How Rooled and HSBC Team Up to Finance Innovation

This transcript was AI-generated. Please excuse any typos.

David (Host)
Welcome back to the Angel Nest, where real angel investors and entrepreneurs partner to build great companies. I’m David Hemingway. I’m a five-time founder and now an active angel investor.

And this is another of our series of podcasts with Johnnie Walker of Rooled, Outsource, CFO and Accounting Services, where we talk about great startup founders, the companies they’re building, and how they’re financing their ventures in the current environment. Ruled are the startup finance experts. Today, Johnnie and I talked to Adam Millsom, a managing director of the HSBC Innovation Banking Team here in New York.

He adds financing to venture capital to help companies grow. Johnnie and Adam, thanks so much for joining us today.

Adam: Thanks for having me.

Johnnie: Thank you. Great to be here again.

David: Johnnie, tell me, are you finding more companies now looking for financing that goes beyond VCs?

Johnnie: Well, I think, you know, in the market, companies should always be pursuing something that is complementary, and I think in partnership with VCs.

If you’ve got VC money and you don’t want sort of competing or somehow in conflict with that. So I think it has to be complementary. And I think venture debt, which I think we’re going to get into in great depth here, has been there for a long time.

And that’s something that I think is still very much valid these days. I think we’ve got some business models or fintechs that we work with that are, they have by nature, their business models got to find other alternative sources of financing that are complementary to finance cash flows, all sorts of manner of business activity that they are doing. So I think there is like a very healthy, obvious business sector that provides financing for companies beyond VCs.

David: Yes. So Adam, thanks again for being here. Can you tell us how venture debt works? Sure.

Adam: It’s first helpful, I think, to look at the landscape of traditional lending, which was done either asset-based, which has been around since the advent of banks, or more recently, cash flow lending. So in cash flow lending, lenders take a look at whether a company is throwing off sufficient cash flow from operations to be able to debt service that facility. And they kind of size and structure the covenants based on that.

That model doesn’t work often for earlier stage venture capital, high growth cash burning companies. So a debt facility that has become available in the last couple of decades or so, it falls in the category of venture debt. A few different flavors of things, products that fall under venture debt.

But traditionally, they are broken up into two sort of main structures. One is a term loan, set commitment amount, followed by some form of set repayment schedule. Typically, these are longer-term facilities for growth scenarios, for CapEx, tuck-in acquisitions, runway extension, things like that.

And then the other is lines of credit, which are often structured either asset-based, right, and you’re financing the working capital cycle between the payment of AP and the collection of AR. Or if it’s a SaaS-based business, there’s not a true working capital need because they’re often paid up front, but you’re leveraging the reoccurring revenue that that company is generating to formulate a borrowing base, a size of the facility. So those are the two main types, but there’s various other debt-like products which would fall under the category of venture debt.

Simply, it is debt facilities for companies that are backed by venture capital firms that are in cash-bear mode. What should an entrepreneur be looking for in a venture debt partner? I think team. What’s the background of that team? In our case, we have a bunch of, you know, senior bankers and lenders, right? And we’re partnered with a team of relationship managers with dedicated loan structures and, you know, servicers, right, from a monthly maintenance or whatever.

Like, what is the strength of that team? What other services are they providing? You know, venture debt is, you know, a product that a subset of banking institutions and private credit firms offer. But in the case of, you know, what else are they bringing to the table? In our case, we feel we have got top-notch banking services, you know, starting with the online banking platform. But there’s the bank’s international reach.

We’re in close to 50 countries. So there’s a multitude of ways that we can help them, obviously going international, but can we help connect them into large corporates that are banking clients, right? Can we move the needle to help accelerate their business?

David: So do you find that these days, where founders may not want to go out for a priced round, that they’re more likely to try to use venture debt as a substitute? Does that happen?

Adam: I wouldn’t directly correlate it to a substitute. I would say complementary.

How the facilities are often structured is contemporaneously or shortly after an equity raise. The closer you get to cash out, that becomes very bridgy. So those can be challenging situations.

But how these debt facilities are usually structured is, if these companies just raise an equity round, it doesn’t behoove them to actually draw down on the debt unless there’s a specific use case. So there might be a draw period, an interest-only period, followed by the amortization. So this gives companies the ability to choose to advance on the venture debt when it is beneficial to them.

That could be waiting until the end of the draw period. But typically, when you use venture debt, you want to, you know, again, if there isn’t a specific use case before this, it’s the business is going up and to the right. Something’s working.

The sales has become predictable. I can go out and raise now. But if I have some additional runway, boy, I could really increase the valuation of this company.

This is really a value-creating event. So that’s going to give extended runway. So it wouldn’t necessarily be a substitute.

David: Instead of that, equity would be more complementary. Do you have some examples of how venture debt has really made a difference?

Adam: Sure. One, you know, this is a fairly unique situation, but you could kind of extrapolate this.

