Direct-to-consumer eCommerce has exploded in recent years, as anyone with a social media account is well aware. DTC brands have gained an extra boost alongside e-commerce more broadly as the pandemic has convinced more shoppers that it’s safer and easier to shop from home. From razors to retinol and from shoes to booze, hundreds of thousands of brands (or, as some have put it, “blands”) have popped up to disrupt commodity goods markets.
The old playbook goes something like this: Identify a product category that needs a facelift and offer a more consumer-friendly, attractive version. Skip the typical sales channels like big-box stores and other wholesale avenues and go straight to the consumer, often via ad spend on social media.
Why? Well, if brands skip the middlemen, in theory, they can capture more of the profits. In reality, this has proven to be less straightforward than many initially envisioned.
And so, the game has evolved. Some DTC brands have realized that it’s tricky to balance the amount they are spending on advertising (or customer acquisition cost, a.k.a. CAC) with the lifetime value (LTV) of their customers. For example, mattress disruptor and IPO darling Casper has famously never turned a profit. Other DTC brands have experimented with extending their reach by opening storefronts or building partnerships with big-box retailers to get in front of more customers.
It’s safe to say that DTC e-commerce is going through a period of rapid evolution, as new brands hit the market nearly every day and both the original players and the newcomers experiment with how to build a DTC ecomm business that actually, well, makes money.
From the beginning, many DTC brands have followed the traditional VC model of raising equity to fund growth while operating at a loss. In fact, whether the product is software or shaving cream, startup culture and VC culture have become synonymous. However, software and ecomm are different beasts, with different trajectories and sales paths to navigate. Even software companies have started to question the VC model, and many DTCs are exploring other ways to fund their growth without giving up so much equity and upside.
That’s not to say that venture capital is inherently bad or not appropriate for any startups. But it’s important to take a step back and think critically about capital, especially as a DTC company with specific business goals. Ultimately, it’s key to consider your goals and the potential outcomes of different capital strategies.
To that end, we think it’s really important that DTC founders and stakeholders have a clear-eyed view of how, when, and why to leverage different types of capital in the service of their goals. That’s what this eBook is all about. A lot of D2C brands are interested in learning about alternative forms of financing like bank loans, lines of credit and crowdfunding.
Our focus is on helping DTC and eComm founders understand the different forms of capital, decide which are the best for them at their current stage and know which forms will be available to them as they grow their business.
We want to help founders think critically about whether, when, and how to take on funding and how it will impact them and their businesses down the line. Read on to learn more.
A Word on Focusing Your Time
If you read the headlines on TechCrunch and VentureBeat, you may start to get the impression that closing a round of VC funding is a sign of success in and of itself. But as many jaded ex-founders who have been forced out of their own companies or seen the doors close altogether with little to show for their blood, sweat, and tears can attest — it’s often not all it’s cracked up to be.
The reality is that taking on outside funding should only be done thoughtfully and strategically. Furthermore, different types of capital should simply be seen as tools you can add to your toolbelt. Not all capital is equal, and understanding the fundamentals of each option (and how they do or don't work together) is key to making decisions that ultimately push you toward optimal outcomes rather than unsatisfying endings.
We see founders spend a lot of time and energy chasing capital sources that are not suitable for them. Founders often chase VC when they are not really VC fundable — meaning they are unlikely to see the growth multiples that VCs (and their limited partners (LPs)) will ultimately expect in return for their investment.
Based on our data, we estimate that VCs provide capital to about 1% of all US eCommerce companies doing between $5M and $50M in sales. In other words, VCs largely recognize that e-comm isn’t the right profile for their investing strategies.
Even if a particular DTC business model is the right profile for VC funding, founders often waste time chasing firms who are wrong for their stage or industry and thus will never bother meeting with them or funding them if they do.
What’s true of VC is also true of debt. Just like VCs, lenders have specific mandates for the types of deals they will do. There is no point chasing those deals if you don’t fit their mandates.
“What’s the harm in trying?” you may be asking yourself. In reality, chasing the wrong types of funding may be costing you more than you think. For one, your time and energy are finite. Don’t waste them. Going after inappropriate sources of funding can prove to be a massive distraction and lead to wasted time, effort, and energy (read: money!) We are speaking from experience here.
Inevitably, when DTC companies chase VC or debt funding, they will spend a lot of time doing things like tweaking sales decks, refining business plans, editing elevator pitches, and crafting data models in an effort to win over a potential source of funding. Then they scour LinkedIn looking for anyone they know who might be able to get them an intro to a firm.
That might sound like a good use of time, but it’s often wasted effort. It’s important to know what the right type of capital is at a given stage of your business, and to be strategic about seeking it out when the time is right. That’s what this eBook will help you do: Focus on identifying and choosing the right capital “tools” for your near-term and long-term goals.
A Primer on Capital Tools for DTC Businesses
As you grow your business, your ability to leverage the right capital tools at the right time will determine the level of your success. In fact, we would argue capital selection will be the single most important determinant of size of outcome for your company. That’s a bold statement, we realize. “What about my awesome eye for products or our killer Instagram marketing strategy?” Those are, of course, important — foundational, arguably. But the ability to choose and deploy the right types of capital at the right time will give you the tools to maximize your potential.
Why? Well, DTC and e-commerce are operationally complex, capital-intensive businesses. You have to master product development, merchandising, marketing, paid advertising, international supply chains, logistics, customer service, talent acquisition, management, and financials. That’s a lot of skills, platforms, and data.
The capital intensity comes from the working capital needs of DTC businesses. When you buy from suppliers, you are often paying for goods long before you can sell them. The faster you grow, the more cash you have to have on hand to pay these suppliers. In nearly every case, you are also spending gobs of money on ads and marketing. After all, there’s no point in having all this inventory if no one knows about it.
So, over to Facebook and Google you go. And then your capital needs increase again, because you are now paying for ads before making money from your customers. This is called the cash conversion cycle. A positive cycle means you are paying for future sales before you realize them. A negative cycle means you get paid by your customers before you have to pay for your goods. And while a negative cycle may sound impossible, some companies do pull it off (Amazon, Gymshark.)
It’s much harder for DTC e-commerce companies getting off the ground to do this. That’s why the elation of landing a big order from Wal-Mart often quickly turns into fears about how you’re going to pay for that inventory ahead of time. By extending its own terms, Wal-Mart is just using you to create their negative cash conversion cycle.
You can see why capital management becomes so important, and so tricky, for DTC brands.
Capital Management Strategies
There are really only two ways to get the capital you need:
- You make it yourself through profits.
- You get it from someone else. (A note: Even if you personally have a lot of cash, you are still borrowing the money from yourself, because you could be investing your money in something else. Alas, the stories of entrepreneurs bankrupting themselves are legion.)
When you take capital from someone else, you are “renting” it. When you borrow money, you must later pay back the money plus interest for the use of that money. When you raise equity, you are getting money now in exchange for more money (hopefully) at some point in the future. The technical aspect of selling shares and redeeming shares is just the mechanism by which the parties decide that some money today can be worth some more money (hopefully) in the future. The cost of renting that money will be driven home when you see those wires go out to your investors. You won’t be able to stop yourself from thinking “some of that could have been mine.”
