The Four Roads to Frontier Tech Debt Financing

Greetings and welcome to 2024! After some wonderful downtime with the ones we love most, Team Overlap is ready to go again, rolling up our sleeves for another action-packed year. No one could ever say 2023 was predictable, but nevertheless it was an amazing time to build our business. Huge thanks to everyone who supported us on our journey; you know who you are, and we are grateful.

Now it’s our turn to pay it forward. In this month’s newsletter, we decided to share our informed perspective on the question we get asked most: what debt investors look at when financing a frontier tech startup. Our hope is that this blog post will serve as a valuable base of knowledge to those who need it—and contribute to building a stronger frontier tech ecosystem as a whole.

Wishing you a fantastic start to the year ahead.

At Overlap, we often find ourselves giving advice to frontier tech startups about debt financing. A lot of these discussions start in a similar way—with us explaining how lenders think about underwriting in general, and enumerating the four basic philosophies that come into play when making a lending decision. So, as a helpful jumping-off point for founders and frontier tech startup execs wrestling with these issues, we decided to write this blog post.

We’ve framed the debt financing journey for a frontier tech startup as a metaphorical road trip, with four different paths to the ultimate destination (i.e., a successful debt raise). While the piece is meant to engage a wide audience, it does assume a basic level of understanding of what debt is and how it works. (Think of it as a 201-level course.) If some of this material is difficult for readers to comprehend, we recommend starting with the “Overlap 101: Debt” video we posted in last month’s newsletter.

(Editor’s note: This post is focused exclusively on debt provided by commercial/corporate lenders motivated primarily by economics, and does not include government loan programs, foundation subsidies, or other non–market-based lending. That's another post for another time.)

Prologue: Packing for the Journey

So, you’ve decided you want to get a loan for your frontier tech startup. What do you need before you reach out to lenders? There are several “must haves” and “very good to haves” before beginning the drive.

• The most essential piece of equipment for a road trip is, obviously, a car. Similarly, if you want to raise some corporate debt, you need a company—or more specifically, you need to actually be in business, with equity capital already invested and a management team focused full-time on the business. Debt investors are much more risk-averse than equity investors, as they should be—their upside is (usually) capped, and their downside is the same as everyone else’s (i.e., a complete loss). With that in mind, they want to know that there are equity investors and a management team who are focused and invested in the business’ success—and who will lose out before them should a liquidation happen. In general, you’re MUCH better off if one or many of the investors in your company are well-regarded, with a track record of successful investments. Usually this means a respected institutional VC firm, but it could also mean a private equity firm or a sought-after angel investor.

• Lenders will almost universally want to know that you have some level of cash runway for the business already in hand. This typically means a minimum of 12–18 months prior to counting the debt raise, but more is always better. Lenders don’t want to be the ones extending the runway—they view that as equity’s job. To some people, that seems counterintuitive, but that’s just how debt underwriters view the world. We sometimes say (half-jokingly) that you can’t get debt unless you don’t need it. There’s some truth to that.

• While there are isolated exceptions, we generally suggest that pre-revenue companies avoid debt. Lenders typically want to see customer traction for a business they're going to lend to—they don’t want to take science risk. The one variance to this is discussed below in the section about Collateral debt.

Now that you’re ready to start, let’s take the four roads one by one.

Road #1: The Positive Cash Flow Parkway

The first and most obvious road is cash flow. If your company generates strong free cash flow (net profit adjusted for non-cash charges, or a proxy metric such as EBITDA, as explained below), you're an excellent candidate for financing from a large pool of lending providers. If you’re a scrappy startup that’s not going to be profitable for a while, feel free to skip this section. You’ll have plenty of time to come back here later.

All lenders view the world slightly differently, and you'd be amazed at how varied the loan specifics can be from a handful of lenders that you speak to, so it's still very important to go out to a number of these financing sources and run a process to ensure the best terms. There's an art and a science behind negotiating with multiple lenders, and if you’re not putting real thought and strategy into it, you’re leaving money on the table.

Cash flow lenders typically utilize a formula that determines what your annual (current and expected) free cash flow is, and then give you a multiple of that in debt—the assumption being that you’ll have the ability to use said cash flow to pay them back. Let’s say your company generates $5 million in free cash flow; maybe they’ll decide to lend you up to $20 million, or 4x that annual amount, knowing that they can be expected to be paid back over the course of the next four years (or more like five, after accounting for interest).

Obviously, things aren’t that simple in practice. Most lenders use a more complicated formula than simply the net earnings from your audits to accurately reflect your company’s debt paydown capacity. For instance, the existence of debt itself, and the interest payments that come with it, reduces a company’s tax bill (interest expense, up to a limit, is tax-deductible). This leads some lenders to add back a company's taxes to this calculation. In addition, if a company has existing debt that will be refinanced as part of this financing, they add back the existing debt’s interest expense. By adding back both interest expense and taxes, one is left with a term called EBIT, or “Earnings Before Interest and Taxes.” Taking this a step further, some people also like to remove certain non-cash charges on a company’s income statement, like asset depreciation and amortization (to avoid a long tangent, if you don’t know what those are, just look them up). Adding back these figures leaves us with the well-known acronym EBITDA, which has become even more ubiquitous of a concept than net earnings as a tool to determine leverage size and scale.

Road #2: The Collateral Causeway

The second road to debt financing is a collateral-based loan. These lenders provide financing based on the value of the assets you have, which they can repossess and sell if you miss your payments.

Collateral-based lenders are much less focused on the financial viability of your business itself than other types of lenders. In their underwrite, they are inherently assuming a downside wherein your company goes out of business, and making sure they generate a good return on their loan even in that scenario, because they'll repossess and sell your collateral for more than they lent you.

