Stealing Signs - Issue 22
All Things Venture Debt, EdTech, New Media & Content Bundles, Early Stage Financing Report, and SwineTech
Support the Startup Community!
I've been on the lookout for ways to support both startups I know and the broader community, and last week one of the co-founders of Branch reached out with an awesome idea. They're an NYC-based startup that typically furnishes high-end offices but has pivoted to helping people with WFH setups during the lockdown. They're having a big sale and discounting ergonomic chairs and desks up to 35% right now, and on top of that we're working together to donate 8% of revenue to Good Sports for every Stealing Signs purchase. For those who miss your office chair and desk, check out Branch using this link to support a cool startup and a great cause with your purchase! Thank you!
Worth Reading
All Things Venture Debt with Zack Bahm
Zack Bahm, Venture Debt @ HSBC
A bit of a changeup here! Last weekend, I interviewed Zack Bahm, a Venture Debt Analyst at HSBC and former right-handed pitcher at Columbia University. It’s an awesome conversation. Zack provides great insights on the venture debt model and helpful perspective on the current state of startup financing.
Very excited to share this convo and I hope you enjoy! Below are a few highlights and paraphrased quotes from our chat, and you can find the full conversation at the end of this newsletter.
Increasing trend with companies who invest heavily in Facebook and/or Google ads to use venture debt to finance these costs instead of giving up equity
Important to understand lender incentives. Some lenders are focused on the long term banking relationship, which means their incentives are aligned with the founders and equity investors. Other lenders only care about getting paid back, which often means their incentives are misaligned with founders and equity investors
Venture debt diligence is more focused on the worst case scenario and protecting downside than equity investors, who are typically optimizing for company upside
There is strong momentum behind founder ownership retention in the startup world. Companies are increasingly leveraging venture debt to protect founder ownership and avoid dilution, a trend likely to continue post-COVID-19
Fun fact: Zack and I played against each other in college and we played on the same summer baseball team (although different years) — the Shelter Island Bucks #gobucks
What We’re Learning About How We Learn
Hanel Baveja & Hannah Murdoch, USV
Aggregators such as Wide Open School may seed the landscape for novel open source curricula — dynamic virtual textbooks that link directly to lectures, problem sets, and enable interactions such as pinging a tutor.
Great insights about the evolving remote learning world from Hanel and Hannah in this post. I particularly like the their “in-betweener” concept — schools which leverage both remote and in-school learning dependent on curriculum. Field trips and group projects might occur in-school while less interactive lessons may be remote. I haven’t heard much chatter about this model, but it seems to have some legs and aligns with the historical trend in education of optionally driving demand.
I’m also interested in the potential of open-source curricula. Textbook sales have long been a massive scam in the education world and the astronomical prices have likely limited endless numbers of students from access to proper materials. I’m excited about the potential of the open-source curricula model.
Seed is the New A — But What’s Next?
Peter Wagner, Wing Venture Capital
What lies ahead in the Freefall phase won’t be much fun. The venture capital market will freeze as investors wait for the bottom and triage their portfolios. The pace, size and valuation of financings will all contract. Companies with high burn rates will need to reset them quickly if they expect to survive. Tourists (both investors and entrepreneurs) will go home. The grittiest entrepreneurs and venture capitalists will remain, they will depend on each other, and the work will be hard for both.
One of the most interesting insights here is from Wing’s analysis of the change in seed-stage financing. Their data shows seed rounds have increase nearly 4x since 2010 and seed valuations nearly 3x over the same period. This growth is often questioned and criticized in the media, but what gets less coverage is how the typical seed company has changed over the last decade alongside the rising seed rounds and valuations — Wing shows that seed companies in 2019 were more mature than ever, with “years since founding” increasing over 3x since 2010, reaching 1.72 years on average, and “percentage generating revenue” increasing over 7x during the last decade, reaching 67%. An important caveat is that the quality of this revenue is unknown and it’s easier now to bring a product to market than ever before, likely reducing barriers to revenue generation.
