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Term Debt and Venture Backed Businesses – No Thanks!

Nate Lentz
August 31, 2015

Maybe it is because I started out my career as a loan officer at what is now J.P. Morgan Chase, but I really have a hard time with debt.  To be fair, not all debt, and not for all companies – I have a hard time with term debt to small, volatile, cash flow negative companies.  This aversion likely comes from an early lesson in the year-long credit training course I was put through, during which they taught us that term debt was debt that was outstanding typically for longer periods of time and was to be repaid with the cash flow generated by the business.

So why would a lender make loans to small cash-flow negative start-ups?  Well, for starters, it is because they can charge high fees and get equity, and these loans can be really profitable if they get paid back.  Second, they look to the investors (who would sit behind the lender on the balance sheet) to repay the loan should there not be an exit, another funding event, or, in rare circumstances, the company’s ability to generate positive cash flow prior to the repayment of the loan.

Why would an entrepreneur take term debt?  It can sound very attractive because debt is less dilutive than equity, and thus it can be used to bridge to an exit or to lengthen the period before a next round of fund raising, allowing value in the business to grow.

Why would the investors support term debt?  Frankly, I don’t know.  On the boards I am on, I rarely do.  Many of our companies have AR lines of credit where loans are available against a percentage of eligible receivables.  These work well and are designed to support working capital expansion.  They tend to be inexpensive and are not repaid through operating profits but through receivable collection.  Often, the lenders suggest a second line of credit not supported by accounts receivable and the question I ask is always – what is the source of repayment of these loans?  When a board I am on approves one of these lines of credit, I always push for the caveat that they cannot be used without board approval at the time of drawdown.

Here are some further thoughts on term debt:

  • As a number of well-known economists have pointed out, excessive debt and loose lending practices have been the driver of many economic maladies over the years
  • As positive economic cycles lengthen, banks get used to making money and keep pushing to make more, thus many banks continually loosen their lending practices often until loan losses mount, then they retrench, often to the detriment of those to whom they have lent
  • Banks have proven an inability to self-regulate, and often put short term profit ahead of long term risk management (mortgage crisis, savings and loan crisis, junk bond LBO crisis, Latin America debt crisis – to name a few).  Entrepreneurs and their boards need to be the regulators because the banks can’t and won’t self-regulate, and thus these term debt term sheets show up in many board rooms
  • Investors, especially new investors, hate the use of proceeds in a financing to be debt repayment.  Investors want to fund future growth in the business, not repay the costs of past growth

If you are an entrepreneur, look at the repayment schedule on the debt and ask yourself – if you could not raise additional capital then could you ever make these payments?  And remember one of the first lessons from credit training:  a company without debt cannot go bankrupt.