Asset Backed Lending (ABL) provides capital backed by revenue-creating assets, such as hardware or receivables. Unlike traditional venture debt, asset-backed lending is differentiated by the nature of its security. Since the assets that back the lending can be sold or transferred should a business be unable to pay its obligations, ABL can provide more capital than traditional venture debt, in some cases. And, of course, like all forms of debt, ABL requires only warrants for equity in most cases – far less than is ever required in traditional equity financing.
I connected with Mark Paris, Managing Partner of Third Sphere’s credit platform, to dive deeper into ABL, when startups should consider ABL, and what startups should consider when looking at ABL.
When should startups consider ABL, and what can ABL be used for?
MP: ABL is typically used to help solve cash flow problems. That said, ABL can be used for a variety of things:- Acquiring assets
– Inventory or equipment finance
– Manufacturing
– Solving supply chain problems
– Stand-alone financing for specific uses – such as project finance
What are the benefits of ABL?
MP: ABL, when compared to other debt, is:
– Cheaper: Cost of capital is cheaper when compared to equity (which was the only game in town for early-stage startups for decades) when looking at the implied return rate (10%-20%) and is adjusted according to the risk of the actual investment.
– Flexible: Loans can be used for a variety of things.
– Structure: Loans can range from six months to five years, typically and there are many different ways to reduce stress on a startup’s liquidity – from delaying initial payments for a period of time (known as PIK), to creating aligned structures where the lender takes risk for upside benefit, incentivizing refinancings for a lower cost of capital, etc
Since ABL is tied to assets as much as anything, as assets grow (or are expected to grow) the ABL facility can grow with the startup – thereby increasing the amount of capital available and saving time and trouble of doing a new search for capital.
ABL can often be used to unlock specific types of growth, like Buy Now, Pay Later (BNPL). When it comes to climate action, ABL can help startup customers to avoid technology or cash flow risks by getting access to emerging climate solutions now, while sharing risk with lenders and/or the startup.
Who is eligible?
MP: Eligibility varies depending on the lender, but common criteria lenders pay attention to include:
– Revenue (consistency and growth)
– Contracts (pipeline and length)
– Balance Sheet (financial history and organization)
– Asset Type (and how liquid is it)
– Customer/counterparty quality of revenue source
What has your experience been like working with startups in ABL?
MP: One of the primary advantages of working with Third Sphere is that we are early-stage investors, first and foremost, and that ethos informs us, as lenders. As such, all of us have spent at least a decade (and much more) in venture capital and credit capital. We provide financing for early-stage startups because early access provides the highest probability of catalyzing positive movement for the startup and returns for our investors.
We have seen it all in regards to the startup interface when it comes to lending. Many startups are not sophisticated in capital markets, and many founders are intimidated by lenders. Our job is to do everything we can to reduce anxiety about the process.
When we started, founders and their boards were suspicious of what might happen if things go wrong. It’s quite common for founders to believe that lenders will do everything to take control of their companies while believing that VCs are much better aligned. We find that we’re able to work with founders on initial terms, but also as they encounter surprises which are the only predictable part of early-stage startups.
What is the process for a startup to apply for ABL?
MP: Although there are several steps to finalizing an ABL transaction – including structuring of the transaction, term sheet, due diligence, and documentation – the process is quite deliberate and clear. We start with a conversation and questions, followed by discussing terms and structure for a transaction, if appropriate. This is not to say you won’t need a lawyer before you close a transaction, but our job is to make this easy, not painful.
Because of the potential for financial surprises during a startup’s journey, it is good to build relationships early – so both the lender and the borrower can conduct early due diligence.
When talking to ABL providers, what should a startup pay attention to?
MP: Startups should pay attention to the terms a lender is providing. One of the early mistakes startups make is that they don’t read the fine print and they agree to terms that are strict and inflexible.
A few terms to specifically look for are:
– Guarantees – Which party is responsible to pay back the lender. NOTE: Some lenders require personal guarantees – just make sure that requirement is “market” relative to the risk.
– Payment in Kind (PIK) Period – A way of delaying the payment of interest until later. NOTE: The cash flows that would have happened and the interest that would have been paid during PIK Period is embedded in the loan on the backend
– Interest Rates – The proportion of a loan charged as interest to the borrower, typically expressed as an annual percentage of the outstanding loan.
– Time Frame – How long the loan is for and when it needs to be paid back.
– Upfront Fee – Paid at the start of the contract
– Exit Fee – Should the transaction be prepaid or not, the lender usually seeks to have a minimum rate of return and this is where the Exit Fee may come into play, if applicable.
– Multiple on Invested Capital (MOIC) – The measure of the current value compared to the amount of money invested. MOIC is simply a measure of total net benefit to the lender divided by the original loan.
– Internal Rate of Return (IRR) – An estimate of the rate of return that an investment is expected to provide. IRR captures some of the time value of money – the longer it takes the lender to get paid, all things being equal, the lower the IRR.
– Amortization – How the loan decreases over time.
Other than scrutinizing the terms, when looking at different lenders, below are questions businesses should ask about the lender:
– Is there mission/vision alignment? Are there terms that grant the lender warrants for equity? Can the lender grow with your business (as you grow)?
– What have been other business’ experiences (reference checks)?
– What happens when things go wrong? Do lenders more to take control or do they work with teams to get to adjust terms? Do lenders scrutinize legal terms or focus on the bigger picture path to getting the best result, which often requires some uncertainty and patience which is not a hallmark of most lending
The takeaway is to look beyond what the loan amount and the interest is, as lender flexibility is more important, especially when things go badly.
What happens when a startup can’t repay debt?
MP: Ideally, you don’t get to this stage. However, if a payment is missed, this will trigger the cure period, which is the time between when a payment is missed versus when you are actually in default and lose control of your options.
Depending on the lender, at this point, debt can be restructured. Often, this will be in the form of extending the payback time. This is where the rubber meets the road – reputable lenders should not only do all they can to protect their investors but also figure out how they can preserve the startup.
If a business defaults and can’t pay back the loan, lenders can take possession of the collateral to recover their capital. As a result, one thing you will notice is that the borrowing base (the value of the collateral) will always be more than the loan amount. Just like a home mortgage, where the primary mortgage is never more than 80-90% loan-to-value, ABL adheres to a similar ratio, depending on the type of collateral and structure.
About Third Sphere
MP: Third Sphere is, first and foremost, an investor in very early-stage startups providing climate-focused solutions. For first investments, 70% of teams have no revenue and main their interaction with customers is to understand their needs. Third Sphere invests in software and hardware-based companies that can deliver climate impact in the next decade. While VC investments focus on pre-seed and seed, asset-backed lending is for Seed+, Series A, and Series B startups. Third Sphere also serves a community of over 12,000 startup founders, investors, end-users, and influencers, so that great companies can have access to an open and transparent network to solve various problems unique to climate-focused startups. Today, we are going to discuss the less understood world of asset-backed lending for early-stage companies.
There are many more things about ABL to discuss that I would be happy to share should people have questions. [email protected] is the best way to reach me.