Here’s where it gets interesting: It’s simply the how and when of paying money back that defines the variety and complexity of capital products.
Another way to think about the equity vs. debt decision: You, as the owner(s) of the company, pay the “rent” on equity. When you sell shares, you decrease your potential returns down the line. On the other hand, the company pays the rent on debt. That’s a key difference and one worth understanding before you make any decisions about capital.
How to Use this Guide
Throughout this guide, we’ll lay out the different types of equity and debt available to DTC and eCommerce founders, along with the pros and cons of each option. As you educate yourself on each option, keep the following questions — specific to your unique business and situation — in mind:
- What stage of growth are you in?
- What is your business growth strategy?
- How much capital do you need, and what do you plan to do with that capital?
- What are you willing to give up for that capital?
- How much time will you need to use the capital you receive?
- How do you want to repay the money?
- What are you willing to risk to fund your business?
- Do you want guidance in growing your business? What kind of partners and guidance are you looking for specifically?
About Bainbridge (a.k.a. Why Listen to Us?)
Wondering why you should listen to us? Bainbridge's founders combine a long history in the eCommerce analytics and business intelligence industries with capital markets and corp dev experience. We’ve taken that knowledge and built a data analytics platform specifically for DTC eCommerce brands. With Bainbridge, you gain access to a community of other DTC founders, and step-by-step playbooks (like this one!) with advice and insights about how to run a successful DTC company. It’s more than a product. It’s also a community of entrepreneurs and business leaders just like you, learning from one another about how to build a DTC brand that customers love and trust while maximizing the bottom line.
Of course, the first stop on any DTC founder’s funding journey may very well be their own pocketbook. If you already have some wealth accumulated (or your co-founders do), investing your own money in the business means you are not giving equity away to someone else — in other words, when the returns come in, they’re all yours.
Realistically, not every founder can afford to bootstrap their DTC businesses for long — or at all. But these days, it’s more and more common for DTCs (and even software companies) to be fully bootstrapped. When the pandemic hit in 2020 and investors got spooked, some of the DTC brands who saw the most success were those that could lay claim to being fully bootstrapped. Examples include skincare brand Rosen and “superfood” drink purveyor Golde.
For some founders, bootstrapping isn’t an option past the very early stages. But if you can swing it as a product-based entrepreneur, it may be worth considering the upside. That said, if you’re like most entrepreneurs and not made of cash already, this guide will help you understand the other financing options available to you.
- You’re not giving away equity to investors.
- There’s higher return potential.
- You are fully in control.
- Cash is generally limited, unless you’re already quite wealthy.
- Focus on cash can cause slower growth than is possible.
- None of the extra expertise, networking opportunities, or social proof that can come with a seasoned investor.
- Profitability! If you can build a model that turns fairly quickly, you might be able to keep going without taking on outside investments.
- Almost all debt products
- Anything, beyond that — in other words, you can bootstrap as long as you’re able and then move on to other funding sources.
Friends and family are exactly what they sound like. If you are fortunate enough to have family and friends who can invest and like you enough to do it, then this is a really good place to seek early funding.
- These “deals” are typically quick to close.
- Deals often require little to no pitching, decks, or due diligence, because there is inherent trust.
- Friends and family are often flexible about deal structure and terms.
- You can use easy-to-source legal docs like SAFEs and Convertible Notes.
- There is often limited “follow-on” capacity — in other words, your friends and family may not be able to support you past the first check.
- They typically offer limited to no industry expertise.
- They typically offer limited to no networking opportunities.
- There is limited to no social proof or validation for other investors.
- Anyone who can swing it!
- This is mostly a fit for early-stage companies. Your mom is eventually going to get sick of writing checks to you, and your rich uncle’s pockets probably only go so deep.
Another option that is becoming increasingly popular and accessible is crowdfunding. Some DTC brands who have successfully crowdfunded at least part of their growth include Dame and Pepper. You’re probably familiar with platforms like Kickstarter, Indiegogo, and Patreon, which serve various niches. There is also iFundWomen, which provides startup funding exclusively for (you guessed it) women.
Additionally, average people can now invest in startups via platforms like Wefunder, SeedInvest, StartEngine, Republic, and AngelList. Many of these have low minimums to invest (think $100-500), certainly as compared with angel networks and venture capital funds.
- Can serve as an early marketing vehicle and build your initial customer base
- Quick close and straightforward terms, generally speaking.
- Not a lot of financial risk for you up-front.
- If your business does not meet its funding goal, it can hurt your reputation and ability to source other types of funding.
- A lot of up-front work to market and sell your idea.
- Generally limited capital.
The main differences between friends and family investors and angel investors are experience and perception. For example, your mom (probably) doesn’t pretend to be a startup investor — she’s giving you money because she believes in you.
Angel investors, on the other hand, invest regularly. In fact, for some, it’s a full-time job. Angels almost always invest their own personal money. They may be individuals or parts of formal or informal networks of angels.
Angels can bring experience and a certain level of professionalism to the table. That said, as a result, they will also likely have more expectations. They will want to see the deck, the pitch, and the monthly reports. They will want to hear the pitch, do due diligence, and hear your answers to their questions. And you may not know these people personally already, so seeking angel investment may require heavy networking.
👼 A note about angel networks: Unless you are a big mover in the startup world, succeeding as an angel investor can be hard. How do you get enough deal flow? How do you qualify and decide which deals to do and which to pass on? How do you decide where to spend your time with investments? How do you stay on top of investments and at least keep in touch and make sure you are around if/when the company does well? It’s a lot easier to do that as part of a group. So, many angels have banded together to form networks to share this work.
- Angels can be a nice way for DTC companies to ease into venture capital funding. The process is generally easier and friendlier, and there is much less “ghosting.”
- It is typically a lighter lift with lower legal fees. (The legal documents required are usually simple SAFEs or Convertible Notes.)
- Angels often provide fantastic networking opportunities. They know other angels, VCs, potential new hires, partners, and more.
- Angels typically want to help and will continue supporting you along your journey. As your company grows and evolves, you can continue tapping them for access to their networks and advice.
- Angels will sometimes ask for non-standard terms in docs or pro-rata rights and other requests. At the time, this may not seem like a big deal (and you may be tempted to say “yes” to just get the deal done), but later these terms can become a real pain to deal with and hurt you financially. Our advice? Keep terms vanilla, standard, and in your favor.
- Angels want to see an exit and expect some huge multiple (e.g., 50X, 100X) of their money back when that exit happens.
- Angel investment is best for companies committing to the venture capital path. See below to better understand whether the VC path is for you.
- Early-stage founders are often the best fit for angel investment. At this stage, you have more than just an idea and a deck — you are up and running, making some sales, and showing how the business will work in the future. But that’s not to say that every early-stage DTC founder should go with angel funding.
- Venture capital (down the road)
- Credit cards, merchant cash advance (MCA), working capital SMB lenders
Once you grow to a certain size, you may want to consider institutional investors. Institutional investors rent capital from other investors who are called limited partners (LPs). As a result of these relationships, there are even higher expectations and more complex processes involved. Institutional investors include pension funds, insurance companies, private family offices, sovereign funds and endowments and other managers of money.
