?
The innovation financing game is played with different rules when FC and PC are aligned vs when they aren’t. In the ramp up of the installation phase, culminating with the frenzy of a bubble, you’re navigating a lot of ambiguity, and tolerate a high failure rate. The Deployment Phase is structurally different. In today's VC model, businesses are built with all-equity capital stacks and portfolio construction. So, the VC anticipates a power law return curve and their model is hyper-optimized to play the high ambiguity game.
But when you want to really align FC and PC, maybe equity isn’t the best tool anymore?
5. Bringing it all together
Here is a statement:
“Because Startups fail, the best way to finance them is via equity.”
Why? Who came up with this? Did they have an MBA, a PhD? Why should we believe them? And what happens if we invert this statement?
“Because startups are funded by equity, most of them fail.”
If you feel an aha moment coming, join the club. It’s very uncomfortable, isn’t it? Especially for people like me who have been doing this for 15 years. But it gets right to the core of the FC-PC misalignment that saturates the modern tech industry. In the early stages of a startup, the conventional cause-and-effect direction is correct. We use equity, because there’s uncertainty.
Plenty of people these days preach that startups need to rely less on fundraising but few who will question the gospel of equity iself. Equity is expensive currency (even with billion dollar valuations). If you are a founder, you have two optionalities - the equity you have not diluted yet (self-explanatory), and the valuation (read, insanely high, reality divorced number) you haven’t tacked on yet.
Yes, high valuations and easy capital inflate egos, destroy discipline and blur focus. But in terms of optionality - high valuation is a loss. The higher your equity valuation, smaller the set of possible future trajectories for your business. I think most founders get this. First off, try and not raise a ton of capital. And if you have to raise a ton of capital, then boosting your valuation isn’t preserving your optionality; it’s just an arbitrage trade. Another bad one.
And a good 10 minutes after I promised to talk about Debt in tech cos, we come to it.
Debt is preserved optionality when we look at it from the lens above. Sure, Debt can blow up in your face but so can preferred equity - and it often does. Debt is just very upfront about it. Preferred equity’s liquidity preferences5 aren’t generally a problem until they are - they hit you like a 18 wheeler on a Thursday afternoon. FC version of an acceptable outcome is a very narrow window. PC demands flex to zig and zag. As a founder, I certainly want more paths to be open to me than my VC demands.
To be fair, debt is not runway. My point is that there’s more than one way to construct a capital stack. And that some debt in the mix can be a smart way to finance a business. When was the last time you saw an infra company build roads with only equity?
And once this debt is raised, it is an easy thing to see how recurring revenue models are up to the job of servicing this debt very well.
However, the typical silicon valley (or whitefield) tech company does not use Debt because it looks like a red flag. The current environment is over indexed on growth. Somehow growth and debt are seen as incompatible. Sure, there aren’t enough lenders who will fund loss-making startups but increasingly, there are funds set up specifically for the purpose like Innoven who will.
Think about it - Lenders are among the most conservative folks on the planet. That a startup has raised debt should be a good sign - that it has very sound business fundamentals. My theory is that VCs (myself included) don’t like to not be the most senior capital in the stack.
We do see venture debt get used in scenarios like bridge rounds and other special situations, but its customers are really the VCs, not the businesses themselves. It’s not primary growth fuel. It’s purpose is to stay in the holding pattern. The benefits of debt aren’t worth the risk you’d take by potentially alienating yourself from future access to capital. Here is a fellow VC evangelizing against:
I smell shenannigans.
You know what will tip the scale towards debt? Securitizing the recurring revenue. Someone will eventually figure it out. Go straight to securitizing senior tranches of your recurring revenue, and keep moving it off your balance sheet. We can see a high-quality startup financing its growth this way.
Raise your initial equity to establish your product, go-to-market, and first big cohort of users.
Once you understand that first cohort of users really well, securitize the first XYZ% of the cash flows they generate and get them off your balance sheet.
Use this money from securitizing to create your next cohort of users.
Rinse, repeat!!
I don’t think many people appreciate how many great startups and SaaS companies have cash flow profiles remarkably similar to Asset Backed Securities. And now you are tapping into an extremely abundant pool of capital.
As a VC, I will probably be OK with it. My ideal business has a bread-and-butter base layer, and a cream-on-top expansion layer of revenues. This plays right in that. As an ex-investment banker, I am just staggered by the possibilities of a basket of recurring revenues from companies who have raised money from Tier 1 VCs. Let’s call it the “Unicorn Basket”. Can you imagine the demand for that product?
Now, the risk to VCs is that they have immediate and credible competition. Now, this doesn’t lead to an existential crisis, but the muscle memory for how to structure funds and term sheets becomes obsolete. And some of the better VC funds are pre-empting this with some rolling partnerships with Goldman Sachs and Morgan Stanley right into their Series B Termsheets.
Alex Danko had a funny take on this:
Expect, at this point, some pretty funny “Actually, four legs good, two legs better” blog posts from some of the same VCs who told us to never take debt a few years before. “Ah, see, that debt was reckless gambling; this debt is being equity efficient”. K thanks.
If you thought that companies hooked onto softbank were a calamity, imagine startups mainlining debt markets. Whichever way it goes, it will be pretty entertaining….
Suggested Reads:
Doing Capitalism in the Innovation Economy: Reconfiguring the Three-Player Game between Markets, Speculators and the State by William Janeway.
Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Perez.
The Deployment Age - Jerry Neumann.
Housekeeping
As always, I look forward to hearing from you. If you liked this post, pls feel free to share this or subscribe to this newsletter using the links below. While I have been tardy of late, I try to write a 1000-2000 word essay once a week.
I have a couple of school friends who are in the IAF. Incidentally, identical twins. I asked one of them what I should do if I am being out-rated in a Mirage 2000 by an F-18. He deadpanned - “I am a Su-30 Pilot. The Mirage 2000 and I only have a nodding acquaintance”. Then he blocked me. Apparently even if he wanted to he could not have told me my options because of national security and the SOP calls for immediately cutting off contact and reporting it. Ah well, at least his clone is happy to talk to me. In the meanwhile, I estimate there is maybe a 10% chance I will be asked questions by authorities about why I want to know how to defeat an F-18 in a dogfight.
Ok, I will stop with the Yes Minister references here.
I am very proud of this joke. Oh you are not? Well, screw you too.
Highly uncertain investor meets highly certain entrepreneur.
Liquidity preference is defined as: “Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference)”.