On Debt and Boards

Not enough is said about board composition in early-stage technology companies and the decisions they encourage founders to make.

Increasingly, we're seeing venture-backed companies loaded up with debt, equal to or greater than what they raised in venture. Most of these businesses have real revenue, in the millions of dollars, but are burning significant amounts of money each month. Not only are they not cutting burn in any meaningful way, they're also servicing debt in the tens of thousands of dollars each month. Clearly unsustainable for anyone that has any experience running a business.

It makes you ask the question, why? These aren't stupid people on the board or running these companies.

It is worth looking at the incentive structure. I wrote a few months ago about investor's increasing unwillingness to bridge existing investments that need more runway. There's better opportunities (and less history) with new investments. Companies that aren't rocket ships become stale and uninteresting for venture investors, both new and existing. At that point, with additional investment capital unavailable, boards and founders are turning to debt. That's because it's all or nothing for the venture capital model. You're either a winner or a loser.

These boards would rather saddle the company with debt they know is unsustainable. This is a desperation move to accelerate growth in hopes that the business will then be attractive enough to raise the next round and continue the path of burn, in hopes of an inevitable exit.

With boards predominantly made up of the venture capitalists that funded them, most of which have never actually operated a business, and who also require 10x+ type outcomes to fit their model, founders need to be aware of the decisions they're being encouraged to make and why. It's devastating (and completely avoidable) to see these businesses shut down, with all of their employees losing their jobs and founders losing their company. Particularly with a real business with real revenue underlying them, and a clear path to operating sustainably. By leveraging up with debt and erratically swinging for the fences, the sustainable operating path closes.

This is broken.

If you're a founder in this situation, this is something you can say no to. Either through recapping the company or proposing a different operating path, there's ways to avoid this. It also stresses the importance of adding diversity to your board, both in terms of backgrounds and incentive structures.

At the end of the day, the reality for most venture backed-businesses is that the system they're injected into doesn't support a path of profitability. Most companies at the earliest stages raise capital at valuations ranging from $5 million to $15 million, occasionally with liquidation preferences for certain investors. This means that they need to see an exit of at least that amount to get their money back. For a business with a few million dollars in revenue and a clear path to profitability, but modest growth, this isn't a path boards are supportive of given the valuation backdrop I mentioned.

Zooming out, this explains directly why the all or nothing debt move is becoming more common and the clear incentive structure of the boards that oversee these businesses.