Preparing to Raise Debt
The internet is filled with fundraising advice from VCs on how to sell equity to — you guessed it — VCs! In today’s newsletter, we’re going to offer some fundraising advice with a different funding source in mind. It’s a question that’s been submitted several times: How can you prepare for a debt raise?
Fundamentals > Fairy Tales
Most advice for raising money focuses on storytelling. In the case of equity fundraising, paint a big picture with the right team and timing, and watch the dollars roll in (and equity and optionality roll out). When preparing to raise debt, you’ll want to focus on your numbers. Unlike Angels, Seed Funds, and VCs, lenders rely largely on the underlying numbers of your business to make funding decisions. The numbers tell the story, not your deck or elevator pitch.
It’s important to make sure you’re able to show your business in the best possible light to a potential lender. You’ll need to know your numbers and set proper business expectations. Don’t focus on fairy tales and unicorn dreams – lenders want to hear and understand the facts of your business.
Paint-By-Numbers
Your income statement and balance sheet will only get you to the starting line with lenders. Sharing more data, like metrics and KPIs, that you use to drive your business can help paint a more complete picture about how your business is performing. Understanding the drivers of your business is a test administered by lenders – and you don’t want to fail. When you know your data, it can inspire confidence that you know how your business works, where the funding can be used, and how you’ll keep the money safe.
With most lenders, it doesn’t matter whether you’re doing simple cash accounting or fancy GAAP accounting. What matters is that you have accurate data and can explain what the numbers mean. This is certainly true of modern debt providers, like our alternative financing partners in INTRO. Lenders are increasingly focusing less on presentation of the numbers and more on how the numbers drive the business.
That said, each lender differs in what they’ll want to see to be comfortable lending money to your business. In the case of financial statements, some lenders may simply ask for an export from your accounting system, but other, more conservative, lenders may require a full third-party audit of the numbers before funding. The formality and amount of documents they’ll need will vary wildly, but don’t be overwhelmed. Here’s the minimum you should have prepared:
Articles of Incorporation — This is a document that proves you’re a real business. If you don’t have this, ask your lawyer.
Financial Statements — If you don’t have a few years of history, send what you do have. You can usually export the following financial statements easily from your accounting system:
Balance Sheet
Income Statement
Cash Flow Statement
Metrics or KPIs — Make sure you can explain how you’re calculating metrics and how they drive business decisions. It’s especially important to make sure you know how your metrics may differ from industry standards like we see in SaaS. (We’ll explore industry specific metrics in another post).
At least a 12 month forecast — More on this below.
You most likely have some form of these that you’re using already. Make them presentable and clear. It bears repeating that you may be asked for more information depending on the lender and financing instrument, but the above is a solid baseline to have clean, concise, and prepared to be conversational with.
Goldielocks and Forecasting
Unlike equity investors, lenders will require Covenants. Covenants are effectively a promise from the company to meet certain metrics, like maintaining defined performance thresholds (e.g. minimum amount of revenue or cash flow). Setting those thresholds starts with reviewing a company’s prepared forecast. Unlike VCs who will invest behind 10x year-over-year growth projected out to infinity, lenders will need something a bit more realistic. Your forecasts will be used to set your covenants. So tone down the bombast.
A quick primer on forecasts: create a forecast that looks like the inverse of your Capital Stack. The higher someone is on the Capital Stack, the more confidence they’ll want that the business is performing to plan. You should adjust the aggressiveness of the forecasts for the audience and to their relative position in the Capital Stack.
Starting with the common shareholders at the bottom of the Capital Stack, your internal forecast should be the stretch goal for the company. This plan should be at the edge of what is achievable for the business. This ambition can fuel a relentless pursuit of outsized results that can lead to a successful outcome large enough to change the lives of those at the bottom of the stack. But, being a stretch goal, there’s a higher probability of failure.
Your board forecast should be aggressive. Balance that ambition with achievability. Growth is paramount for equity investors and can’t be ignored. But, you’ve given them ownership and control in your business, and that could spell disaster if you consistently miss your overly ambitious goals. Adding in a larger margin of error can mean the difference between looking like a hero or looking for a job.
Setting a lender forecast requires additional adjustment. The lender will use your forecast to set the requirements and covenants in your debt agreement. The goal for the lender is not to get a 10x return, it’s to get their money back at the agreed upon rate and schedule. When preparing a forecast to share with lenders, you should be aiming for “just right”: high confidence in achievability while maintaining aggressiveness. The framework should look something like this:
*Warning* — the different approach to forecasting should not look like completely different businesses! Too often, companies make the % difference between the three too stark. Managing expectations can be more of an art than a science, but you should not have more than a 25% difference between forecasts.
Equity investors love a big ambitious forecast, even if confidence to achieve it is low. Smoothing the divergence of forecasting curves between ambition and confidence is critical to building a productive working relationship with lenders. They’ll trade outsized ambition and upside for consistent and measured performance every time. Sharing an overly optimistic or pessimistic forecast with lenders can result in a worse deal for the company – or even leave them feeling like Ron Burgundy.
Trade Fiction for Facts
There’s an old VC saying: there’s nothing like numbers to F#@$ up a good story. That may be the case for many equity raises, but debt is a different kind of story altogether.
Knowing what lenders look for and value in your business, from documentation of past performance to achievable forecasts they can be confident in backing, will push you out of the world of fiction and into a whole new genre of storytelling.
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