Venture debt is a specialized form of corporate credit that differs from traditional corporate lending in a number of important ways. While traditional credit is typically backed by assets or cash flow generated by a business, venture debt is used by fast-growing companies that are consuming — rather than producing — cash to support their continued growth. A typical venture borrower is therefore very unlikely to qualify for traditionally adjudicated credit. And, conversely, the kind of borrower that’s appealing to traditional lenders isn’t typically growing fast enough to attract venture debt providers.
As a result, while traditional debt and venture debt share some superficial similarities, they require very different underwriting practices. A key example is the importance venture lenders place on revenue growth and growth efficiency in assessing a business’s ability to deleverage over the term of a loan.
Different measures of leverage
In traditional cash flow lending, leverage is measured relative to EBITDA, effectively measuring a company’s ability to generate cash flow to service and repay its debt. Deleveraging occurs either as the borrower reduces its indebtedness by amortizing down the loan via cash flow, or by increasing its EBITDA and therefore improving its capacity to service and repay the debt.
By contrast, lenders to fast-growing companies in the technology and other high-growth sectors that generate negative EBITDA must look to other metrics to measure leverage. As these companies are generally valued using a multiple of revenue approach, venture debt loans are also generally measured, or sized, based on a multiple of the company’s revenues. This approach therefore measures leverage relative to a company’s enterprise value instead of cash flows.
As a result, in venture lending, deleveraging occurs mostly due to growth in revenues since increasing revenues drive increases in enterprise value and a corresponding reduction in loan to enterprise value. Consider a scenario where a loan is made to a software company representing 20 percent of its enterprise value. Assume the business grows its revenue by 25 percent annually over three years and that its valuation revenue multiple remains unchanged. While the loan amount remains unchanged, the growth in revenue will materially increase enterprise value, and will thereby reduce the implied loan to enterprise value ratio, or deleverage the loan, by nearly 50 percent by the end of year three (see table below).
|Software Co. ($ millions)||Inception||Year 1||Year 2||Year 3|
|Implied loan to enterprise value||20.0%||16.0%||12.8%||10.2%|
Given the importance of revenue growth to deleveraging a venture loan, venture lenders put a lot of weight on revenue trajectory. However, beyond the pace of revenue growth, its quality, sustainability, and, most importantly, efficiency, are also critically important.
Why growth efficiency matters
Growth and growth efficiency are foundational for making decisions about any kind of venture investment, and debt is no exception. To illustrate, a dollar of investment that generates a dollar of recurring revenue might result in five dollars of incremental enterprise value assuming a five times enterprise value to revenue multiple. If, however, a business spent five dollars to acquire one dollar of recurring revenue, the payback on the capital invested is much less attractive, resulting in a lower valuation compared to a more capital-efficient business. Obviously, the retention rate and lifetime value of these new revenues also matter to investors, and are baked into the enterprise value attributed to each dollar of new revenue created.
Looked at in their proper context, growth rates can tell a lender a lot about its borrower’s value. In isolation, though, revenue growth can be confusing or even misleading. Is fast growth a sign of great execution or secular market expansion? Are the channels for growth sustainable in the context of costs to continue adding new customers? Are its existing customers increasing their spend on its products or are revenues from new customers disguising the fact that dissatisfied customers are churning out? In the same vein, entry into new markets could mask disappointing sales in existing geographies, and new pricing strategies might generate attractive looking near-term growth rates at the expense of future periods via lower renewal rates.
So while growth is great, efficient growth is much better. If a business can grow revenue without investing a lot of incremental capital, more value will be created for current investors. For venture lenders, more efficient growth can serve to reduce the risk that the company won’t be able to access sufficient capital in the future to meet its revenue forecast. More efficient growth will also affect the valuation an investor (or acquiror) will pay for that revenue, a key driver of a venture lender’s assessment of loan to enterprise value, or leverage, over time. Prudent venture debt lenders understand this dynamic and thus actively seek out businesses that are growing efficiently.