This analysis also includes an evaluation of the current venture landscape and which phase of the VC cycle we’re likely to be in (shown below). Shocker: we seem to be in the “free fall” phase. I hand’t seen this visual before, but found it very helpful in providing context for the significant slowdown in VC activity in response to COVID.
The Birth of New Media Companies & Content Bundling
Jacob Cohen Donnelly, A Media Operator
For years, media companies have viewed writers as liabilities. It’s a cost center on the budget that, with some fancy financial machinations, maybe you can trim a little here or there… I’m talking about the fact that those that are producing the content the audience consumes are always thought of as an expense worth cutting.
Let’s compare this to tech companies. The people who create the goods—the engineers, designers, product managers, etc.—typically are incredibly highly paid and have a stake in the business. At a media company, the journalists are the lowest paid people even though they create the goods.
This a thoughtful and timely analysis of the independent content creator model and the impacts of content bundling. John focuses on the recent bundle offer from Substack authors Dan Shipper (Superorganizers) and Nathan Baschez (Divinations). John points out the enticing benefits of bundled content such as more subscribers and more revenue for the authors, despite the decrease in revenue per subscriber, but the most interesting point is his extrapolation of this model. Could a content bundle morph into a “new media company” where Dan and Nathan, for example, expand their content offerings with podcasts and events? John thinks it could. The important difference in this model compared to the traditional media model, and why this is a new media company, is that the writer is the owner, which eliminates the misaligned incentives between owners and content producers of the old model.
Jacob nails this analysis and makes what I think is a very accurate prediction, which is that multiple solo writers will realize the merits of the “new media company” and band together with other producers. I love the idea of subscribing to writer-owned media bundles that either 1. digs super deep on a particular topic, business model, technology, industry, etc. or 2. connects models and ideas across various industries. I’d like to see an investor/operator combo, too — maybe Lenny Rachitsky and Andrew Chen to cover marketplace building and investing?
<stuff> Weekly
LOL Weekly: Even Big Leaguers Break Windows
lollllll. If you can’t relate to this experience, don’t worry, I’ve done this enough times to cover all of the Stealing Signs readers. Changeups, man 😤
Funding Weekly: SwineTech
Key features and benefits of the SmartGuard Farrowing Management Platform include:
Autonomous prevention of piglets getting laid on by their mothers, which has led to a consistent 17% reduction in overall piglet mortalities at wean.
Real-time insights to each sow's behavior, allowing for reduced labor and more timely intervention, as well as a more efficient and effective use of antibiotics.
Individual stall micro-climate control, providing the optimal environment for piglet safety, as well as piglet and sow health.
SwineTech, an animal health company that leverages voice recognition, computer vision, and behavioral tracking to safely raise pigs and reduce production inefficiencies, raised a $5M Series A from Innova Memphis, Johnsonville Ventures (!!), Ag Ventures Alliance, Quake Capital, and others.
First, Johnsonville has a venture arm!! Second, it seems this product may revolutionize pig farming — SwineTech’s Smart Guard system could save 160M+ baby pigs each year. If true, pig farmers’ business model would be fundamentally altered. On the surface, it’s clear this would increase output significantly, but I imagine the increase in “production” would stress the farmers’ existing infrastructure, like farm land and pig pens, at least initially. Can farmers handle this increase? Do they reduce the number of baby pigs produced since the survival rate is higher? Might some farmers struggle to weigh the tradeoffs and suffer potentially fatal over-production? My guess is that SwineTech has an opportunity to offer a managed service layer or software tool on top of the core product which helps farmers optimize production levels, for example.
Baseball Weekly: Local TV Revenue for MLB Teams
Craig Edwards, FanGraphs
High-revenue teams can shield some of their revenue from revenue sharing by making it a part of owning a Regional Sports Network, which aren’t considered part of the pool divided among all the teams.