These types of loan agreements are structured in a way that makes it crystal clear that, if things go wrong, collateral-based lenders get first crack at that collateral ahead of other stakeholders. A whole subset of different agreement structures are used to do this, with names such as “repurchase agreements,” “hypothecation,” and more—but those are probably best saved for a future post.

Collateral-based loans come in a variety of flavors, based on which assets you have on your balance sheet. If your company is capital-heavy, with a lot of machinery and robotics, then you can probably get an equipment-based collateral loan. On the other hand, if you have a large receivables balance, you can get what's called “trade finance,” or a receivables loan. Furthermore, if your company has sellable intellectual property / patents, you can work with an IP-based collateral lender.

What all these types of collateral lenders have in common is their focus on the Net Orderly Liquidation Value (NOLV) of your collateral. In other words, if you go out of business, and the company liquidates, how much money (net of sales costs) can they get from selling this collateral in an orderly fashion? So, when thinking about whether you'll be a good fit for collateral financing, you need to put yourselves in the shoes of the lenders asking themselves that same question:

• If you have a lot of receivables, are they with large public companies? Or, small startups that might go out of business?

• If you have a lot of equipment, is it custom-tooled and only really useful to you? Or, would a lot of established companies be interested in buying it?

• If you have IP/patents, is there a wide pool of potential purchasers of that intellectual property? Do those potential purchasers have the financial wherewithal to purchase it for a substantial amount of money?

These are the key questions collateral-based lenders are going to ask when making the loan. The higher value and probability of successfully selling your collateral in a liquidation, the larger of a loan they're likely to provide.

Road #3: The Total Enterprise Value (”TEV”) Turnpike

The third road to debt financing is a loan based on a company's overall valuation, known in the industry as its Total Enterprise Value. At Overlap we like to call these TEV loans, though in the startup ecosystem people will often use the term “venture debt,” as this is the form of lending that startups typically first have exposure to.

In a more normal lending environment than the one we're currently in, startups could expect to receive several term sheets from lenders for this type of debt after publicly announcing a successful Series A or B debt raise.

The lenders offering this type of venture debt are making an underwriting decision based both on the quality of the VCs involved in the equity raise, and the implied commitment of those VCs to the investment they've just made. The general logic is that if a bunch of professional investors just invested in the company at a valuation of, say, $100 million, then a lender providing that company with a loan of $20 million is probably going to be fine, because the equity holders are likely to pony up whatever money is needed to repay that debt to protect their investment if the company has trouble doing so itself.

In today's market, we typically tell companies to expect somewhere in the 10%–20% “loan to value” range for venture debt, assuming they raised their round recently (i.e., that valuation was recently validated by external investors who are actually writing checks at that level) and had buy-in from numerous institutional VCs (not just insiders and small investors whom the lenders don't know). In a more aggressive lending environment, those numbers can go upwards of 40%–50%.

It is also worth noting that there tends to be a fairly wide difference between the venture loans provided by banks and those provided by non-bank lending institutions. Banks typically offer more attractive economic terms (interest rate, initial and exit fees, etc.) but have more onerous operating requirements, such as making companies keep most of their cash at their institution. These requirements mean that the bank can keep a “tighter leash” on the company, and can give them the ability to restrict maneuverability during difficult times. It's important to appropriately weigh these concerns in making a decision as to which lender to work with.

Road #4: The Revenue Roundabout (or the Hybrid Highway)

Our fourth and final road to debt financing is a revenue-based loan—or what we at Overlap often refer to as a “momentum” or “hybrid” loan. Companies receiving a revenue-based loan are those that do not yet generate positive free cash flow, but have a growing revenue base, underpinned by numerous, viable customers.

Lenders see this topline momentum, compare it to the company's cost base, and make a determination of the company's path to profitability. They also take into account additional factors that other types of lenders utilize as outlined above, such as collateral quality and the probability of subsequent equity rounds. They then bake all of these characteristics together to come up with a view on the company's overall risk of default (and their potential recovery therein), and use that to determine the appropriate return they require to make their investment.

To state the obvious, a company getting a revenue-based loan is going to have to pay more for their loan than a company that already generates cash flow on Road #1. How much more is determined by the lender’s perception of the factors in the paragraph above. These lenders recognize that they are taking on a higher risk, and therefore want a greater return to justify it. As a result, they will charge a higher interest rate on the debt (anywhere from high single digits to low 20s%) and require the company to give them substantial equity warrants as well. (It's not unusual for small amounts of warrants to be given in the other types of lending transactions, but they're a considerably larger share of the economics in a revenue-based loan.) The warrants allow the lender to participate in the company’s success in a way that normal debt lenders do not, hence why we call this hybrid lending—it incorporates the features of both debt and equity.

Hybrid lending is an emerging and essential part of the lending ecosystem. It's an invaluable lifeline to many growing companies, and can provide the essential flexibility that many frontier tech companies need as they scale. We are fortunate to have relationships with many of these firms, and have a keen understanding of the exact types of companies they're looking to finance.

Conclusion

Whoever said “Life's a journey, not a destination” never tried to get a loan for a frontier tech startup. If you're a founder, we hope you find this primer useful in helping you map your way through the process.

The commentary on this blog reflects the personal opinions, viewpoints and analyses of Overlap Holdings employees providing such comments, and should not be regarded as a description of advisory services provided by Overlap Holdings. The views reflected in the commentary are subject to change at any time without notice. Nothing on this blog constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy or activity is suitable for any specific person. Any mention of a particular security or activity is not a recommendation to buy or sell that security or engage in that activity. The commentary on this blog is solely for informational purposes. Please remember that past performance may not be indicative of future results.