Two important concepts to understand when considering whether to raise equity capital from institutional investors are “the next round” and “the exit.” The investor at each stage is asking themselves how likely it is that your company will have an exit worth betting on. Next, they are asking themselves how likely it is that you will get the capital along the way in order to reach that exit. It’s rare for a company to raise a single round and have a big exit. More common is the alphabet road of A, B, C, D, E funding rounds necessary to reach the scale of exit needed to make investors happy.
As a result, investors at each stage are always considering who may fund the next round. So what you may not realize when you are pitching seed-stage investors is that you are often indirectly pitching Series A investors, too, because the seed stage investor is feeling out their buddies about whether they’d do a follow-on round.
Venture capital firms are considered private investors, as contrasted with institutional investors described above. As we discussed earlier, venture capital has become a widely-known source of capital as a result of the software industry boom. Most tech companies will chase venture capital funding at some point or another. But eCommerce businesses are unique, and it’s important to understand the pros and cons of leveraging VC funding as a DTC ecomm.
First, let’s explore some critical information about how VCs make money. VCs have to make bets on companies that are relatively early in their lifespans. That means usually they have to wait years before a big payday. So VCs have to think not only about which companies they believe will make it big, but also about how they’ll sustain themselves until that happens.
They obviously don’t know in advance which investment is going to pay off big, and they know from experience that only a small percentage of investments actually pay off. In fact the rule of thumb in the industry is one out 10 investments hit a home run in terms of exit. As a result, VCs use portfolio math. They make enough bets to diversify their portfolio, so they can increase the chances of getting one of those home runs. The more bets you make, the higher the chance you have of hitting it big.
But what about those 9 losses? Great question. That money is usually gone or, at best, returned with some small return. So that means those home runs have to be big enough to not only cover the losses, but give the LP’s (and the partners) the monster returns they want to see.
Adding to that big return pressure is time. It takes time for companies to grow into something really big. So venture funds need a time horizon to match. The average venture fund has a lifespan of about nine years. As a result, VCs need really big payoffs to make the annualized returns look attractive to investors. For example, doubling your money sounds like a great investment, right? But what if it takes nine years? That’s an 8% annual return… and there are plenty of less risky ways to make that kind of return.
To raise money from LPs, VCs need to produce much higher annual returns than what the LPs can get elsewhere. And to get those higher annualized returns, they need their big payoffs to be 10X, 20X, or even 100X returns.
What does all this mean for you? When you reach out to VCs, keep in mind that they are constantly trying to assess whether or not your business will earn them massive returns.
Market size is often the biggest factor in answering that question for them. Are you in a market large enough to support a big company? VCs may have different market size assumptions, but they are going to assume that, even if you kill it, you aren’t going to win the majority of the market. To be safe, they may ask themselves how big the company will be if they end up with 10% of the market. And then they will want to know if that is a large enough company to produce a worthwhile return for them.
That poses an issue for eCommerce companies. Consider this scenario:
- A VC invests $1 million in Company X at a $10 million post-money valuation.
- The VC now owns 10% of Company X.
- The VC wants a 20X return which is $20 million.
- In this simple scenario, let’s say Company X raises no more money. So in order to provide the VC with $20 million in returns, the company needs to be worth $200 million ($20 million is 10% of $200 million.)
- Using the Bainbridge DTC Benchmarks, we know that many public companies are valued between 1X and 2X of their annual sales. So let’s give Company X a 1.5 multiple.
- In that scenario, Company X needs to do $133 million in sales in order to get a $200 million valuation.
Can you name an eCommerce company that raised only $1 million and got to $133 million in sales? Let us know if you can!
eCommerce companies have to fund inventory, working capital, and ad spend — which means they need a lot of capital to reach that $133 million mark. And if each subsequent VC is doing the same math on returns, this number is even more amplified by follow-on rounds.
Bottom line: VC can be a difficult path for eCommerce companies for two main reasons:
- It’s hard to capture or build a significant share in multi-billion dollar markets.
- The capital intensity of eCommerce businesses means you need a lot more capital (than, for example, a software company) to drive high sales.
All that said, VC is right for several sub-segments of eCommerce, and there are multiple active and specialized investors in the space chasing those opportunities such as Cowboy Ventures, Forerunner, Lerer Hippeau, Bling Capital, and Lyra Growth Partners. If you fit the criteria of addressing a huge market and believe you have the ability to capture it with capital efficiency, definitely look at VC. Think: market disruptors who introduce a new way of supplying commodity goods — like Dollar Shave Club.
- You can get money when you are losing lots of money. VCs don’t want to hear about how you eked out a profit by cutting your Facebook ad spend, reducing your inventory buy, and getting your niece to do the books for free. They want to hear about growth, scale, and market domination.
- There is a well-trod alphabet road of future rounds. As long as you execute (and the market doesn’t fall apart), you can make it down that road.
- Networking: By definition, VCs know a lot of people and companies. VCs compete on how much additional value they can provide companies. Take advantage of it.
- Discipline. This cuts both ways. When they are on your board (which they will want to be), they will require a level of reporting, financial, and management discipline that is likely new to you.
- Once you take VC money, you are committed to the VC path. VCs hate lifestyle businesses. You must provide rapid growth and an eventual exit.
- In general, you will steadily sell more of your equity and lose more ownership of your company as you follow the VC path. Counter-examples like Zuckerberg and Facebook are out there — but far more common are the stories of founders being left with less than 10% of their company and eventually being fired. So, enter VC Land with eyes wide open.
- While there is always another round ahead on the alphabet road, the dirty secret is that many companies don’t reach that next round. This is the cruelest drawback. You commit to growth above profits, and so you need the next round to survive. But what if you can’t get the next round, which can happen for a variety of reasons? Many companies either close up shop or go through a long process of scaling back, scrambling to focus instead on profits and self-funding.
- VC is great for companies that are going after huge markets with credible capabilities to capture significant market share.
- Founders who embrace the mindset of rapid growth.
- Founders who are good at telling their story and pitching, pitching, pitching!
- Earlier stage: Credit cards, new banks (Brex, Ramp et. al.), working capital lenders, MCA
- Mid-stage: Venture debt, sponsor-focused banks like SVB or Bridge Bank
- Later stage: Just about everything (if profitable)
Growth Capital & Non-Traditional Investors
There is a class of mega-funds, often global in scale, who are now doing deals that used to be the domain of VC firms. These funds include Tiger, DST, Softbank, Wellington, and Fidelity. They measure Assets Under Management (AUM) in the hundreds of billions and are often focused on later-stage, mega-sized private companies. Recently, some have started chasing earlier-stage deals.
- Money. Lots of it.
- Bigger valuations.
- With non-traditional investors, deal terms are clean and more flexible than what you get with VCs. Two-page term sheets are not uncommon.
- Little due diligence. There’s a saying that deals are never done until funded. VC’s can use due diligence to lock up a company and then decide through more thorough investigation whether to do the deal or not. Non-traditional investors move quickly. So, not only are you more likely to close, you waste less time and effort.
- Non-traditional investors offer good support for eventually going public. These funds know the public markets well and their stamp of approval and help in the IPO process can be valuable.
