Using Debt Like Growth Equity

If you are in the venture or startup business and don’t read Dan Primack, consider changing that. He’s great.

From his newsletter this morning:

Indebted: Last week we noted that Wal-Mart subsidiary had acquired ModCloth, an online retailer of vintage women’s apparel. No financial terms were disclosed, but this didn’t feel like a success for either ModCloth or the venture capitalists who had invested over $70 million into the business since its founding 15 years earlier. Here’s what happened, per sources familiar with the situation:

  • In 2013 ModCloth went out in search of Series C funding, but the process was felled by a back-to-back pair of lousy quarters. So instead it accepted $20 million in unsecured bank debt.
  • ModCloth effectively treated the debt like growth equity, rather than recognizing the time bomb it could become.
  • When the debt first came due in April 2015, existing ModCloth investors pumped in new equity to, in part, kick repayment down the road for two years. This came amid four to five straight quarters of profitability, and just after the company brought in a former Urban Outfitters executive as CEO.
  • Once the income statement returned to the red, ModCloth again tried raising equity ― but prospective investors cited the debt overhang as their reason for passing on a company whose unit economics were otherwise fundable. Insiders could have stepped up but didn’t.
  • heard of ModCloth’s debt coming due debt month, and pounced. We’ve been unable to learn the exact amount it paid, except that the amount left over for VCs after repaying the debt (and accounting for receivables) won’t be nearly enough to make them whole.
  • 2 takeaways: (1) Debt is not inherently troublesome for startups, particularly if it’s supplementing equity as opposed to substituting for equity. But startups must recognize that not all cash is created equal. (2) ModCloth was founded in Pittsburgh, but later moved its HQ to San Francisco. It’s impossible to know if things would have worked out differently had the company remained in the Steel City, but some of its quirky retail culture did seem to get commingled with the “grow grow” tech etho

I have lived this story several times in my career and we are seeing this play out again in the market.

It is tempting to use debt instead of equity to finance a high growth company, particularly when you cannot get equity investors to value your company “fairly.” When a company has achieved “escape velocity” and is growing quickly, lenders look at it and say “there is enterprise/takeout value here and we are senior to the equity so the risk to us is pretty low.” And so they will underwrite a loan to the company even though the market hasn’t made up its mind on how to properly value the equity. So the temptation all around the table is to take the debt and kick the can down the road on the equity in the view that more time, more growth, more market validation will fix things.

This can work out well. Our portfolio company Foursquare is an example of where this did work out well. A debt deal in the middle of a business model pivot gave that company the time to re-engineer its business model and validate it. And time also allowed the company to come to terms with how the equity markets would value it and its new business model. Foursquare went on to raise another round of equity capital and refinance its debt and is in a great place now.

But, as the Modcloth story points out, debt can also work against you. If you can’t execute well post raising debt and get to another equity round or some other transaction (an attractive exit being the other obvious option), then you can have your debt called from under you and lose the control over the timing and terms of your exit. I lived through this story with a company I backed in 1999 and which was sold a few years ago in a transaction that was very good for the lenders and good for the management and very bad for the early equity investors.

Dan’s point that substituting debt for growth equity is a risky bet is spot on. That doesn’t mean it shouldn’t be done. But it should be done with care and with eyes wide open.

#entrepreneurship#management#VC & Technology

Comments (Archived):

  1. awaldstein

    Words to the wise.I know this one but welcome the reminder to tread smartly here.Thanks.

  2. falicon

    There is *large risk*, and cons, no matter how you take money from anyone that is not your *actual* customer….and as soon as you do take that money…you’ve got a new/additional type of customer that also needs to be considered/satisfied (whomever gave you that money/debt).

  3. JimHirshfield

    tl;dr Know how to use the tools in your toolbox.