This analysis is helpful in understanding the Cubs recent decision to create a new, wholly-owned TV network to broadcast games. Teams don’t have to share the revenue generated from their TV networks with other teams in the league, as they do with all of the revenues as part of the revenue-sharing agreement in Major League Baseball. These dynamics make it lucrative for team owners to own TV networks, too. Craig breaks down a great example of this with the Red Sox and NESN, a TV network the Red Sox have an 80% ownership stake in. I wouldn’t be surprised to see more teams embark on their own television ventures when existing deals expire, especially the high-earning teams, as these ventures likely require significant capital to build and operate.
Art Weekly: The Gleamy Blue of Your Sparkle Dance (2017)
Martin Soto Climent
In his work, conceptual sculptor Martin Soto Climent reshapes everyday items through minimal gestures of recontextualization and balance.
FULL INTERVIEW:
All Things Venture Debt with Zack Bahm
Below is the transcript of my conversation with Zack Bahm, a Venture Debt Analyst at HSBC.
Our convo has been edited for length and clarity.
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Jackson Bubala (JB): Let's start with a bit of background -- what did you study at Columbia?
Zack Bahm (ZB):I had a pretty unique major called Sustainable Development. I would say it’s unique to Columbia and it's a mix of engineering classes, economics classes, and political science classes. I primarily focused on the finance side of things, but the curriculum was started by an economist named Jeffrey Sachs. The thesis of the major is to see how the world can grow more sustainably, from a financial perspective, social perspective, and technological perspective.
JB: And you were a baseball player, correct?
ZB:Yes, I was a right-handed pitcher, but was not exactly any sort of a flamethrower or anything. It was a great experience and very much felt like a full time job, even in college. Definitely a unique college experience in that sense, but really valuable in translating skills to the real world like work ethic, persistence, and leadership -- you can see it really come through and in the professional world.
JB:Moving onto your professional life, how’d you wind up in venture debt?
ZB:There's an interesting path for sure -- I certainly didn't plan on it. I joined HSBC in July after I graduated and I was part of the standard banking analyst program. As part of that, we rotate across different teams and a couple of months in, I heard about this new venture debt team that was starting. I've always been interested in technology and just by the nature of it being a new team at the time, I thought I'd get more responsibility than some of the traditional banking groups.
I reached out to the guy who was running the team and it just kind of went from there. We kept in touch for a while. I tried my best to help them out with whatever I could in terms of market research, trends in the industry and, and things of that nature. So I was one of the first members of the venture team.
By the nature of it being a newer team at HSBC, it felt a bit more entrepreneurial and startup-y than the more traditional banking banking groups.
JB:And how’s the experience so far -- does the group operate more like a startup than other internal groups?
ZB:I hesitate to say that because obviously, you know, in a 150 year old bank with 200,000 employees, nothing really feels like a startup. But in some sense it does. Even in getting our name out there in a space that SVB, for example, dominates — it’s almost like finding product market fit.
It’s also been entrepreneurial in the sense that I'm active in sourcing deals, due diligence, and portfolio management. So it's really a multi-sided job. It's very much an iterative process that has developed over time.
JB:For what reasons did HSBC start a venture debt group?
ZB:As you know, and most people know, much of the economy in the U.S., and the world is, is dominated by these huge tech companies. Obviously in the U.S. you have the FAANG companies, and even more so in the middle market, you're seeing a lot of these enterprise software companies and even consumer software companies make up a huge, huge portion of the global thought leadership, and also the economy.
A symptom of that is the banks and the relationships that these companies build as startups tend to evolve into mature banking relationships when they become Fortune 100, Fortune 10 companies. Not all of them make it to that stage, but the idea is that HBSC wants to establish long-term banking relationships with the next generation of Fortune 100 technology companies. And the best way to do that is to get our foot in the door and establish a strong relationship at the early stage -- a really good way to do that is through lending.
Traditional lending isn't exactly fit for these startups for a number of reasons, so a new venture that team was proposed and established to specifically lend to high growth, VC-backed tech start ups that will hopefully become the next FAANG stocks in the next decade.
JB:Transitioning now to venture debt as a financing tool, can you explain what venture debt is and who uses it?
