Specialty Finance - Post 4

Comparing financing options

In today’s post I wanted to provide a breakdown of five different funding options for fintech lenders and originators and emerging specialty finance companies. I will do a more detailed post on each option in the future.

Warehouse Facilities - Typically start at $20-$25 million and can go up to several hundred million dollars. These facilities generally take 3-6 months to negotiate (if you are prepared) and have terms of up to 4-5 years. An SPV (or bankruptcy-remote entity) protects assets and limits recourse to the parent company. The borrower will need to put up first loss or equity haircut capital to access debt capital available under the borrowing base. As I explained in a prior post on this subject, haircut capital is the borrower’s ‘skin in the game’ and helps protect the lender from an impairment of principal. The specialty finance company or fintech lender must also pay ALL legal fees in these deals (including those of the lender). Borrowers taking out their first warehouse facility will want to carefully negotiate ROFR language (right of first refusal) as well as other key points like eligibility criteria, advance rates, concentration limits, and financial covenants. For newer fintech originators and specialty finance companies looking to build their loan volume, fighting tooth and nail for the lowest interest rate may not be as wise as gaining flexibility in other areas of the term sheet.

Forward Flow Agreements - Similar in size to warehouse facilities with a related amount of time required to close a deal. Terms will be shorter and more like two years or less. If scaling rapidly, these arrangements can provide needed breathing room. Originators can earn revenues from a) originating loans, b) servicing loans, and c) interest income above a forward flow buyer’s required bogey (or minimum return threshold). These financing arrangements are often synonymous with later-stage companies who have more data and loan tape to underwrite against. Check out this white paper from Clifford Chance on these transactions.

Recurring-revenue Advances - The area of revenue-based financing has grown tremendously in recent years alongside the explosion in SaaS (software-as-a-service) business models. Early-stage companies with hundreds of thousands in recurring revenue can get advances ranging in size from 3-12x MRR (monthly recurring revenue). Generally speaking, terms will be for a year or less, require no warrants or dilution, and have no covenants. Check out these providers resources for more information: Lighter Capital, Stripe, Pipe, and Capchase. Also, review this analysis from Toptal on recurring revenue advances.

Venture Debt - Venture debt is an alternative to equity and has re-emerged in recent years given the challenges in raising venture capital and the overall economic environment. A venture debt transaction typically is done via a senior loan that is either secured or unsecured and is quite bespoke depending on the company, stage, characteristics, and other factors. A venture debt facility will often include warrants (also known as equity kickers) as part of the lender’s term sheet as well as amortization after an initial seasoning period lasting upwards of 6-12 months. SVB, a Division of First Citizens Bank, is one of the largest providers of venture debt. I recommend reading this piece from SVB and this white paper from Bessemer Ventures to learn more.

Loans from Family and Friends - One of the best pieces of advice I heard recently on the topic of fundraising strategy was to have an ‘institutionalized way to know who you know.’ Create a detailed map of your relationships instead of simply scanning a list of contacts and then execute an outreach strategy. This is such wise advice. In thinking about capital providers for your fintech or specfin startup, institutional investors, including private credit funds and large banks are going to be much harder to secure commitments from early on. Some of the more flexible, nimble institutional investors who are willing to invest in an unproven venture will take you more seriously at the early stages. While certain strategic investors and lenders are worth pursuing, as outlined in prior posts, one of the best, if not the best channels to consider, are your family and friends.

While getting meetings (ideally in person) with large capital allocators can be a signal of traction, many times your highest ROI from capital markets activities in the early days will be from your personal and professional networks, as well as friends and family. I like the idea I heard recently of setting up an executive feeder fund to pool smaller commitments. Early-stage founders often make the mistake of overlooking this valuable set of relationships in their quest to pursue large, well known lenders. When thinking about your closest relationships, don’t forget mentors, sponsors from prior jobs, former managers and bosses, colleagues at previous employers, ex-classmates, old teammates, professionals in your community in the financial industry, as well as the introductions any of these individuals may be willing to offer.

The foundation of an effective capital raising process is good planning. It is essential to know what kind of capital you need and why. Understanding the relevant timing, sizing, characteristics, and trade-offs amongst these five financing options will help narrow your focus. On my ATLalts podcast and in future posts I will spend time interviewing experts about each of these options given their importance to early-stage fintech lenders and emerging specialty finance companies. In the earliest days of your organization, your time is likely going to be spent looking for deals, raising money, and building your company. Organization, clear and concise messaging, effective and succinct articulation of your value proposition, professional and consistent follow up, and a relentlessness to find lenders and investors who believe in you and your success is time well spent.