  4. LE

    I would imagine that issues like this are a perfect example of how having good advice from the right investors (and other advisors) can be of great benefit when the time comes to make a decision like this. Anyone can ‘fly’ a plane when it’s already in the air. It’s the takeoff, landings and emergency situations that you need experience for. Ditto for many professions you can teach anyone to give an injection or make a cast.. Looking at Modcloth’s investors it then raises the question of how involved any individual investor is in a decision like this (I guess as anything, it varies with the company). [1][1] Edit: Seems that the threat of debt could be used as leverage for follow on rounds. Depending as always on the circumstances.

    1. JamesHRH

      4Sq story would be one of those emergency situations……

    2. cavepainting

      Exactly. Take-off. Refueling, and Landing are the inflection points that need to be handled with great care. Debt is an instrument that is great when used to plug working capital needs, or to short term bridge to an eventual equity round, but is very tricky when used as a proxy for growth equity. You are literally putting your fate in some one else’s hands. You do it only when a) the only alternative is to shut down, or pursue a fire-sale, or b) you are taking a very well thought out and calculated risk fully cognizant of the consequences.

      1. PhilipSugar

        OR… have a depreciating asset.Let’s say you are Charlie’s business and need ovens and a factory.Those things are going to last you 20 years. Right now is a great time for that. Take 6% of net cost and just run.So if that is going to cost you $10mm you can take that dilution or pay $50k a month out of operating to pay down the debt. (rough numbers)Now you better make that “nut”. But if you can it’s the way to go.Always has been always will, and with interest rates the lowest I’ve ever seen the best thing to do.Understand look at my comments if that is not your position…..the pain is coming your way.

        1. cavepainting

          Yes. When you have steady and predictable cash flow to service debt ( like in the situation you have outlined), it is indeed the smarter decision to use debt vs. equity.But, tech and e-commerce type businesses in early stage and growth phases are typically not cash flow profitable, at least not in a predictable way. Worse, the business may also be uncertain or fluid because of macro and company related issues. Debt does not go well with uncertainty, especially when it is a big check size.

          1. PhilipSugar

            As we say preaching to the choir. Meaning we totally agree.

        2. LE

          Now you better make that “nut”. But if you can it’s the way to go.I agree with you and that’s the way I did it back when I needed money. And at that time money was at iirc 14% or 16% not what it is now.But since we are talking about baking I will point out the ‘rich guy neighbor’ when growing up again. He owned a commercial bakery and had the A&P contract among other business that he did. Baked donuts I think. Anyway for whatever reason lost that contract and had to declare bankruptcy. Most likely the loans were personally signed for all the sudden he was poor. Had to sell his 16 year old kids brand new Firebird that he bought for him.Knew another guy in the last decade who owned a commercial bindery. Made lot’s of money because pharma was allowed to market to doctors and that was his niche. Bought expensive machines to do really high end product which they gladly payed for. Then the rules changed and pharma could not market like it was 1999 anymore. He had to go bankrupt as well. When things were good his biggest problem was not being able to buy a 7 series BMW because he had a union contract coming up and didn’t want to let it be known how well he was doing. Did a good job of hiding assets to keep them from the creditors. (Was stupid enough to tell me also for some reason not that I would do anything with the info just think it’s stupid to brag like that obviously and I didn’t know him that well.)So the thing is there is no way that someone wet behind the ears is going to be able to make a decision like this w/o having some people who know more point out all of the ups and downs which vary for each particular situation. And even then it’s a crap shoot.

    3. PhilipSugar

      When the debt first came due in April 2015, existing ModCloth investors pumped in new equity to, in part, kick repayment down the road for two years. This came amid four to five straight quarters of profitability, and just after the company brought in a former Urban Outfitters executive as CEOThis to me says: We put in money only under the condition we bring in a CEO that we are comfortable with i.e. big company.One of the biggest weaknesses I see are when people that are used to working with big company people are not comfortable with the people that have the passion and drive to build something.

  5. Jason T

    The counter argument is that if you’re a founder, take the debt financing if you can get it because…1) if the company is successful, you can pay it down/off or fundraise your way into a less expensive cap table. I guess your 4-square example is a good one.2) if the company is struggling, you’ll may very likely be looking out a down round in which case your equity stake probably goes close to 0%. I’ve never seen a VC make a founder whole during a down round.Either way (as a founder trying to get a payout) you won or lost because the business you built either worked or didn’t. But if you won with debt financing, you owned more of the company.TL/DR:. As a founder, think for yourself and do what’s right for you and your team. The VCs have their own agenda, and it shouldn’t necessarily be yours.