ZB: At a high level, it’s the same as traditional debt -- lenders are lending an amount to a company and they’re paying back that principal amount plus interest, and included in that debt facility are covenants to ensure that the company's doing well and other protections for the lender. The risk in the venture debt space is obviously higher than investment grade public companies, so the interest will be higher, the overall structure may be a little different, but the important part here is that there isn’t (rarely, at least) an equity stake in the company. Because of that, it ends up being the cheapest form of startup financing if it's leveraged correctly, because you're not giving up a portion of your business. You're only paying the interest on that debt facility.
Venture debt is primarily reserved for high growth, VC-backed tech startups where lenders can become a bit more comfortable with repayment. No one wants venture debt to be a lifeline for a company. You'll rarely see companies raising debt if revenue is declining year over year, because that's not the point of venture debt. The point of venture debt is to establish bank relationships with very high growth, promising tech startups.
I'll end this with one last point, which is the reason venture debt is a separate debt classification than traditional bank debt, and that reason is startups lack the cashflow or the hard assets that are generally needed for bank loans. Traditional bank loans are either issued on the basis of cash flow for repayment or hard assets as collateral. So, for example, a retail company will use their inventory as collateral and that will comfort the bank on the ability to repay or lend. In venture debt, in the startup world, repayment is generally through additional equity rounds or exits through M&A or IPO, or in a best case scenario, if the company is about to turn cash flow positive, maybe they'll be able to repay that debt through cash flow generation.
JB:And which types of companies are best suited to leverage venture debt?
ZB:HSBC is focused on the growth stage. I know other lenders such as SVB and Comerica, and some of the private debt funds, are more in the earlier stage. But in the growth stage, SaaS companies and recurring revenue startups are really well suited for venture debt because the business model has become a fairly predictable quasi-math problem with customer acquisition costs, LTV, retention rates, churn, etc. In that sense, it's fairly predictable. For that reason, SaaS companies, especially in the enterprise space, are able to get pretty attractive terms on debt and it makes them a really good candidate for venture debt because it makes the capital even cheaper.
There's also an increasing trend with any company that's looking to advertise through Facebook or Google. They pretty much have a monopoly on the digital advertising market and there's an increasing interest in not using equity for that purpose because, again, that's almost become a math problem where you put in X amount of money to Facebook or Google, and you're going to get Y amount of sales. So, it's not a great use of equity since banks are able to lend on that basis.
More generally, companies with strong VC backing, strong board members, and a mature finance team are really important for venture debt because debt facilities can get complex pretty quickly if you're not careful.
JB:I actually heard Jeff Richards of GGV Capital bring this up on Jason Calacanis’s podcast. He said he generally advises companies to stay away from venture debt if they don't have some sort of chief finance person or mature finance team because it can get complex…
ZB:A lot of people view debt facilities as relatively simple because, again, in the best situation, you pay back the principle of interest. But in other situations, it can get a bit complex with covenants and keeping track of certain metrics. So it is important that you kind of have a dedicated finance person or dedicated finance team who is comfortable with dealing with debt.
JB:What are the important considerations for a company to take into account when evaluating venture debt as a financing option?
ZB:One key thing for companies to evaluate is who they can take venture debt from. I think that's an under-discussed topic, but it's really important. There are two types of lenders in this space: banks and private debt funds, and they actually vary pretty significantly because of the incentives. The banks — SVB, HSBC, Comerica, etc. — are the traditional banks with separate venture debt arms. And often the venture debt facilities will be bundled with traditional banking products such as deposits, investment banking, advisory, asset management, and FX. It's really important that the incentives are aligned because the banks make more money off of the relationship if the company does well. So it's in their best interest for the company to do well. On the other side, you have the debt funds such as Hercules, TriplePoint, WTI. And I'm not saying they're malicious at all, but the incentives are not exactly aligned in this space because they only care about getting paid back with interest. So if they lend $10 million to a company and the company almost fails and gets acquired for $20 million, that's fine for them because they get paid back. But that's obviously not what the founders or equity investors are going for. So, the company really needs to take a look at what incentives the lenders have because you don't want to get caught in a spot where you owe money and the person you owe money to doesn't really care about the outcome of your business.