- Often don’t take board seats or even observer seats.
- Beware of the terms offered with non-traditional investors. These are big players on Wall Street and have the mindset and law firms to match. They can be ruthless at times. Fortunately the trend is towards vanilla and clean terms, but get a good lawyer in advance.
- Unicorn valuations can come with drawbacks. High valuations mean ever higher bars to clear as you look for more capital.
- It’s unclear how committed to the asset class these funds are. Follow-on capital may be difficult if the fund changes their priorities a few years down the line.
- Companies looking for big checks, unicorn status, and eventual multi-billion dollar public exits.
- Sponsor-focused banks
- Credit funds (they often have their own credit funds in-house)
With few exceptions, private equity firms are looking to buy later-stage, profitable companies. Like other institutional investors, PE firms are concerned about a company’s exit. The nice thing about PE, however, is that their ideal exit is often a sale to another PE firm. Exits also happen to strategic acquirers or public markets.
PE also almost always means majority ownership. When founders take PE, they are usually giving control of the company to the PE firm. The founder may still serve as C-suite and on the board, but when push comes to shove, they are just employees with valuable equity packages.
PE has one basic play in its playbook: Take a company that’s profitable (or near profitable) and then try to rapidly increase that company’s valuation through increasing sales, profits, and strategic value. The goal is to quickly build the company into something bigger, which the PE firm will then look to sell to someone else.
The means of this increase in value will often be a maniacal focus on profitability. (Say goodbye to any employees with inflated salaries!) To increase sales, PE firms will focus on:
- Expanding teams, product lines, and geographies.
- Acquisitions. (Why spend time and money to build something if you can just buy it?)
PE firms are less concerned about the 10X and 20X return we see with VCs. That’s because of the nature of these investments. PE funds are investing in theoretically lower-risk companies (profitable, later-stage), and they like to use debt to fund their acquisitions and capital investments.
Here’s an illustration of how this works: Say a PE fund buys a company for $100 million. The PE fund may actually have only invested $20 million from their fund, and then borrowed the remaining $80 million needed. This leverage allows them to significantly juice their returns on their $20 million.
In this example, let’s say the PE fund turns around and sells the company for $200 million a year later. If they had paid all cash, they would have earned a 100% return on their money. Not bad for a year’s work! But because they borrowed most of the money, they instead earned a 900% return (I am ignoring the nominal cost of that debt in this calculation.) And now you know why PE guys fly private.
- PE can provide lots of capital to help you reach your full potential. For the founder who knows they can dominate their market or the world, PE is often a good source of capital to help them do it.
- Secondary is often part of the deal, which means founders can sell some of their stock to the PE fund and turn it into cash.
- PE funds demand discipline. Any sloppy, wasteful habits or poor uses of capital will almost certainly be eliminated post haste.
- Founders become mere employees. They may still retain their titles, but ultimately, if they don’t do what the PE fund wants, they will get fired. If you have spent your career at a huge enterprise corporation like IBM, you may not be surprised by that. But founders, by nature, are usually highly independent and not accustomed to or interested in taking orders from others. Suddenly not being 100% in control can be very difficult for these personality types, and it’s important to have self-awareness about whether this applies to you (and whether the trade-off is worth it).
- PE Funds are also notorious for over-leveraging (Hey, why get a 2X return when I could get a 10X return with just a little more leverage?). There are numerous examples of over-leveraged companies cratering when things don’t work out the way the Excel models said they would.
- You’re along for the ride — wherever that ride takes you. Say you sell your DTC company to the PE fund that spends a ton of time wining and dining you. You build trust and assume you’ll have a long-term relationship with that fund. That could all change in an instant if the PE fund decides to sell off the company. At that point, you’ll be working with strangers — they could be from another PE fund, or your biggest rival. Again, you have to know yourself and whether this potential outcome would be a deal-breaker for you.
- Founders looking for some liquidity and cash but who still want to be involved and help grow the business.
- Sponsor-focused banks
- Credit funds
- Mezzanine debt
One form of debt that can be used to help you build your DTC business is the terms you have with your suppliers — whether net-30, net-60 or longer. “That’s not debt!” you might argue. Actually, it is. Your supplier is lending you money, so it is by definition debt. Moreover, supplier terms are often the best financing you can possibly get. Terms can almost always be negotiated, and doing so can have a big impact on your cash flow. Remember the negative cash conversion cycle from above? This is one of the ways to do it. Always negotiate for better terms!
- Supplier terms are often negotiable, as long as you are willing to ask.
- This is hands down the cheapest financing you can get.
- Supplier terms allow you to build relationships with key suppliers because your suppliers will be more likely to extend terms with more commitment or transparency on your part.
- Supplier terms are measured in days, so the money is short-term.
- This type of debt can require larger order volumes or commitments, so be careful not to over-order just to get credit or extended terms.
- You’ll likely need to share financials with suppliers in order to negotiate.
- You can get locked in, either by order minimums or commitment to the supplier.
- Everyone at every stage.
Like the name suggests, venture debt is for VC-backed companies. If you don’t have VC or institutional equity backing already, don’t bother with venture debt firms. The reason is that venture debt funds are ultimately underwriting the likelihood that your institutional investors will write a check for another round and bail them out if things go sideways.
When you first set out to pursue this type of debt, you’ll encounter due diligence requests that will sound a lot like the traditional loan underwriting process. But venture debt actually relies on institutional support, and not all institutional backing is the same. Just took $20 million from Sequoia? The venture debt fund will love you! But if you took $250K from Capital-a-Rama VC, you might not get your e-mail returned.
- This is a longer-term debt option. Terms typically span 24-36 months.
- Venture debt offers flexible repayment terms, such as interest-only periods and partial amortization.
- You can get venture debt relatively quickly — typically within 30-90 days.
- You are paying for money which you are unlikely to be able to use right away. If you take a $1 million loan, you start paying for that $1 million right away. If it just sits in your bank account, you are literally paying for the privilege of holding that cash.
- Venture debt often comes with warrants (e.g., the venture debt fund wants equity).
- You’ll be locked in. Once committed, you can repay early, but usually with penalties or make-whole provisions. With that in mind, your ability to get more debt or funding is limited for a long period of time.
- This type of debt usually comes with lots of extra fees (closing fees, monitoring fees, prepayment fees, exit fees, etc.). These fees add up.
- Complicated terms.
- Legal fees (both yours and the credit providers’).
- VC-backed companies. The better the brand name of your VC, the easier it will be to get venture debt, and better your terms will be.
- Venture Capital
A Note: Venture debt can be paired with senior secured loan products if the venture debt is coming from a bank such as SVB or BridgeBank. If venture debt is coming from a fund, though, it’s hard to get the fund and bank to agree to the intercreditor agreement. Taking venture debt from a fund means you will likely be precluded from other debt options until you pay it off. This is important to keep in mind because, while $3 million today might sound like plenty, you may want more in the near future. It’s possible you will have the cash on hand to pay off your balance and seek other funding, but raising capital specifically to pay off debt isn’t easy. Equity investors aren’t wild generally about the idea — they want their capital to fund growth instead. Lenders are less particular, but you’ll need more money (the payoff amount, plus whatever you want for growth). Ideally, you’d secure that money at a lower rate.