Measuring growth efficiency
There’s no single formula for growth efficiency, but there are a number of analyses that illustrate the concept in different ways. Some of the most common include the Rule of 40, customer acquisition cost (CAC) payback period, and retention rates. Let’s look at each in turn.
The Rule of 40
Coined by Brad Feld, The Rule of 40 is one of the most popular standards that has evolved for evaluating growth efficiency in the public markets. This measure is calculated as the sum of a company’s year-over-year annual recurring revenue (ARR) percentage growth rate and its free cash flow margin (FCF as a percentage of revenue) as shown below. A result above 40 shows a healthy balance between growth and profitability, and thus efficient growth.
Theoretically, software businesses that are able to maintain this balance will benefit from higher valuations. The Rule of 40 has become a commonly used tool to provide a quick indicator of how a company is balancing revenue growth and the investment required to achieve that growth. However, it’s important to note that the Rule of 40 is more applicable for later stage companies (e.g., growth stage or later) than smaller, earlier stage businesses. For earlier stage companies enjoying very high growth rates, the implied level of negative free cash flow a company could record while still meeting the Rule of 40 may be unrealistically high and mask inefficient growth. For that reason, lenders often look to other measures of efficiency for earlier stage companies including CAC payback period and retention rates.
The CAC payback period
The CAC payback period measures the time it takes a company to recoup the money invested in sales and marketing to acquire a customer. It’s calculated using the formula below:
There are numerous variables that will affect CAC payback period and the optimal payback period will vary between companies based on the unique characteristics of their business. Sales strategies, average contract value, the ability to up-sell/cross-sell, cost of delivery, and complexity of the sales process, among other factors, will all impact a company’s payback period. For earlier stage companies, a payback period of less than 12 months is generally regarded as good. For larger companies, with access to less expensive capital, longer payback periods may be acceptable. Furthermore, it’s important to view the implied payback period in the context of a company’s churn (e.g., expected customer lifetime) to understand a customer’s underlying profitability. Notwithstanding these variables, for venture lenders, CAC payback periods can provide important insights into a company’s future capital requirements (longer payback periods may imply larger working capital needs) and growth prospects (shorter payback periods can free up cash to invest in growth).
The Rule of 40 and CAC payback period are examples of metrics that help measure how quickly and efficiently new revenue has been added to a business. Next, it’s important to get an understanding of how long new customers will stay and how effective the company is at increasing revenue from existing customers over time. The metrics to track this are customer (logo) retention (the change in the number of customers in a period), gross revenue retention (the percentage of recurring revenue retained after cancellations and downgrades in a period), and net revenue retention rates (a measure of retained recurring revenue in a period, including the positive impact of upsells).
While each of these measures provides insights into a company’s revenue base and growth, net retention can provide particularly important insight for venture lenders seeking to evaluate a company’s ability to support debt. If a company enjoys very high net retention rates (e.g., over 100 percent), it means the business is growing organically before accounting for new customer acquisitions.
For venture lenders, high net retention rates may be an indicator that the business is better able to withstand any challenges it may have in the future attracting new customers (e.g., it needs to attract fewer new customers to maintain its existing revenue base). High net retention rates may also suggest that a company has the ability, if needed, to reduce its cash burn via a reduction in sales and marketing investment without immediately impacting its revenue base. That’s an important consideration for venture lenders in assessing a company’s sustainability and therefore suitability for taking on debt.
Growth efficient companies make good investments
Traditional finance metrics are often difficult to apply to software companies, which are fast-growing businesses, often with negative EBITDA and negligible balance sheets. To evaluate these companies, venture debt providers need to appreciate not only their growth, but also their growth efficiency and retention rates. While there are more factors that go into assessing a potential borrower, these are a few of the most important. Growth efficiency helps venture debt providers understand how much and how quickly companies can increase their value, thereby reducing risk and helping to safeguard investors’ capital.