Aside from that, and we touched on it already, it’s important to have the right structures and resources in place within your company to handle the debt, figure out where the cash is going to go, and to monitor the interest payments, covenants, and repayment. These are important aspects that aren't exactly super sexy parts of startups, but they're really important because debt facilities can get really hairy if you default or breach a covenant, for example.
The last thing I'll say is having a really clear picture of your revenue engine. For example, if a bank lends you $10 million, where is that money going and how much will come out of it? That's a really important thing to keep in mind because banks and the debt funds want to have a picture of where their money is going. And I guess a symptom of that would be really understanding your customer acquisition costs, retention, churn, etc.
JB:What does the diligence process look like on your end?
ZB:Some parts are definitely similar to equity investing diligence. We think about how the business scales. Why are these the right founders for this business? What's the competitive landscape? How big is the market? What are potential exit opportunities? So I think in that way, at a high level, it's similar to equity. From a financial perspective, as you get more granular, it is a bit different because lenders are trying to get paid back with interest while equity investors are optimizing for upside. So equity investors, they look at what is the ceiling of the company? How does the company reach that ceiling and how do we help along the way? Which is obviously super helpful and a crucial part of the process. But on the debt side, it's more what is the worst case for this company? What's the downside case? How does that downside case occur and what protections can be put in place to prevent that? So on the debt side, there's more focus on the downside case and how we get paid back, and the diligence is probably more focused on a wide range of outcomes rather than just optimizing for the ceiling of a company.
JB:Moving into the deal-making process, can you walk us through the typical terms, or how you guys think about that?
ZB:It's definitely on a case by case basis and it's hard to give a general structure because it varies significantly by industry. Super generally, though, for an enterprise SaaS company, a possible debt facility would be in the range of three to six times MRR, and even that can vary. Between industries, it's really dependent on how capital intensive the business is. On the consumer side, they can obviously spend tons on sales and marketing with pretty low monetization at the beginning, so the debt facilities will be structured a little differently.
Covenants are always included in debt facilities, but they're never meant to be constraining because the last thing you want to do is constrain a startup from growing. So, the covenants are usually performance to plan covenants or just making sure the company is achieving some sort of growth.
Another piece is on the bank side of things. An important part of the relationship is the other banking products. We always discuss a company’s growth plans in terms of financing needs. For example, will this facility be refinanced in two years? Is this a pre IPO facility? And even beyond pure lending, if they’re IPOing, is there a chance to also loop in our equity capital markets folks into the IPO and make it a more holistic relationship.
Even more basic banking products like deposits or corporate cards are always a part of the deal making process because it's a symbiotic relationship and the more skin that we have in the game, the more aligned we are on incentives. If it's a situation where we're just lending to the company, there's not as much skin in the game. So we always discuss what the broader banking relationship could be and where they see the banking relationship going, because, at the end of the day, HSBC, or any bank, is not just making money by lending.
JB:And how frequently does the venture debt relationship convert to a broader banking relationship?
ZB:It varies by which lender you're talking to. I would imagine that at the Comerica’s and the SVBs of the world, where they're not really focused on the investment banking space, it’s lower -- the focus is less so on the conversion to converting a broader banking relationship.
As you get into larger, global institutions like HSBC, JP Morgan, and Wells Fargo, the focus is very much on the broader banking relationship, advisory, and the more lucrative banking products. Candidly, and this isn't a secret, lending is not the most profitable business for banks. The most profitable business is high margin advisory and fees where there's not really any capital going out the door. So there is a ton of interest coming in from other institutions -- this gets competitive. I think it was last fall that JP Morgan announced that they brought over a number of people from SVB to get into this space a bit more because they realized the same thing that HSBC realized, that there are opportunities to be capitalized on in these early stage startups where you can develop long term banking relationships.
JB:Let’s shift to the impact Coronavirus has had on the venture debt space...
ZB:Coronavirus has impacted the venture debt space from multiple angles. The first way is more generally across the economy, and that is the drawdowns on debt facilities. This increased very, very quickly in about a two or three week span in late March and because of that, a lot of banks saw a liquidity crunch, which made it more difficult to issue debt. So this kind of turned everyone's world inwards toward existing portfolio companies.