Banks act more conservatively than other financial actors and institutions because of regulation. Dodd-Frank dramatically increased the regulatory requirements on banks, and the net result was that underwriting became far more conservative. An unintended consequence of this has been the rise of private credit. As banks left whole markets, funds stepped in to fill the void. Today, banks have very specific rules about the types of loans they can provide, the reserves they have to keep on-hand for various loans, and the type of reporting they must conduct.
Everyone seems to know someone who knows someone who got a loan from a bank at some incredible interest rate. Before you go hunting for your 3% interest rate, remember these loans typically happen in one of two ways:
- A borrower has a ton of underwritable assets (Hey, we own the warehouse!) and/or a good history of profitability.
- A borrower got a loan from Silicon Valley Bank or one of its competitors.
With option number one, you’re looking at what we refer to as a “Non-Sponsored Bank Term Loan.”
- Low rates and longer terms.
- It’s easier to mix and match among third parties, as compared to the process of trying to mix and match with Sponsor-Focused Bank Term Loans.
- Often there are bullets, balloons, and other structures available for flexible payment options.
- You have to be profitable to get this type of loan and/or have real, easy-to-value assets. The longer and steadier the history of your business and the easier it is to value and liquidate your assets, the better.
- This type of loan usually includes lockboxes and cash sweeps (if you are on the smaller side).
- Expect lots of covenants.
- There are lots of reporting requirements required with bank term loans.
- Profitable, maturing companies with a CFO and built out finance and accounting teams.
Everything, given the constraints above.
If you don’t have a lot of hard assets and are not profitable, then you are left with option number two outlined above — getting a loan from Silicon Valley Bank or one of its competitors.
Silicon Valley Bank, Bridge Bank, and Republic Bank all compete for startup and young company business. We call this subgroup of banks “sponsor-focused banks.” A sponsor is a trusted institutional investor. The key to getting a sponsor-focused bank term loan is to have a brand-name institutional investor in your cap table (similar to venture debt). Again, if you just took a $50 million round from Andreessen Horowitz, the folks at Silicon Valley Bank are your new best friends. If you took $200K from your rich uncle, you probably won’t hear back from these banks.
The loans you get are also generally part of a larger bundle — expect to give your lender your banking business also. The sweet term loan might also have an incredible interest rate, but don’t expect it to be a very large loan. If you want more money, the bank will be happy to give you another loan for more money, but the rate will be higher.
It’s worth noting that these banks look at you as a steady stream of fees — after all, this is how they make money on you. They will set a target revenue amount for your account, and everything you do that can generate fees for them will go toward that target number. They also want to lock you in, so layering in other debt from third-party providers will be virtually impossible. The banks want those fees all to themselves.
In short: A really attractive interest rate on a 5-year term loan might be enticing, but really consider whether the loan amount is going to be enough for your business, since it can lock you out of many other funding options.
- Low rates and longer terms.
- Often there are bullet structures or partial amortization options (meaning you owe all or some portion of the balance at the end of the term, as opposed to paying back all of the principal during the term of the loan).
- This is similar to venture debt in that you are paying for money which you are unlikely to be able to use right away. If you take a $1 million term loan, you start paying for that $1 million right away. If it’s just sitting in your bank account, you are literally paying for cash.
- You are likely paying higher fees elsewhere in the relationship.
- These contracts usually include lockboxes and cash sweep terms.
- You are locked into one bank for just about everything. It’s hard to get debt from other providers. Expect lots of covenants.
- There are lots of reporting requirements.
- This option is really only available to venture-backed or sponsor-backed companies.
- Venture capital
- PE / growth capital
- Other debt products from the same bank
Credit Lines or Lines of Credit are standby facilities that you can use when you need them. They technically come in two flavors: revolving and non-revolving. For the purposes of DTC and eCommerce, we are only going to discuss revolving debt. (Non-revolving debt is typically just used for a one-time event, like setting up a foreign subsidiary.)
These are great tools for managing cash needs on a day-to-day or monthly basis. With bank revolving credit, the bank sets a credit limit, and you can draw down, pay back, and draw down again as needed. In general, banks don’t love revolvers because of the uncertainty of their usage. They have to make the amount available for you to draw on within tight timeframes which requires them to reserve or have cash available as needed. That in mind, banks will often want you to use other products to generate other fees in order to get a revolver.
- Low interest rates.
- This option provides peace of mind, as the money is available whenever you want it.
- You only pay for what you use.
- Nothing is free. With standby rates, you are partially paying for the ability to get cash when you want it.
- These loans are often only available if you have other business with the bank that generates sufficient fees. Banks generally look at all the ways they do and could generate fees from you (accounts, mortgage, investments, etc.) That potential for fees then determines what you get and at what rates.
- There is limited capacity. To free up credit, you have to pay down what you owe. It can be hard to get increases in credit lines, so your ability to scale as you grow may be limited.
- VC-path companies with sizable revenue and/or recent rounds and cash in the bank
- Profitable, established companies with good credit
- Other bank debt products
- Venture debt
- *Does not go well with MCA or ABL (see below)
Asset-based lending (ABL) comes from the world of traditional retail, where retailers (or wholesalers) could borrow against the value of the inventory they had on hand or in a warehouse. The key to ABL lending is the liquidation value (sometimes called the net liquidation value) where the lender makes a judgement about the amount of money they would get if they had to take possession of the inventory and liquidate it.
The ABL lender is asking themselves:
- If I had to, could I get this inventory and take possession of it?
- This is sometimes harder than it seems. Is the inventory in a warehouse or store? Is the warehouse dedicated to the borrower or is inventory from multiple retailers mixed together?
- How would I liquidate the inventory? Do I have to come in and do a “going out of business sale”? Can I liquidate online? Am I selling inventory to discounters?
- What percentage of full price (or cost) am I likely to achieve in all these various liquidation scenarios?
- How much time and money will it take to liquidate inventory? Will I have to pay rent, employees, or costs to keep sales sites running?
- How long will it take me to liquidate the inventory? Getting money back quickly is often more important than taking the risk of getting a higher price over a longer timeframe.
Based on the answer to those questions, the ABL will set the net liquidation value. They will then haircut the NLV in order to set a borrowing base, which is the amount they will lend. The good news is that the interest rates on ABL are much lower than other forms of debt, because the loan is backed by hard assets.
ABL can be tricky for DTC and eCommerce because access to inventory can be complicated by third-party logistics (3PL). Liquidation values are hard to determine and liquidation processes are hard to implement. For example, when CitySports went into liquidation, the lenders could walk into prime storefront locations and sell much of the inventory at high prices because that inventory included a lot of name-brand products from Patagonia and North Face.
But what does the lender to Ben’s Brand of Awesome Kitchen Knives do? Ben’s knives are in a 3PL center mixed in with 100 other DTC brands. The Ben’s brand is not well-known, so T.J.Maxx and other discounters are not interested. And the primary sales channel has been the website, so now the ABL lender has to run and maintain a website (and pay for more ads) in order to sell through whatever inventory they can actually get their hands on. So while ABL can be appealing in theory, it’s often a tough financial product to acquire for DTCs.
