Debt 2.0 — Funding the Legos of a Modern Business

Plus: Better Markets; Transaction Costs Are Dead

In the last post, we established two basic business models and the two basic financing options.

• Locality businesses sell to the customers geographically surrounding them. Their straightforward sales models and tangible assets often make them a good fit for a simple loan with a principal and an interest rate. These are the staple brick-and-mortar businesses, like restaurants and retail shops, that have inhabited Main Streets for thousands of years.
• Expeditions are speculative. They often but are highly lucrative when they work. By selling equity, founders create alignment with funders around their long timelines and pursuit of outsized success. This was first used with whaling expeditions in the 1700s, and coincidentally, is the exact same model employed by VCs today to fund “tech expeditions.”

However, it is 2021. There are more than just two ways to make money.

As a result, funders have adapted debt and equity funding structures to meet today’s business demands. Sort of.

Debt 1.5

To be fair, debt has evolved since the invention of the most basic loan. To make debt more applicable to more businesses, lenders have flavored the vanilla version of debt. The majority of debt innovations fall into two categories:

• Introducing More flexible terms
• Reducing Transaction Costs

To explain this, let’s give real terms to the vanilla loan that is thousands of years old: $100k principal + 10% interest. In addition, imagine the vanilla lender expects this to get paid back over 5 years (roughly $20k per year plus interest).

Those terms may not work for everyone. Some may not be able to afford the interest rate. Others might not have the ability to pay any principal back for a few years while their business grows. Others simply might not need a full $100k. So how do lenders appease all of these businesses in need?

The simple answer is offering more flexible terms. This can take a lot of different forms, but at the end of the day, it all comes back to interest rates and timing.

For example, collateral, theoretically, lowers the risk of a loan, allowing lenders to take an asset if the lender fails to pay (aka defaults). Adding collateral to the same vanilla loan should result in a lower interest rate (say 9%) or make the vanilla loan available to an otherwise too risky of business.

The timing lever offers another chance for term flexibility. Take balloon payments — when a company is allowed to delay repaying the principal until the end of a loan. This lets the company pay less (just interest) until it can build its cash position. Through balloon payments, the vanilla loan gets stretched to accommodate companies with more sensitive short-term cash flow.

Whether it is through rate or timing, most debt innovation has simply allowed lenders to make their product more flexible.

The second form of debt innovation is reduced transaction costs. Underwriting (the process of making a loan) has a cost. It takes time to diligence (aka research and evaluate) the loan opportunity, legal fees to draw up the loan agreement, fees to transfer the funds between the lender and the business, and then more time to monitor the company/loan performance. However, some lenders have figured out how to either standardize or automate much of this process. Lower transaction costs make it cheaper and quicker to lend, resulting in smaller loans and easier access for businesses.

Knowing those two drivers for debt innovation, what opportunities exist for debt to improve for founders?

Intro to Debt 2.0

First off — transaction costs are a race to the bottom. Microfinance evolved out of standardizing terms and using tech to reduce underwriting costs. This was groundbreaking innovation and greatly increased capital access for small businesses that were previously uneconomical to lend to. Thankfully, fintech is commoditizing this innovation for all businesses and all loan types. Over the course of the next decade, transaction fees will decrease in every corner of finance.

So what makes today’s Debt 2.0 exciting?

With transaction costs increasingly obsolete, real financial innovation will occur through more flexible terms.

It is important to distinguish competing on terms as a separate phenomenon. For example, any lender could offer our same vanilla loan at 9% interest to win on terms. In an efficient market, the most affordable terms should win. Impact investors will often come in at even cheaper terms too, thanks to their investors’ lower return expectations. All that is to say, simply offering a cheaper loan is not a feature of Debt 2.0 but rather a benefit of the free market.

Debt 2.0 introduces more flexible terms by recognizing the assets of modern businesses.

Think of assets as lego pieces. Founders build and assemble assets in order to create neat structures which generate revenue — businesses.

However, lenders have been breaking businesses into legos for decades. There’s inventory financing for, well, inventory. Factoring underwrites accounts receivable. Equipment financing is for, you know, equipment.

With Debt 2.0, funders reimagine what constitutes an asset and then use first principles to conceive how to fund them. A century-old bank is often looking for hard assets (equipment, buildings, inventory) and years of profitability. Debt 2.0 funders are looking past the hard assets, sometimes just a few computers, to redefine lendable assets.

Paid social media is a perfect example of a modern lego. Profitable online customer acquisition is not a tangible asset, but it is a very lucrative one. Clearco spotted this and introduced revenue sharing for paid social. As these paid ads translate to revenue, Clearco recoups its investment. Instead of a best-guess as to the company’s performance and ability to repay the loan, Clearco’s revenue share marries its returns to the real-time business performance. Today, Clearco is one of numerous companies offering debt repaid via revenue-share to fund online customer acquisition.

The modern legos don’t stop there. In fact, in 2020, Alex Danco practically laid out the business plan for one of today’s hip lego funders — Pipe. Danco spotted the value of recurring revenue, most commonly found with SaaS companies. Pipe recognized that same lego in countless other businesses and created a market for MRR, SaaS or not.

Next, consider the modern business platforms themselves, such as Stripe or Shopify (where Danco uncoincidentally works), which now offer capital. Through their core technology products, these tech companies have an unrestricted view into a company’s performance. This lets them spot the legos and more accurately identify a company’s financial risk. When they can spot a lego before others, or better diagnose a company’s true financial risk, they can step in to offer debt at better terms. In fact, tools like Intro even provide a singular front door for founders to connect with all of their lego funders at once (caution: managing a lot of funding partners is real work). This is true high-resolution funding.

Debt 2.0

• Technology is driving transaction costs to zero.
• Data is providing a more accurate assessment of risk which leads to more efficient pricing and a cheaper cost of capital.
• New-school debtors are reimagining what constitutes a lendable asset, unlocking innovative new ways to fund the legos of a modern business.

So who needs Equity 2.0?

Stay tuned for the next post…