So the liquidity crunch was kind of the first big impact. Second, more on the company side, we've talked to a number of VCs that are advising all portfolio companies to draw down on any available credit they have to get cash on the balance sheet and to weather the storm, however long it may take. It's kind of this reinforcing cycle where VCs are seeing this liquidity crunch in the banking market, which is then forcing them to tell companies to draw down their facility, which causes even more of a liquidity crunch for the banks.
The last thing is that every startup is revising projections. Most companies are revising down, but there are the lucky few, you know, delivery companies or workplace collaboration tools, that maybe be advising up. This obviously changes the due diligence process because most companies are revising down projections to show lower new logo acquisition, less upselling and cross selling, and higher churn. Especially if you're selling to a lot of SMB clients or consumers, there's a fair chance that those kinds of founders will be revising the projections to show increased churn.
JB: How has COVID-19 changed the type of company that you're looking for?
ZB: Everything's very uncertain now, so it's hard to project the full impact. But generally I would say companies that are selling to large enterprise customers are more attractive right now. I would say they're always more attractive, but any workplace collaboration tool that's only selling to SMB customers, small mom and pop retail shops -- that's obviously a tough space to be in right now and not something that has a lot of interest.
On the other side, there are going to be industries that have already seen benefits and will continue to see benefits. There's the obvious remote work tools such as Slack and Zoom, and the cloud infrastructure and cybersecurity space is obviously going to see increased usage.
I saw Microsoft release some pretty staggering numbers on the increased usage of Microsoft Teams and I actually heard from a couple of people that Microsoft Azure was down because of the usage. So, there are examples of obvious benefactors of Coronavirus.
As we move out of this, there are a couple of sectors that I'm personally pretty excited about and will be looking for. The industrial automation and warehouse fulfillment space is really interesting. I think companies will start to realize, if not already, that having warehouses and supply chains totally run by humans is extremely risky, where these kinds of pandemics pretty much shut down the whole thing. So, I think any sort of software or robotics technology that automates the packing, shipping, and logistics of supply chains will get really popular.
Another area we’re paying attention to is FinTech. I think people will start to realize how archaic the current rails of the financial system are because it's taken so long to get these stimulus checks and the confusion and mess that the PPP program resulted in. I think there'll be an increased focus on the rails and the infrastructure and the financial system.
JB:Last question on COVID-19 — how has it changed they types of companies that are approaching you for venture debt?
ZB:Even before coronavirus, there was pretty strong momentum in the venture debt space. A lot of VCs, prominent bloggers, and thought leaders in the space were talking more about venture debt. There was an increasing focus on founder ownership and founder equity retention even before all of this. You can see with some of the recently IPO’d companies, especially like Lyft and Uber, a lot of them are going public and the founders are holding under 5% ownership of the company, which is pretty crazy to think about. And obviously they're still making a killing, but I do think that there is an increased focus on non-dilutive financing, which is the big advantage of venture debt. I think that's only going to accelerate, but I would say post-coronavirus there'll be an increased emphasis on ‘rainy day funds,’ or a liquidity backstop, just in case these Black Swan events occur where the whole supply chain shuts down, revenue shuts down, new logo acquisition goes to zero, and you somehow have to survive 12-18 months with no new revenue.
I doubt there's going to be a ton of companies rushing to get venture debt in the near term because everyone is dealing with their own stuff right now. Everyone's dealing with cuts or supply chain disruption. And it’s also like the old ‘getting insurance when your house is on fire’ — now is just not a great time to get venture debt. Not saying that people aren't open for business, but factually, two months ago was a much better time to get venture debt than it is now. So, once we know the full impacts of coronavirus and this slows down a bit, more companies will be interested in the product.
Especially, again, I think people are realizing that equity financing is not the best way to finance all uses of capital. And I think as founders look to retain more ownership, venture debt will only become more prominent and a more popular source of startup financing.
Thanks to Zack Bahm for this brilliant conversation!