- ABL offers a low interest rate compared to most other debt options available.
- There is a straightforward formula and process. It’s easier for borrowers to understand how their Borrowing Base can and will change based on their business.
- There is never enough money. The borrowing base is always going to be a fraction of the value of the inventory on-hand.
- ABL does not finance inventory that’s in progress or in transit. That means you can’t finance the deposits to your Chinese supplier or what’s on a boat on its way to your warehouse. You can only finance what is on-hand.
- This form of debt involves intense reporting requirements. Reporting on inventory is often monthly and can be more frequent if the borrower is experiencing difficulty.
- There is an expensive due diligence process. Larger ABL lines will require appraisals and third-party verifications where appraisers visit warehouses.
- Borrowers with sufficient inventory in-warehouse
- Borrowers with high brand recognition or selling name-brand goods
- Borrowers with good terms from suppliers
- Unsecured debt products like mezzanine or credit card debt. Senior lenders or collateralized lenders don’t want to carve out the single biggest part of the collateral picture for the ABL lender.
Factoring is another popular borrowing source in retail. While there are many flavors of factoring, the basic idea is that the lender buys or lends against a contract for payment from a counterparty (e.g. Wal-Mart) to the borrower (that’s you).
For example, Ben’s Knives gets a $1 million purchase order from Target. Ben turns around and sells the purchase order to the factor for $900,000. The factor pays Ben $900,000 and then collects the full $1 million from Target. Another flavor would be lending against that contract and then collecting once Target pays.
Why does anyone do this? Let’s say Target is slow to pay Ben. While Ben is eventually going to get $1 million from Target, he may not get it for 150 days. Say he needs the money faster so he can buy more inventory, pay his employees, buy ads, etc. For Ben, $900,000 today is worth more than $1 million five months from now.
In this scenario, Target doesn’t really care. In fact, the presence of factors allows them to force longer payment terms on their suppliers. (“Just go get it factored if you want it sooner!”)
The factors can easily assess Target’s credit, so they are confident they will get their money back. And time is money. So while making 10% doesn’t sound like a lot, making 10% four times a year adds up.
As you can imagine, people get creative and fancy with factoring. Why stop with the borrower? Once the factor buys the PO, they can turn around to the supplier (the person who is going to pay the PO) and offer them a discount (“Hey, I have this PO of yours for $100,000. I know you can pay me the full amount in 60 days, but I will give you a 2% discount if you pay it now.”). The factor turns their money sooner, allowing them to redeploy it and make more through compounding.
- There is lots of competition in the world of factoring. You can shop around and drive down prices.
- Factoring works well when you have POs from large, established companies. It’s easy to factor a PO from a large retailer like Target, but you won’t find many takers for a PO from a mom-and-pop shop with one location.
- This is a very straightforward process.
- This is a quick option for debt financing.
- Factoring keeps your balance sheet cleaner, as you are not taking on debt (just selling a receivable at a discount). But, this will certainly impact your ability to get senior debt because you are allocating some of the cash coming into the business to another lender.
- It can be expensive when you calculate the effective annual interest rate. Getting better terms followed by cheaper capital should still be your goal.
- As mentioned, this does not work well with POs from small mom and pop shops or unknown suppliers.
- This does not work for your DTC revenue, as there is no commitment from your thousands of customers to ever buy again. So it’s best used by omni-channel companies.
- Factors are savvy about terms from retailers. If your contracts include lots of ways the buyer can send back goods to you, reject goods, charge you for breakage, or similar, the amount you will get when you factor will decrease.
- Companies with significant wholesale business (i.e. selling to retailers like Wal-Mart or Kroger). You will want enough volume for the Factor to make it worthwhile for them. If you have thousands or tens of thousands of POs, they may not want to bother.
- All equity
- Most debt except senior secured
Pioneered by Lighter Capital, revenue-based financing or RBF is when the lender lends against the forward revenue from a collection of contracts. RBF is used primarily in the SaaS world, but providers are experimenting with RBF in the retail world, especially around subscription-based models.
A SaaS company may have thousands of customers paying for their services on some form of payment schedule. The more locked-in these contracts are, the more likely the future payments will come through. For example, credit issues aside, you would feel better about a three-year contract than you would about a month-to-month contract. The RBF lender will assess the likelihood of those forward revenue streams and the ability of the borrower (company) to continue generating those streams (for example, does supporting those contracts require massive R&D and customer support teams, or is this a super high-margin, low-effort business?)
Some capital providers are starting to combine RBF with factoring. The idea is that instead of buying a PO from Target, the capital provider is buying the revenue contract or stream of revenue of an individual customer (or a collection of customers) of the borrower. For example, a SaaS or subscription company may have 1,000 customers on monthly contracts. The factor in this case buys the forward revenue from those contracts at a discount to their face value. The borrower gets money now, and the factor gets to compound their money. Pipe and Capchase are innovators here.
- Facility size (i.e., the amount you can borrow) can grow in step with your revenue growth
- You can shop around for good offers, as the landscape is increasingly competitive.
- Many of these lenders started with SaaS, so they tend to underwrite and think about eCommerce subscription businesses with that mindset. Their ability and interest to do subscription eCommerce deals will vary. You may end up having to do a lot of education about your business model and subscriber base. Pipe and Capchase have pushed harder into eCommerce and others are following suit.
- RPB is similar to mezzanine debt (see below) in terms of pricing e.g. mid to upper teens — and can even be higher.
- Pay attention to the terms. For example, prepayments may be a challenge.
- Subscription eCommerce businesses
Mezzanine debt earned its name by sitting between senior debt and equity. In that sense, many forms of debt would be considered mezzanine debt. In general, what makes mezzanine debt different is that it’s subordinated to the senior debt. This simply means that, if there’s a problem, the senior debt holders get first claim on all money until they are fully paid back. Whatever is left goes to the mezzanine debt holders until they are paid back fully. And if there’s anything after that, the equity holders get something.
Almost by definition, mezzanine debt is unsecured. In very rare cases, mezzanine debt providers and senior debt providers will agree to carve out assets that the senior debt provider does not have claim to, thus giving the mezzanine debt provider some secured assets
Mezzanine debt carries much higher interest rates than senior debt, since there are no assets to back it up, and it often comes with equity kickers or warrant coverage. These are warrants given by the borrower to the lender that the lender can then keep in their back pocket and cash in should the borrower go public or be acquired.
Warrants in private companies are obviously hard to value. Who is to say if the company will ever go public or be acquired, and at what price? Add in all the preferred share math of multiple rounds and coming up with a value is nearly impossible. But that does not mean you should not put a value on warrants when considering this form of debt. The lender obviously does — otherwise they wouldn’t ask for them. And, unless it’s a super competitive market, lenders don’t like giving them up.
In some ways, the lender is treating you like a VC treats a portfolio company. They may not be able to say what you are worth, but if they get warrants in enough companies over enough time, they can be confident on hitting some home runs and significantly juicing their returns.
So, how do you value warrants given to a mezzanine debt provider? A simple way is to think about the cost to you of those warrants when exercised. Add that to the interest cost and your sweet 11% annual rate probably won’t look so sweet any more. Private company warrant pricing is complicated. We can help you at Bainbridge on this, but for the purposes of getting to a rough apples to apples, adding in that equity value to the total fees will give you a sense of how expensive giving up warrants can be.
