Why Profitable, Growing Companies Can't Get Financing
When I started my company I had only a minimal understanding of how I might fund it. I knew what equity, and debt were, and had heard of “mezz,” but I didn’t understand the nuances and when each might be appropriate.
Years later I’ve done angel, venture capital, private equity, commercial debt, and mezzanine debt deals as a founder, operator or board member for companies of all sizes, and have a much better understanding of what works when. I've also come to realize that there's a stage at which your company is growing, and to you, it looks like things are all good from here on out. And that's exactly when it suddenly becomes much harder to find financing. It's worth understanding why this happens.
Debt providers come in two primary flavors: commercial banks and private lenders. Commercial banks get the first lien, meaning they get first dibs on company assets in the event of default. Private lenders get the second lien. They get in line behind the first lien lender, and are therefore "subordinated," which is why they are sometimes referred to as sub-debt. There are other options, such as lines of credit, receivables financing, factoring, and so on, but we'll leave those for another column.
In general, commercial banks lend to the following types of businesses:
- Mature businesses, with minimum revenues ranging from $50 million to $100 million, that are very profitable and have a long history
- Companies with substantial tangible assets, such as real estate, buildings, and machines, that can be sold off to recoup the loan balance in the event of default
- Companies whose loans will be personally guaranteed by the owner.
Private lenders (often referred to as “mezz” or “sub-debt” providers) typically seek to provide debt to somewhat less mature businesses than banks. In general, the threshold for such loans is at least $5 million in earnings before interest, taxes, depreciation and amortization (EBITDA), some tangible assets, and long-term customer histories.
Commercial and private lenders issue debt that businesses must pay back on some set of conditions--interest rates, duration, and so-called covenants.
You might have heard of venture debt. That’s really just a commercial bank that lends to venture--or private equity-backed businesses.
Most importantly for growth companies, loans do not reduce entrepreneurs' equity ownership.
Equity providers historically come in three flavors: angels, venture capital, and private equity.
- Angels, which include friends and family, typically invest less than $1 million into their portfolio companies. In 2010, about 250,000 angels invested $20 billion in 60,000 companies. The average investment was $324,000.
- Venture capitalists invest larger amounts, typically in companies with less than $5 million in revenue. In 2010, about 460 venture capital firms invested $22 billion in 2,800 companies. The average investment was $7.8 million.
- Private equity firms invest much larger amounts in more mature companies (those with more than $25 million in revenue). In 2010, about 2,800 private equity firms invested $350 billion in 450 companies. The average investment was $760 million.
As you can see, private equity firms invest bigger sums into more mature companies. Additionally, most private equity dollars go into buyouts, whereby the private equity firm takes more than 50 percent ownership. These deals are usually structured so the owners get some cash and retain some equity.
Unlike banks, angel investors, venture capitalists, and private equity firms all want equity in your company. The general rule is that angels take some equity, venture capitalists take more, and private equity firms take the most.
What About Crowdfunding?
Crowdfunding is when many individuals invest small amounts--as little as $1--to help a business reach its financing goal. Crowdfunding is almost always for total investments of less than $1 million. It's most suitable as an alternative to angel investors for seed or very early-stage businesses.
Kickstarter is one of many crowdfunding platforms that won't dilute your equity. Kickstarter campaigns are often structured as pre-payments for future products. These pre-payments allow early-stage companies to gauge demand, build market awareness, and get cash for development and delivery of products.
Sites such as Microventures and Rock the Post allow entrepreneurs to sell equity, by allowing angel-level investors to efficiently screen and invest in very early-stage companies.
What Capital is Best for Me?
Seed stage businesses (those with no revenue, and those in the idea or early-product stage) have a clear set of options: personal savings, angels or early-stage venture firms. For some pointers on how to approach venture firms, see my article here.
Later stage businesses with more than $20 million in revenue and more than $5 million in EBITDA also have a clear path. They can self-fund through profits, or approach private equity firms, bank or private lenders.
For these companies, the real challenge lies in deciding whether to go it alone or to get outside capital. Not to worry: plenty of investment bankers, advisors, and capital sources will lavish attention and advice on such businesses if they just raise their hands.
The Murky Middle
The companies in the toughest spot are those in the murky middle: businesses with roughly $5 to $15 million in revenues and with cash flow at breakeven up to about $3 million. These companies are a bit too mature for venture capitalists, not mature enough for private equity or private lenders, and certainly not mature enough for commercial banks.
When I say these companies are “too mature for venture capital,” I mean that venture capitalists have a tough time making their strategy fit those companies. The venture industry is built on the assumption that a small percentage of investments will be intergalactic grand slam home runs. That means venture investors need to own a pretty big slice of businesses that have a shot at providing lottery ticket-level returns. And owners of businesses in the murky middle tend to be intolerant of significant dilution.
A bread-and-butter venture deal looks something like this: invest $5 million of preferred equity into a company with a pre-money valuation of $10 million. The venture firm will own a third of the equity, and between sweeteners such as accumulating paid-in-kind dividends ranging from 8 to 13 percent and liquidation preferences, the venture firm can own up to half or more of the business when it exits.
A “murky middle” business with $7 million in revenue and $1 million in EBITDA won’t accept a $10 million valuation, and doesn’t want to take $5 million in capital. They may want a $30 million pre-money valuation, and only $3 million in dilutive capital. Otherwise, all that dilution is just a bridge too far, especially when the company doesn’t need the money to survive - it's profitable, after all.
So now this terrific business, growing fast, with a big opportunity and good numbers, walks away from venture capital and can’t get private equity funding.
Why Debt Won't Work, Either
So they go to a mezzanine/subordinated debt firm. These firms typically need to lend a minimum of $5 million to companies with at least $3 million, and preferably more than $5 million, in EBITDA. Even if the company with $1 million in EBITDA can find a firm, the lower the EBITDA, the riskier the lender thinks it is, and the more dilutive equity warrants they’ll demand -- sometimes asking for more than 20 percent of the company. In most cases, the company doesn’t qualify anyways.
A commercial bank would certainly lend to this company, but only with a personal guarantee from all the founders. And it'll be rough going: imagine a really invasive home mortgage underwriting process.
So what capital options is this terrific, growing, profitable company left with? They can go it alone. They can try to get one-off super-angel financing, which is hard to find. They can look for a smaller later-stage venture capital or private equity shop that can do the smaller deals with friendlier terms, or they can personally guarantee a bank loan.
Most companies in the murky middle walk away from all of these, and try to grow organically through profits.
ALAN YING | Managing Director, Polus Capital
Alan is the non-executive chairman of KLAS Enterprises, a leading provider of healthcare information services. He is also the President of Polus Capital, a provider of entrepreneur-friendly capital to growing and profitable businesses based out of Houston. He was formerly the founder and CEO of MercuryMD.