FIN 711 Week 6 Debt and Alternative Financing Example

Extending the Runway Without Selling More Shares: Venture Debt, a Federal Grant, Equipment Financing, Customer Prepayments and Crowdfunding for TerraSorb After Its Series A

[Student Name]

University of Phoenix

FIN/711: Financial Measures of Value Added

Week 6 Assignment

[Instructor Name]

[Date]

TerraSorb, its lenders and all figures are composites written for a model paper; financing features, program rules and research findings come from the sources listed and are stated generally.

TerraSorb, the composite soil carbon sensor company, closed its $8 million Series A six months ago. Its plan, from Week 3, assumed about 20 months of runway to reach registry approval and paid pilots. Since then, the registry has added a second year of field validation to its review, which could push approval back six months. The board asked how the company could extend its runway by six to nine months without raising more equity at the Series A price, before the milestones that should support a higher one. Selling shares just before the company proves its value is the most expensive financing it can choose, so the board's question is how to borrow time cheaply. This paper evaluates the alternatives.

The Cost of Equity Now

Raising another $3 million of equity at the Series A post-money valuation of $28 million would dilute existing holders by about 10 percent. If the Series B prices the company at $75 million as planned, that same 10 percent would then be worth about $7.5 million. Selling it now costs the existing holders the gain they expect from the milestones. That opportunity cost is the yardstick for every alternative.

Venture Debt

A venture lender offered a $3 million term loan: interest at about 11 percent, interest-only for 12 months, then 24 months of amortization, a 2 percent fee and warrants to buy shares worth about 6 percent of the loan, or $180,000, at the Series A price. The loan would extend runway by about eight months at the current burn. The all-in cost, counting interest, fees and the expected value of the warrants at the Series B price, is roughly 16 to 18 percent a year, well below the implied cost of equity at the Series A price.

Why Venture Lenders Lend

TerraSorb has no profits to service debt from, so why lend? Hochberg et al. (2018) found that venture lending is more available to startups with patents that can be sold if the company fails, and that lenders rely on the commitment of venture investors to fund future rounds. A venture lender is betting that the equity investors will keep the company alive long enough to repay. TerraSorb's patents on its sensor design and its well-regarded Series A investor make it a credible borrower.

The Risks of Venture Debt

Venture debt has real dangers. If milestones slip further and the Series B is delayed, amortization payments begin while the company is still burning cash, shortening runway rather than lengthening it. Covenants, often including a material adverse change clause, can let the lender call the loan if prospects deteriorate. The board would want no financial covenants beyond a minimum cash balance and a clear definition of default.

A Federal Research Grant

TerraSorb applied for a Phase II Small Business Innovation Research award from the Department of Agriculture to fund its second-generation sensor. Phase II awards run for about two years and are worth several hundred thousand dollars. Howell (2017) found, using the scoring cutoffs of Department of Energy grants, that early-stage awards substantially increased the chance that a firm later raised venture capital, suggesting that grants certify technology as well as fund it. The grant would not dilute or require repayment, but it can fund only approved research, arrives months after application and requires reporting.

Equipment Financing

TerraSorb needs a $900,000 production line to assemble sensors at volume. An equipment lender offered to finance 80 percent over four years at about 9 percent, secured by the equipment. Matching the financing to the asset's life preserves cash for operations and costs less than venture debt because the lender holds collateral with resale value.

Customer Prepayments

A food company buying soil carbon credits to meet its emissions commitments offered to prepay $1.2 million for measurement services over three years, in exchange for priority access to verified credits and a discount. Customer prepayment is nondilutive and signals market demand to future investors, but it commits TerraSorb to deliver services at a discount and concentrates revenue in one buyer.

Revenue-Based Financing

Revenue-based financing, which repays a set share of monthly revenue until a cap is reached, suits companies with recurring revenue. TerraSorb's revenue is still small and lumpy, so such financing is premature, though it may suit the company after Series B.

Equity Crowdfunding

Federal rules allow companies to raise up to $5 million in a year from the public through registered crowdfunding portals. Crowdfunding could build community among farmers, but it would add hundreds of small shareholders to the capitalization table, complicate later rounds and require ongoing disclosures. The board set it aside.

Evidence on Debt in Young Firms

Robb and Robinson (2014) found that outside debt is a major source of financing even for new firms, contrary to the view that startups rely almost entirely on equity. For venture-backed firms, debt complements equity rather than replacing it, which fits TerraSorb's plan to use debt to bridge between equity rounds.

Bank Lending as an Alternative

TerraSorb's commercial bank, which holds its operating accounts, offered a $1 million line of credit secured by cash deposits and a guarantee from the Small Business Administration. The line is cheaper than venture debt, near 9 percent, but it is small, requires the company to keep balances at the bank and may carry a covenant on minimum liquidity that could bind just when cash runs low. The board treated the line as a backup for working capital rather than a runway extension.

Sequencing the Options

Timing matters as much as choice. The customer prepayment can close within weeks and signals demand, so it comes first. Equipment financing follows the production line order. The venture debt facility should be signed while the company still has ample cash, since lenders offer better terms to companies that do not urgently need the money, with drawdown delayed until it is needed. The grant decision arrives on the agency's schedule and is treated as upside rather than relied upon.

The Combined Plan

TerraSorb should take the $3 million venture debt facility, negotiating a longer interest-only period of 18 months and no financial covenants beyond minimum cash; finance 80 percent of the production line through the equipment lender; accept the customer prepayment with a cap on the discount; and pursue the Phase II grant. Together these extend runway by about eleven months without new equity, enough to absorb the registry delay with a buffer.

Signals to Future Investors

Series B investors will read these choices. Venture debt from a reputable lender and a customer prepayment signal confidence from informed parties. A small equity extension at the Series A price might signal that insiders doubt a higher price. The combined plan sends the better signal.

Conclusion

Raising more equity before the milestones would cost TerraSorb most. Venture debt, justified by patents and investor commitment, equipment financing matched to the asset, a customer prepayment and a federal grant extend runway by about eleven months at far lower cost, with risks that careful terms can contain.

References

Hochberg, Y. V., Serrano, C. J., & Ziedonis, R. H. (2018). Patent collateral, investor commitment, and the market for venture lending. Journal of Financial Economics, 130(1), 74-94. https://doi.org/10.1016/j.jfineco.2018.06.003

Howell, S. T. (2017). Financing innovation: Evidence from R&D grants. American Economic Review, 107(4), 1136-1164. https://doi.org/10.1257/aer.20150808

Robb, A. M., & Robinson, D. T. (2014). The capital structure decisions of new firms. The Review of Financial Studies, 27(1), 153-179. https://doi.org/10.1093/rfs/hhs072