More importantly, remember that your company pays for debt, but you (the founder/owner) pay for equity. So those warrants are coming straight out of your pocket.
Mezzanine debt providers will sometimes create unitranche structures where you essentially blend a senior debt facility with a mezzanine debt facility. The senior debt facility will be at a much lower rate, but secured. The mezzanine debt will have a second position behind the senior debt and be at a higher rate. When you do the math (interest due on the senior portion plus interest due on the mezzanine portion, divided by the total amount borrowed), you will get a lower overall interest rate and more money. This can be really attractive because you are dealing with one entity (no intercreditor agreements), and you get a lot more money at a much more reasonable rate.
- Good availability when the credit markets are strong.
- Good availability when your company can do $10 million+ deals. Plus, the availability goes up as you can borrow more.
- Interest rates and warrant coverage and costs will come down sharply with competition.
- Good lenders can help you get access to more capital in the future. It’s institutional money, with higher levels of reporting and due diligence, so other lenders will like that you have already gone through the process.
- Interest rates and term timelines are usually good.
- Unitranche structures are often available (lower interest rates and more money).
- Warrant coverage or equity kickers can make this an expensive option.
- You (the founder) pay the cost of the equity.
- Mezzanine debt typically requires an intense due diligence process.
- You’ll need a strong finance team to handle reporting requirements.
- Mezzanine debt often includes balloon payments or partial balloons at term, so you either need to have the payoff on-hand or be confident in your ability to refinance. It’s easy to sign up for a three- or five-year loan when things are great, but imagine refinancing that in the midst of a recession.
- Maturing companies that are profitable and still growing well who believe it is better to borrow money (even at high rates) to capture that growth, than to slow growth in order to completely self-fund.
- Sponsorship helps, but is not critical here. Plenty of mezzanine debt funds will do non-sponsored deals.
- Mezzanine debt is very focused on your ability to pay back. The stronger your sales, profitability, and cash flow, the better your terms and larger your facilities.
- All equity
- Senior debt from non-sponsored banks
You obviously know how to use a credit card. Fintech has exploded in this space and there are multiple entrants offering combinations of banking, credit cards, and expense management (Brex, Ramp, Divvy, and Mercury are all examples).
The biggest concern in using credit cards is putting your personal credit on the line. The good news is these new entrants are offering much higher credit lines than your traditional business credit card and without using your personal credit. They also have interesting options like extended repayment terms and other perks. If you are VC-backed with a lot of cash in the bank, you should look into one of these options. If you are scrappy and self-funded, the credit lines will be much smaller (if you can get them at all).
- Everyone can get a credit card.
- There is a revolver mechanism built in, so you can keep borrowing as long as you pay it back.
- You can use this money to pay for things directly (like ad spend).
- It’s easy to repay, and thus reload, the facility — just make a payment.
- Credit cards offer the potential to earn points or perks for your CEO.
- High interest rate.
- Very limited credit availability.
- You’re often putting your personal credit on the line.
- Not everyone accepts credit cards (such as your international suppliers).
- Everyone. (True story: Our founders used to work with a massive eCommerce company who channeled their ad spend on one channel (high tens of millions per year) through a series of American Express cards!)
- New banks like Brex, Ramp, and Mercury are good for VC-path companies, which have a lot of money in the bank but aren’t profitable.
A note: MCA providers are careful to not call these “loans” (or call companies “borrowers”), so they can skirt regulations and usury laws. That said, for our purposes in this explainer, if you take money from someone you are the borrower, the person giving you the money is the lender, and the money they give you is the loan. Despite the jargon, you want to remember that, so you can properly compare your options.
While MCA has a few flavors, a common structure is:
- An MCA provider gives you a set amount of money.
- You agree to pay back that amount of money, plus something extra, by giving the MCA provider a specific percentage of your gross sales on a daily basis until you reach the owed amount.
For example, you may get $100,000 and have to pay back $106,000. You’ll do so by giving the lender 15% of your gross sales until you reach $106,000. Some providers will give you $90,000 and require you to pay back $100,000, while others will add maximum payback amounts per month (or some period) so you have a cap on how much you pay.
MCA is great if you need money quickly. Providers are fast and in some cases, like Shopify, you can get money into your account in minutes. It’s also relatively hassle-free. You always have to provide access to your data (like a Shopify account), but you won’t need to provide heavy-duty reporting or go through a major due diligence process.
Plus, MCA is taking their payment off the top. In Shopify Capital’s case, payment is taken directly from your Shopify account. Other MCA providers will hook into your bank and take money daily based on your previous days’ sales.
MCA providers also like to give you more money as long as you are paying well, so it’s usually easy to keep going. You can get increases over time, but keep in mind that the dollar amounts advertised on MCA provider websites are almost never what you initially start with (or get to). MCA providers tend to like to start smaller and work you up to bigger amounts.
Of course, there are serious downsides to MCA too, which we outline below.
It’s hard to find a more expensive form of capital. The MCA providers will make sure to tell you that you aren’t paying an interest rate and may even try to slide one by you — but now you know better. When you do the math correctly, you can easily get effective annual rates in the thirties, forties and even higher.
The reason is the time value of money, which basically says a dollar today is worth more to you than a dollar tomorrow. If I give you $100,000 and I ask for $106,000 back in a year, then you are paying 6% effective annual interest. But if I give you $100,000 and ask for $106,000 back in a week, then you are paying over 300% effective annual interest. With MCA, you aren’t paying back in a week, but 15 to 20 week payback periods are common.
Additionally, it’s rarely enough money. If you are in a jam and need a few hundred thousand dollars quickly and can take the hit on margin, go ahead. But MCA rarely provides enough money to be a good longer-term solution. The key problem is that you usually have to pay back all or most of the advance amount before you can get more money.
MCA doesn’t play well with other debt. If you have some form of senior debt, there’s almost no chance you will be allowed to use MCA. Senior lenders want (and their terms demand) first call on capital. If an MCA provider is skimming from the top before them, your senior lender won’t be happy. Most lenders are going to frown on your use of MCA (if not forbid it explicitly), but plenty of people do it and hope no one finds out...
Stacking MCA can be dangerous. Some companies who are desperate for money will take MCA from multiple providers. In that scenario, a huge percentage of your sales is being taken off the top — leaving you with much less cash. Obviously, that’s a problem. You need that cash to buy inventory, pay for ads, and keep the lights on.
- Fast money.
- Lightweight reporting and management.
- The money is deducted automatically. You don’t need to save or worry about repayment.
- It’s a competitive space, so you can shop around for the best deals.
- Rarely enough money.
- MCA doesn’t play well with other debt.
- Stacking MCA can be dangerous.
- Early-stage, high-growth companies
- Other MCA if you are desperate enough to do it
As you build and grow your DTC business, there will be many difficult decisions to make along the way. One of the most difficult — yet most important — is how to fund your growth. We hope this guide helps illuminate the many roads available to you, while offering a clear-eyed look at the pros and cons of each. Our goal is to help you as a founder or owner grow and reach your potential.
