The Perils of Taking on Venture Debt
Geoffrey Moore
Author, speaker, advisor, best known for Crossing the Chasm, Zone to Win and The Infinite Staircase. Board Member of nLight, WorkFusion, and Phaidra. Chairman Emeritus Chasm Group & Chasm Institute.
This post is for first-time entrepreneurs, discussing a topic that is painfully well understood by venture investors and more experienced entrepreneurs.? Here’s the situation:
This may be when you hear the phrase liquidation preference for the first time.? It seems innocent enough.? The lender just gets paid back before anyone else.? Totally fair.? And if you do execute as you plan, everyone wins.?
The problem is, more often than not, you don’t.? And the reason you don’t is that you have misunderstood the message the market was sending when it did not develop as fast as you expected.? In addition, you have also misunderstood the dynamics of venture capital, so you don’t see the hole you are digging for yourself.? Let me elucidate on both topics, taking the second one first.
Venture financing is designed to back high-risk, high-reward business plans.? It does so by breaking them up into chunks, each chunk corresponding to a round of funding.? Each round focuses on taking one category of risk off the table.? The first round might be an angel round focusing on technical risk—can you make your magic actually work?? That might be followed by a more formal round to address product/market fit—can you get anyone to buy it?? Subsequent rounds can address market risk, competitive risk, team risk, and eventually exit risk.? Upward changes in venture valuations are tied to risk removals.? When the next investor sees that a material risk has been truly removed, they are willing to invest at a higher valuation than the prior round, thus minimizing the dilution to your current investors as well as to you and your team.??
The problem you face is that you have almost removed the risk you have been funded to address, but you have run out of runway.? Almost is worth, well, sadly, almost nothing.? You can’t raise another round of equity without suffering considerable dilution.? That’s when you hear the siren call of venture debt.? A little money to bridge the gap, no dilution, pay it back with future cash flow—sounds good.? Except now, any future investor is looking at a returns model where the venture lender gets their money back before anyone else.? Still, if you really are crushing it, and your future cash flows look reasonably secure, you’ll be fine.
The problem with this scenario is you only get one bite at the apple.? Should there be another pothole along the way—and this venture, folks, so the road is bumpy—you are now in a real jam.? Equity investors are spooked because any more debt will come with additional liquidation preferences, as in 2X or even 3X the amount lent, all to be paid back before anyone else gets a dime.? And common shareholders, which include you and all your team, are increasingly likely to get zilch.? This represents “working for the man” in the worst possible way.
So, what should you have done?? You should have taken the market signal of slower-than-expected adoption as a yellow flashing light.? It doesn’t say Stop.? It says Slow down.? That means cut your burn rate now.? Take your medicine, bitter, though it may be.? All those planned new hires—not now.? Moreover, that elegant roadmap you had in place—it has to be hacked.? Cut it back to the bare bones to get you to the next milestone.? And as for the people already on board, some must be asked to leave.?
None of this is fun, and if you are a first-time entrepreneur, it may be something you have never done before and have no appetite for doing now.? But if you want to know why most start-ups fail, this is why.? You owe it to yourself, your team, your existing customers, and yes, even your investors, to step up.
Understand one more thing.? You are not going to be good at this, so reach out for advice.? Often, a venture firm will have someone on staff, someone who has been in your shoes before and can help a great deal.? Work with them to draft a get-well plan, and then engage with your board to pressure-test it.? The main thing is to act promptly.? Every day you do not act is another day of excess burn.? Your plan won’t be perfect, you will make mistakes, but you are buying much-needed time and you are protecting the fledgling enterprise when it needs it most.?
No one said it was easy to be an entrepreneur—now you know why.
That’s what I think.? What do you think?
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STATISTICIAN at STATISTICS SIERRA LEONE
1 天前Interesting article.
Unternehmer, CEO, gipsoft d.o.o.
1 天前The annoying thing is that most of the money in the growth phase has to be spent on marketing (market penetration, customer acquisition, branding...) and the amounts are getting bigger and bigger because everyone is doing it more and more. The more advertising, the higher the target groups' resistance to advertising, the more money is needed for advertising. But only the established large companies can afford it, which together with the large advertising platforms (alphabet, meta, linkedin (MS), X,...) are in turn the capital providers for the VCs or venture debt. This spiral makes it difficult for independent startups to enter the market. That's all about the "free" market economy. Many of those involved in this system are also influencers with large numbers of followers on social media. It all only works because all followers want to be like the successful influencers. Crazy world we live in...??
Aspiring Corporate Director / Management Consultant / Corporate Leader
2 天前A Great Article! Thanks for inviting, sharing an informative-insightful article, & Best wishes, Geoffrey Moore. Syed Awees, ACCA. Syed Suheb.
I Sell Speed - Making Lab Data Collection Fun Again
2 天前He who pays the piper, choses the tune.
When Growth Is Your Destination. Business Builder, Growth Advisor, Interim Manager
2 天前So true, Geoffrey Moore ! As usual in life, there are the good, the bad and the ugly. So, I wouldn’t blame all venture debt businesses. However, I saw, what you described, twice in my life. In both cases the founders were (sorry) kind of nerds, living entirely for the app development, with either limited to no business acumen. Both were running their businesses as if they were on drugs. Hiring people, adding features, starting campaigns, and adding more features, no matter what. And then adding debt, to finalize the next big thing … by adding two or so more features. There was no chance to intervene, no interest in advice. Both ?knew“ that this is what the market needs. So, taking on venture debt, is not always the cause, but often the effect; while the perils of not taking advice/hiring relevant skills is the cause.