Venture Capital: Debt & Tech

“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” Archimedes

At Samaipata we have spent a fair amount of time in recent months looking at capital-intensive tech businesses within our investment thesis across different sectors, B2B and B2C (quick refresher: we are a pre-series A fund investing in digital platforms with network effects at scale across Europe). For us capital-intensity is not an end but rather a means to build some very interesting digital platforms.

These are exciting times for capital-intensive business models in tech so we thought it would be interesting to pull a thread on the topic and dissect the momentum behind debt(tech)-enabled tech(debt) businesses (no pun intended, we actually haven’t settled on this argument) and share our two cents on the subject in a post!

Capital-intensity and leverage

In plain English, a capital-intensive business requires a lot of “money” to start up and to operate, relative to the size of its revenue. In other words it runs a large balance sheet that stems from the nature of the businesses. In the tech universe this might take different shapes, for instance: financing sizeable sunk costs (R&D in deep tech), financing valuable inventories (hardware), financing customers (lending fintech) or market-making (in a very curated marketplace), to name a few. We purposely exclude opex-intensive businesses from the scope of this article (for instance a marketing heavy B2C business).

The bulk of this “money” must be contributed by the investors of the business. Corporate finance textbooks say that equity investors need to earn at least their cost of equity on their investment at a given level of risk, regardless of the size of the balance sheet of the business. Funding a capital-intensive business solely with equity drastically dilutes returns on equity. In order to make numbers work, leverage is usually the other side of the capital-intensity coin. Otherwise, capital-intensive businesses would rarely be an attractive investment vs. other businesses for an investor seeking equity returns. To bridge this gap, capital-intensive businesses need to attract more senior resources to their capital structure (debt, in different shapes) to beef up the equity returns and meet investors’ return hurdles

Surely this sounds very nice on paper, but it is no secret early stage VC has never abided by the 20th century rules of corporate finance all that much. Binary outcomes and exponential returns are in the DNA of this asset class. Of course “binary” is not a word credit investors cherish, considering the capped upside behind fixed income, and uncapped losses. For a long time, credit investors were uninterested in supporting early stage ventures. Largely because they had enough demand for their supply elsewhere less risky. We will come to that in a minute.

Early stage VCs have been pretty much the sole institutional capital providers in this space and stage for decades. As a result they have often prioritised asset light businesses that they and their late stage peers could fuel up to an exit, mindful of the significant cost of equity capital. Equity is not only expensive for founders but also for existing investors!

So what has changed?

“Why now” (and “until when”)

The rise of capital-intensive startups is the result of a convergence of the appetite of (a) private debt investors and (b) founders and VC investors. While it is a chicken and egg situation to some extent, supply of debt is probably the most powerful enabler, around which founders and VCs have come up with business models and investments. This can be approached through the classic sources & uses lens.

Sources: The quest for yield

Private debt has boomed in the past decade. Some of the drivers behind are common to alternative issuers in general (private companies) while other are specific to the asset class (private debt).

Although private debt has existed for a long time, it really emerged following the Global Financial Crisis. New banking regulations left a gap that direct lending funds were happy to fill. More recently monetary liquidity and the prevailing low interest rate environment have continued to drive a quest for yield, driving institutional investors into leveraged loans and other alternative asset classes. Supply has cascaded down the private debt stack:

Throughout this process portfolio managers at institutional funds are also becoming more comfortable with private debt as an asset class of its own and specifically direct lending products addressed to startups.

Last but not least, the broader boom of alternative assets has also triggered a positive feedback loop between equity and debt providers. The growth in private equity or VC-backed businesses increases the demand for private debt.

Uses: Founder and VC appetite

Funding supply would be futile without founders and ideas to support and VCs contributing the equity buffers required by credit investors.

As mentioned earlier, VCs have to some extent historically avoided capital-intensive business models. Not only debt supply was not there, but also VCs associated capital intensity with low scalability, where capital takes time to raise and to deploy. This is likely the case for for physical capital intensity (e.g. hardware-heavy models) or marketing intensive businesses (e.g. very competitive B2C verticals).

However, technology and liquidity have proved this wrong for financially capital intensive models. Several fintech serial fundraisers illustrate how quickly can a capital-intensive venture raise and deploy capital in the current environment. These days VCs are much more open to invest in balance sheet intensive businesses, as a means to an end.

VCs are the direct and indirect gatekeepers of equity and debt funding respectively, therefore their stance inevitably curtailed and oriented founder initiative in this space. Founders are now entitled to tackle previously vetoed fields and business models.

“Until when” and risks and opportunities of market timing

Will this “why now” be as strong forever? Most likely not. Will it fully disappear? Probably not either.

When liquidity eventually dries up (if ever) and yield is available elsewhere less risky, debt supply to startups might retreat crunching a few players in the process and raising barriers to entry. However, as we mentioned above a new asset class is born and will probably consolidate a long-term share of global asset allocation.

On the flipside, debt-enabled players that reach escape velocity and gain access to the mainstream capital markets will enjoy a robust financial moat to defend their business model from new entrants.

Capital-intensive tech business models

Below we share a few examples of capital-intensive tech business models and the role of debt in their proposition, including the beauty and the specific risks created (or magnified) by debt.