Bainbridge is an all-in-one solution to help DTC eCommerce brands doing $1 million to $50 million in sales reach their potential. Built by experts in eCommerce analytics and business intelligence, the Bainbridge platform allows users to see what’s happening with their business today, what they should do in the future, and how well they are executing on their plans. With Bainbridge, leaders can track inventory, ad spend, customer acquisition, cash, and more in one single place and forecast inventory needs, analyze margins, predict and track sales, manage cash, and plan optimal capital needs. Bainbridge also integrates industry benchmarks to help businesses track growth, and provides a place for a community of DTC founders to network and share best practices. Build your business with Bainbridge.
Interest is what you pay to borrow or rent someone else’s money. The Merchant Cash Advance folks may be trying to avoid usury laws by using fancy terms, but when someone gives you money and you need to give it back, plus something else, that’s interest. It’s important to keep that in mind when comparing options.
Interest rates are expressed as percentages and are understood as the percentage of the principal balance that is the fee for borrowing someone else’s money. The key to interest rates is understanding how frequently interest is calculated. This is compounding. For example, you may be offered a 15% interest rate, compounded monthly. This means the lender will be calculating and usually expecting interest payments, on a monthly basis. Compounding is good for the lender. The more frequently they can compound, the higher the effective interest rate becomes. Loans can compound annually, daily, or monthly. One compounding frequency isn’t inherently better than another, but you need to understand them in order to compare offers and rates properly. For instance, a loan with a 10% rate compounded daily will generate more interest over a year than a 10% rate compounded annually.
Every industry loves their jargon and finance is better than most at creating jargon. Percentages are often expressed in ‘points’ and ‘basis points.’ This is most commonly used to express interest rates. So, 1% is 1 point. A basis point is 1/100 of a point or .01%. Basis points are also called “bips.” You can say ‘they raised the rate 50 bips, but other than that it’s the same terms’ and everyone will assume you just walked out of Goldman Sachs.
Accrued Interest and Paid In Kind (PIK)
This is interest that is calculated, but not paid, by the borrower. Instead, it is added to the principal balance of the loan.
This is usually the amount you borrow. Accrued interest can be added to the balance. Fees and ‘points’ can also be added to the balance.
Origination Fees (and Other Upfront Fees)
Lenders love these things. Especially when you have to pay fees immediately. Remember what it was like to come home from school and discover freshly baked brownies on the counter? That’s the feeling lenders get when you pay them upfront fees and interest.
If you’ve had a mortgage, you are familiar with amortization. Amortization is the payback of a principal amount over the term of the loan. In your traditional 30 year mortgage, you start paying back principal in month one and you finish paying it back in month 360 — at which time it’s fully amortized. Partial amortization is usually expressed as a percentage of the principal balance — as in, a 5 year loan with 50% partial amortization.
Bullet or Balloon
This is the amount of money due at the end of a loan term. These are often used for loans that have zero amortization — as in a $1 million, 3-year loan with a bullet.
Pre-Seed, Seed, A, B, C, D, E, F is the typical progression in VC funding rounds. Rounds don’t always follow a perfect progression so people will add modifiers to describe in-between rounds e.g. ‘post seed’.
What founders work for. Exits are from being acquired or going public. Mergers is a euphemism for being acquired. A PE fund doing a ‘growth’ round which acquires a majority interest in the company is also effectively an exit even though the founders may stick around to earn more equity.
The document that describes the terms of the deal. Term sheets are often negotiated and then signed by both parties which commits them to pursue a transaction under the terms in the term sheet. Following a term sheet, the parties will complete due diligence as well as negotiate the Definitive Agreement. The deal closes once the Definitive Agreement is signed by both parties and the Buyer wires the money or conveys payment to the Seller.
Leverage is debt. Levered is another way of saying the company has debt as in ‘that company is way over-levered’
Lockbox / DACA
Used by lenders, the term Lockbox and DACA are often used interchangeably. DACA refers to a Deposit Account Control Agreement and it gives the Lender the right to control the bank account through which money flows in and out of the Borrower. The idea is that the Lender doesn’t want the Borrower to one day suddenly transfer all their cash to another account and thus not pay the Borrower. So the DACA gives the Lender the ability to tell the Borrowers’ bank that the Lender now controls the account and any disbursements have to be approved by the Lender. Banks when lending to DTC companies typically don’t bother with a DACA and just require the Borrower to set up their main account at the bank from which they are borrowing.
Words you never want to hear as a Borrower. When a Lender has a DACA in place, they can sweep the cash from the Borrower’s account in the event of default. Sounds reasonable, but Lenders will often create multiple events of default in their loan docs and careless Borrowers can trigger one without realizing it. Additionally, Borrowers may believe they can still pay and be negotiating or trying to find ways to pay and the Lender will sweep the cash thus effectively taking control. Borrowers need good attorneys in negotiating their loan docs and they need strong financial reporting and controls to make sure they don’t trigger a default. Lastly, lenders have varying reputations with some lenders known for being aggressive in triggering defaults and others being more lenient.
Covenants are descriptions of what the other party must do in order to not trigger a breach. In loan docs, covenants are what the Borrower must do in order to not be in default. Some covenants are pretty standard e.g. if you declare bankruptcy you will be in default and others can be highly specific to the borrower and situation such as covenants around minimum revenues or minimum ratios that the Borrower must maintain. Good attorneys help and making covenant language crystal clear is essential. Lastly, good financial reporting and a good team are needed to make sure you don’t get near breaking a covenant.
The cap table is the record of who owns how much of which types of equity. Cap tables get complicated quickly, hence the rise of Carta.
Net liquidation value
This is a term from ABL (Asset Based Lending) which describes the value after expenses that the lender would expect to recoup if they had to seize the inventory of the Borrower and liquidate it.
Debt is either secured or unsecured. Secured means the Lender can take control of the assets providing the security. For example, a mortgage is secured by the home and in the event of default, the lender can take the house in order to recoup their money. For DTC, security is often all assets of the company including the intellectual property such as brand and marks as well as customer lists. For most DTC companies, the highest value assets are the inventory. The brand and customer lists can have real value, but obviously decay rapidly without use. And then there are a bunch of old Macbooks and chairs and desks.
This is debt where the Lender has no claim on specific assets. Credit card debt is unsecured. Mezz Debt is usually unsecured. Working capital lines are usually unsecured.
In the event of default, there is an established priority of repayment. Senior debt gets the first money until repaid, then unsecured debt, then equity. There are gradations within all those.
What VC’s get. Founders and employees get common. Conversion is when holders of preferred convert to common in order to sell and get cash. Holders of preferred shares will have different voting rights as well as conversion rights and even repayment rights depending on the documents that govern their class.
Equity kicker is the right to get equity usually in the form of warrants that Lenders will use in order to increase the yield of their loans. For example, the Lender may get warrants that give them the right to buy a certain number of shares at a specific price. If the company does really well, the warrants have a lot of value.
Another term for a loan or debt instrument. “They have a debt facility in place so they can cover the shortfalls over the next quarter by drawing on it.”
Secondary: Secondary is equity in private companies that founders (or other shareholders) sell themselves. So they get the money, not the company. Founders will use secondaries to take money off the table, buy a house etc