    1. fredwilson

      The all or nothing logic is compelling and I hear it all the time. But it’s wrong because nothing is as black and white as it seems

  6. creative group

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  7. Jean Jacques

    I like this is innovative take on applying corporate finance. This article how startups can use both debt and equity to meet their financing needs for a venture.

  8. creative group

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  9. Tim R. Holcomb

    Thanks for sharing this one Fred.

  10. Salt Shaker

    Interesting the co felt a need to move its HQ to SF, driven by a need to be part of a “movement” (aka a need to belong), access to capital and/or good ole plain shortsightedness. Also, debt financing for sure lacks the flexibility of a VC raise (boxed in). In its brief outline form, this story does suggest a lack of discipline on the part of co mgt.

    1. JamesHRH

      I have chips, warm salsa, Guillermo’s Mamacita’s Awesome Guac and a Guiellermo’s Especiale Margartia to wager that:- insiders got what they deserved by not stepping up to lead post-debt equity round- insiders forced move to SF- insiders did not suggest UO exec as CEOWould love to hear more inside baseball on 4Sq high wire act.

      1. Salt Shaker

        Me gusto la cerveza tambien, por favor.

        1. JamesHRH

          The guac is from another dimension…..ridiculous.I have vowed to show up at noon, consume nothing but chips, salsa, guac and margaritas until my wife has to pour me into an Uber to get back home.Maybe when the kids are in college….

      2. PhilipSugar

        I would not take that bet except to enjoy the meal.This has the absolute typical markings of as you say a VC spin cycle.The debt over equity just killed it quicker.

  11. jason wright

    How did Jet hear the debt was due? I can’t imagine.

    1. fredwilson

      Follow the money

      1. JamesHRH

        You have to admit that getting out of a mistake is a valuable skill.

  12. JamesHRH

    Went back and read the sale announcement. Made me think of Ubooly – a husband and wife, crazy good product company that @bfeld:disqus knows a lot about.CEO of Ubooly gave a talk here in the CGY, her hometown. It made me cringe. Everyone treated her so well, even after she told a story that made my heart break: her product insight was ridiculous; their business sense was nearly non-existent.Is there something about the spouses-as-founders thing there?These women both deserve – in my mind – to be Anita Roddick of The Body Shop.Crazy good product insight.

  13. Ronnie Rendel

    Could be one big difference in Foursquare’s case is that their investors care deeply about the company.

  14. george

    Today’s post was great; loving looking at this from both sides…

  15. Benjamin Adeneye

    interesting stuff. any business taking debt at an early stage would usually have cashflow support to meet repayment easily hence in place of dilution (equity) but in the absence of that it will eventually run into the ‘Madcloth” scenario for investors in the business especially the early investors.

  16. Md Swart

    Hope the Soundcloud debt round results in a positive outcome but many in Europe see similarities with Modcloth

  17. awaldstein

    Of course.But when your business is dependent on distribution as most food businesses are, and Whole Foods particularly, you have more stomach than this individual in thinking that you can plan 5 years out with them.Cause you really can’t.

  18. PhilipSugar

    Of course depends on your position/capital requirements.I think the biggest lesson is that moving your HQ is a very high risk maneuver. I know people think Pittsburgh is not hip, but it has huge talent in this area including American Eagle.

  19. cavepainting

    Yes, if the firm is throwing off predictable cash flows, and the business is steady and growing, debt is great. But one needs to be sure of the ability to service the debt. When things are fluid or uncertain, it is a bad option.

  20. awaldstein

    You are a smart CEO my friend. Very hard to keep WF in balance to revenue stream but essential obviously.

  21. falicon

    The second best moment in a companies life is getting that first paying client…the SINGLE best moment is getting that second paying client so you aren’t so beholden to the 1st 😉

  22. PhilipSugar

    I think people view money as just other people’s money. How much do you think a move like that cost??? More than $10mm is an easy guess. Then you need to pay that back.

