Let's Talk About Levers

This week, I’ve been thinking a lot about leverage.

Why?

Because on Friday I gave a short presentation on startup financing (see observation 2 below). While preparing, I was reminded that a startup’s capital structure (the specific mix of debt and equity that a company uses to finance its growth, and from which we can calculate leverage) has massive implications for an equity investment’s risk. If you’re not familiar with these terms, keep reading and I’ll explain.

For the last 8+ weeks, I’ve been walking through the Angel Ops framework we developed to visualize what the process at a world-class angel network looks like. This week, however, I’d like to deviate from that pattern to address a diligence mistake that is all too easy to make: failing to understand the capital structure of a prospective investment.

Let’s get into it.

Let’s Talk About Doors

Imagine the last time you opened a door. You probably opened and closed a dozen or more just yesterday.

Ever stop to think about how they work and what they’re made of?

They’re pretty simple (let’s ignore fancy sliding doors for the purpose of this illustration). Most basic doors are composed of some kind of body material (glass, wood, fiberglass, etc.), a knob or handle with a matching hardware set, a door frame, and hinges connecting the body to the frame. Infinite details are located here if you’re really excited about this topic.

Now, normally the handle or knob is located on the opposite side of the hinges. Which, if you’ve ever tried to push a door open from just beside the hinges, makes a lot of sense. It takes a lot less effort if the knob is located far away from the hinge.

That is because a door is an example of a lever, which is “a long beam that rests on a point or support called a fulcrum.” The lever is an example of a “simple machine” which is designed to change the magnitude and direction of force. The further away from the hinge your hand is (i.e. the longer the lever), the easier it is to make the door move.

Lever-age, then, is defined by Dictionary.com as “the mechanical advantage or power gained by using a lever.”

Now, let’s translate this Renaissance engineering concept to the world of finance.

Debt is Like a Door

It’s a lever for multiplying financial force. It can help multiply a small amount of capital to accomplish a much larger investment that might not be possible otherwise. The higher the debt/equity ratio, the more leverage is applied.

For example, according to Redfin, as of June 2022, the median home sales price in the US was $425,674. I don’t know very many people that buy their homes in cash - most of us take out a mortgage. To do so, we provide some percentage of the home’s value upfront in cash and work out a loan from a mortgage lender for the remaining amount. Putting up 1% of the value in cash is like pressing on the very far edge of a door, whereas putting up 80% of the value in cash is like pressing on the door fairly close to the hinges - much more difficult.

Without debt, most of us would not be able to afford a home. However, there’s a tradeoff: this flexibility dramatically increases the borrower’s risk.

I Got Out My Finance Textbooks for This Section

In contrast to a debt-free purchase, a borrower must issue a regular repayment of the loan (typically 30 years in a mortgage scenario). That obligation is fixed - regardless of whether the property value goes up or down over time. Plus, the lender has the first claim on the asset (called a lien) in the event that the borrower stops making payments (or defaults). This fixed obligation means that any changes in the value of the asset (the property) affect only the equity position, not the debt.

So for example, let’s say I purchase a home worth $400K, and the value of the property changes by $25K over some period of time. In one scenario I purchase the home in cash (or 100% equity; D/E ratio of 0). In the other scenario, I take on some leverage and finance the purchase with $100K in cash and $300K in debt (25% equity; D/E ratio of 3). All the numbers for each scenario are shown below, but let’s walk through it.

In the first scenario, if the value of the property increases to $425K, my equity position has increased by $25K (or 6.25%). In the second scenario, however, my fixed obligation remains at $300K and the extra $25K increases my equity position to $125K. Having only invested $100K in cash, that’s a return of 25%, which is 4x the relative performance of the equity scenario. Not bad!

However the reverse is also true - if the value decreases to $375K, in an all-equity scenario I’d lose $25K, or 6.25% of the value. But in the debt scenario, I still owe the lender $300K, so my equity position drops to $75K, for a loss of 25%. Yikes.

Here’s the key takeaway: the presence of debt can have a dramatic effect on the sensitivity of equity returns.

So… Equity Investors Should Ask About Debt

Admittedly, most very-early-stage startups carry little/no debt on their balance sheet. They’re considered so high-risk that most lenders won’t finance them (with the exception of friends/family making small personal loans).

But some do. Whether it’s through strong personal relationships with debt financiers, SBA loans, or other creative methods, some founders manage to tap into substantive lines of credit. (For example, earlier this year our team analyzed a company raising a seed round on a SAFE note and we discovered they had managed to tap into about $350K in debt financing so far.)

In my experience, it can be common for angel investors to fixate on the details of the current funding round, and forget to closely examine a company’s financing history. Since most founders have little/no debt, it can be easy to assume that is the case every time and skip asking if the company is carrying any debt. But on the off chance that the company does have substantial outstanding liabilities, this could result in unintended risk exposure. Since many early-stage angel investments ultimately convert to some kind of equity, I strongly believe these questions are well-worth asking.

To Illustrate My Point

You may recall from a post I made a few weeks ago that I recently reviewed the application to pitch at a dozen Texas angel networks, and came up with a list of 402 different questions that they asked founders to fill out. Guess how many of those questions asked about debt funding?

3.

That’s less than 1% of the total questions asked.

Final Thoughts

I believe diligence is all about helping prospective investors make a decision. Understanding the capital structure of an investment opportunity is essential for equity investors since the presence of debt can dramatically increase the risk and sensitivity of equity returns. Regardless of how attractive a deal may look, I believe it’s worth taking some time to ask the question.

What do you think?

Do you ask founders about their debt financing history? What percentage of deals that you consider have some amount of debt on the balance sheet?

Weekly Observations: 3 Lessons Learned

1. Chinese weddings have the coolest traditions.🧧This weekend I got to attend my first Chinese wedding, and one tradition in particular stood out to me: the Tea Ceremony. It was held the evening before, and after enjoying WAY too much food, the bride and groom invited a procession of family elders (grandparents, parents, aunts/uncles, and others) to the front. The couple got down on their knees together and served each elder a cup of tea, after which the elder would offer advice and a gift (the famed red envelope!). I was impressed by the symbolism of the event, and after a few years of marriage found myself appreciating a lot of the advice that was shared.

2. Vetrepreneurs lean in.🎖️One of our company’s core values is “Lean In.” This week, I saw that value on display in a powerful way. On Friday I was given the opportunity to speak with a group of veteran entrepreneurs at the Reynolds and Reynolds Entrepreneurship Bootcamp for Veterans Reunion hosted by the McFerrin Center for Entrepreneurship. Not only had every one of these men and women served in our country’s armed forces, but many of them have been leading businesses for 20 years or more. Despite the fact that I’m a civilian less than a year into my own entrepreneurial journey, they were humble enough to listen to me for an hour, ask excellent questions, and engage in a way that left me excited to come back. And they even sent me away with a thoughtful gift.

3. Real deadlines are amazing motivators.📆This week we turned in 3 Pitch Reports (fairly in-depth 6-page overview of a company’s market, traction, opportunity, and team) for a client’s event, PLUS a completely reworked web application for distributing information to and engaging with members. It was a scramble the week before to get everything built, tested, and rolled out in time, but we did it, and I’m reminded yet again how helpful it is for “getting stuff done” to have real deadlines (as opposed to self-imposed deadlines).

About Me

I cultivate flourishing.

I'm also the CEO of PitchFact, where we help angel networks conduct efficient and collaborative diligence. I'm a proud husband, aspiring father, and grateful friend. My love languages include brisket, bourbon, and espresso.

About PitchFact

PitchFact helps angel networks conduct efficient and collaborative diligence.Learn more at pitchfact.com.