Lending

B2C or B2B financing business models such as Buy Now-Pay Later (e.g. Klarna, Affirm) and Revenue-Based Financing (e.g. Capchase, Uncapped).

• Business model and role of debt: Revenue is mainly comprised of interest income. Yield is a key driver of profitability. Funding proceeds are funneled to lending, debt supply can be a key constraint to grow.
• The beauty: Technology, regulation and risk appetite are moats against traditional lenders. Debt supply is an attractive moat against tech players. Lending creates very sticky relationships to build further business on top.
• The risks: Credit risk, of course.

Leasing

Tangible or countable intangible assets “as a Service”. Car-as-a-Service (bipi), hardware-as-a-Service (Grover), etc.

• Business model and role of debt: Revenue is mainly comprised of rental income on the operating assets. Funding proceeds are invested in operating assets. Tightly priced debt is key to scale the business and enable profitability through leverage.
• The beauty: Technological moat against manufacturers and financial institutions. Financial moat against tech players.
• The risks: Significant residual value risk (mistreatment and obsolescence).

Market-making

Curated marketplaces where the company needs to acquire and curate the assets. Mostly proptech given the size of the tickets and the potential for curation. For instance, fractional ownership platforms like Pacaso or ibuyers like Opendoor.

• Business model and role of debt: Revenue is mainly comprised of asset trading gains. Funding proceeds are funneled to supply acquisition and curation. Working capital uses, fast balance sheet rotation.
• The beauty: Owning supply is key to curate freely, to enable legal trust and to attract capital gains. Debt supply acquisition results in a financial moat towards other tech businesses. Tech acts as a moat against private debt and RE direct investors. And traditional lenders are not into this business!
• The risks: The moment property sits on your balance sheet you face market risk!

How do we look at capital-intensive business models at Samaipata?

Capital-intensive tech businesses are very heterogeneous and debt is only one piece of their business model. Hence it does not make sense to draw blanket conclusions since the bulk of the analysis should focus on the specificities of each business model. Again, capital-intensity is a means to an end.

However, in our view there is one common requirement: the value proposition cannot rely solely on sourcing cheap funding. Conceptually a startup will never be able to outprice other players (lenders, insurers, etc.). Temporary arbitrages do not create sustainable business models therefore we need to see a clear technological, strategic or regulatory competitive advantage regardless of the capital structure.

And obviously, capital-intensive businesses display similar characteristics that need to be duly analysed.

The capital structure journey — Reaching “escape velocity”

Asset-intensive businesses are ultimately an asset and liability flywheel. Happily there is funding in the market for strong founders to cold start debt-enabled businesses, albeit still at a high cost that needs to be rapidly overcome.

As investors, we need to build conviction around a funding roadmap that allows the company to reach “escape velocity”, detach from the gravity of the private capital markets and quickly build a track record to have a claim to cheaper funding, ultimately through the public capital markets.

As it grows, a successful debt-enabled business will work on the optimization of its capital structure over time targeting lower cost of funding and higher leverage (lower equity requirements). Attractive verticals will draw significant interest and investment from newcomers and traditional players. Therefore, steadily creeping up the capital markets ladder will be key to remain competitive.

Affirm (NASDAQ: AFRM) is a great example of a successful capital-intensive VC-backed company that has reached escape velocity and is already accessing the public capital markets at very competitive terms. In its early days Affirm relied on private institutional funding to support its BNPL origination. In recent years Affirm has relied on bank warehouse financing as its main source of funding. As of late, the company has made great progress in diversifying away from banks (such financing accounted for 19% of the company’s funding mix as of June 2021, down from 42% a year earlier). Over time, Affirm has built an increasing pipeline of direct loan sales to institutional investors and securitizations in the public markets.

The beauty of capital-intensity

Capital-intensive businesses have intrinsically higher barriers to entry. The challenge of dual equity and debt fundraising can compound into an even more difficult cold start of these businesses. Conversely, defensibility can be very attractive.

In certain business models the funding flywheel can turn into a proper network effect whereby each asset (customer) or liability (debt investor) counterparty adds value to the overall platform. We can think about lending businesses as an intermediated credit marketplace where the platform acts as underwriter and takes the first loss as an incentive alignment mechanism. In this example, each new customer will benefit from the track record of its earlier peers via better pricing as a result of lower cost of funding.

Following up on our recent article we share a bonus tactic to cold start those “funding network effects” in capital-intensive business. Fund your initial transactions with equity to test unit economics and show your prospective debt investors that pro-forma unit economics would work for customers, equity investors and debt investors.

The role of founders

The importance of the founding team in early stage investments cannot be overstated. Frankly, when looking at capital-intensive businesses we are looking to invest in exceptional founders just like when we look at any other business model. Rather than looking for specific skills, we need to see founders eager to tackle the specific challenges posed by capital-intensive business models.

These businesses require constant debt and equity fundraising. Every VC-backed founder needs to fundraise from time to time, but this becomes an “operational” skill in the case of capital-intensive business. Founders must enjoy this journey and see it as part of their core business. They must be able to address both Power law-driven VCs and capital preservation-driven debt investors, to navigate market conditions and financial structures and to build trust across the capital structure of their company.

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