  23. LE

    I will have to disagree with both of ‘youse guys.While it may come across as trying to be hip and that could additionally be the reason that they did it, I feel that the connections that you can make in a center of activity like SV SF NYC (given the right location and for certain products) can be greatly advantageous. Doesn’t mean for everything and every situation that’s obvious.And yes per @philipsugar:disqus point it does have risk (and cost as well) but depending on the age of the workforce involved might not be deadly. And infact this company moved in 2009 and according to what I read sales did increase after that:In 2009, ModCloth reported $15 million in revenue,[8] allowing them to relocate headquarters from Pittsburgh’s Strip District to San Francisco.[9] ModCloth reported $100 million in revenue in 2012[10] and $150 million in 2014.[11]Noting also that the majority of their funding came post 2009 when they moved according to crunchbase.[1]

  24. JamesHRH

    initial investors are the story, is my bet – see below

  25. PhilipSugar

    I think you and I have seen the play of let’s take control from the founders, let’s start spending money on stuff that doesn’t matter (move) and where the story ends.

  26. LE

    See my other comment and the link below. they raised the vast majority of their funding after the move to SF. And that was in 2009 (although this link seems to indicate 2010).…The news comes on the heels of ModCloth’s $19.8 million Series B funding round. The lead investor, Accel Partners has its U.S. office in Palo Alto, Calif., just south of San Francisco. Koger said expanding the company’s reach with the new offices is designed to help the firm attract the best talent.Now you could argue they could get the same ‘talent’ in PGH or that that talent is overprice but that is a matter of opinion.

  27. LE

    To which I say:e conspectu, ex animo.

  28. PhilipSugar

    I agree.

  29. awaldstein

    Under 20% is hard as they are the volume mover obviously for premium product and the wellness community shops there if they are in the neighborhood.Juice is tough in general. Tough cause competition from WF themselves as well as low end big brands. But need to give Lianna a lot of credit. Refusing to slash prices and sticking with her core base and brand ecosystem feeder system has enabled her to stay in the market. She has a lot of guts.And of course, with that strategy and strong margins for the retailer there should be a piece of every market on the coast for her. And brand leverage to that same customer for other stuff.We shall see.( does sell a decent bit of her stuff btw.)

  30. awaldstein

    help is a good thing.

  31. awaldstein

    bread has ubiquity in a very different way than functional beverages. margin diff as well i bet all around.

  32. awaldstein

    food biz is uniquely challenging for perishable goods as for the most part you are dependent on a number of players.selling bread and selling bits ain’t that much alike.

  33. PhilipSugar

    The strip district is as hip as it gets in Pittsburgh.

  34. PhilipSugar


  35. PhilipSugar

    These are the type of debates I love on this forum.

  36. JamesHRH

    The line you quote puts ‘allowed’ in there like it makes sense.$15M in revenue should have ‘allowed’ them to call the shots.

  37. JamesHRH

    A quick review of Crunchbase indicates that the A & B rounds were lead by people that give me the willies – both former consultants (1 McKinsey / 1 Bain).I think they got Valley VC Spin Cycled.

  38. PhilipSugar

    I really hope we do something together n the Lancaster Valley.I can almost hear the conversation:Look, Pittsburgh is just not cool (wrong) We need to get in some hip rad offices in SF. I love SF if you are there great, but no need to go there to be there.Let’s get some management that has been with a company that was successful not built one that was not into one that was.They know what to do to run budgets not understand when we run out of money, things are gone.Ooops. Nighty, nite.

  39. karen_e

    Agree – I think this is a key part of the story. What makes ModCloth unique is some of that second-city, even homesteader ethic.

  40. PhilipSugar

    I really do feel bad for them. I would love to know how many companies survive the let’s move HQ and then let’s change CEO’s.Both totally scream of VC’s saying let’s take this out of the hands of founders.It is one of the few things I can totally say I’ve seen happen.