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This post is part of our Field Guide to DTC eCommerce Capital. Click the links below to read more chapters from the guide.
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