There was one company that came to me a number of years ago, and the company had just raised a Series A, $10 million Series A. Blue Chip Investors had developed the product, was selling out in the market. It was going well. And they had a decision, like, they were still liquid, so it made sense to offer a debt facility to them.

But they said, hey, we’re getting preempted in a Series B. We’d rather not raise equity because it’s working. Like, I don’t know much about venture debt. Can you explain that to us? So $10 million equity raise.

We ended up giving them a $4 million debt facility. So a little bit higher on the debt-to-equity ratio, which is typical on terminal structures. You know, maybe 25% to 30% is on average, but there’s always exceptions.

In this case, it was a great serial entrepreneur, great, the rest of the management team, great product, Blue Chip Investors behind them. We gave them a $4 million facility. That company ended up selling for $425 million.

Wow. So again, you know, the dilution of a Series A versus the dilution of a Series B, I think he’s quite glad that he took venture debt in that scenario instead of the Series B. Do you see, in your experience of having done these deals, obviously, many times, do you see that VCs are generally supportive of the concept of venture debt? Or is it just a select number that have had good experiences with it, that understand it a bit better? How do you think the VC community views the venture debt? Johnnie, it’s not actually easy to answer because investors are unique in their thought process. Some will publicly say, oh, I don’t like venture debt, or some will say, I don’t like venture debt, but specific use cases, again, it’s really working.

Like venture debt should not be a lifeline, right? It should not be, hey, we’re pivoting our product, maybe we draw down on this debt facility because, you know, then you add, you know, leverage and it can be challenging to get out of it. But also, it gives that entrepreneur leverage. So, in that scenario of, hey, we can raise a Series B, or I have venture debt, or if they’re getting term sheets externally on this valuation, but they can draw down on the debt and have another two, three quarters, and then talk to the investor about a valuation that’s much higher, it gives them leverage in the old sense of the word.

So, and then some investors, by the nature of their fund, maybe it’s a smaller fund, it’s not a multi-billion dollar size fund, there’s a specific pool of capital that they can continue to invest in those companies. So, they might look at the venture debt as complimentary. That actually allows me to add more capital in my company without directly going to my partners and LPs to invest more in the company.

So, it can often depend on the founder, it can often depend on the scenario of the company, and the nature of the fund. And it is the case that, frequently, that you, you as a venture debt lender, you kind of stay in the company, you don’t, not to sort of get bought out at a sort of future financing round, like you’ll find yourself staying through exit. Is that more common or less common? That’s absolutely common.

Again, the scenario, the term loan scenario, very infrequently, if you’re providing a venture debt facility to Series A or Series B company, is that actually repaid through amortization. Often, a company raises Series A, they get a venture debt sized appropriate to that Series A, maybe they utilize it, maybe they don’t, right? And things are going well, but they have that insurance policy, they have that runway extension should they need it, and the B is, Series B is preemptive. Then what we might do is change the terms of our agreement so as to look at it fresh, well, we first gave you a draw period of 12 months based on your Series A, now you have more money and it’s fresh, we’ll kick that out again another 12 or 18 months or something like that.

And then, at a certain point, maybe a company has crossed the chasm from Series A to Series B to Series C, and the revenue stream, I think a SaaS business becomes more predictable, the metrics are more predictable, they might convert that facility to a line of credit as opposed to a term loan. You can literally, once the aperture opens for venture debt, take it from early stage to leading up to IPOs and then creating a different type of debt facility. So, Johnnie and I have spent a lot of time on these episodes talking about what startup founders need to do in order to get ready to raise money.

Sure. Is it different for venture debt versus selling equity in your company? Sure, as far as what that company needs to do to prepare for a venture debt facility. Yes.

So again, often these facilities, what’s easiest for a lender, and therefore perhaps the most favorable term at times, and the right time to do this is contemporaneously or shortly after an equity raise. The diligence is fresh, right? They just closed that, which sometimes it goes very smoothly, sometimes it’s drawn out. They want to get back to operating the business.

They don’t want to spend a ton of time now talking to a lender. So, we’re able to leverage much of the due diligence information provided to the equity investors that have just invested. Now, the further you get from that equity raise, you know, lenders usually like to see 12 months of liquidity.

So, if you burn through all that cash, again, it’s going to be bridgier and more difficult to get comfortable with it. But some of the size of the raises over the last couple years were much larger than in history. So, maybe those companies have been capital efficient.

So, a year later after the equity raise, they still have another 12, 18 months of runway. You can still underwrite to that in those scenarios. So, maybe you’re going to spend a little bit more time getting the fresh story from the investors or the company, and you’re talking more about the recent board meeting as opposed to the recent equity raise.

Yeah. And I think that ironically, but it’s also most convenient to the entrepreneur or beneficial to the entrepreneur to raise at the same time because you haven’t had the chance for the plan to go off the rails. And so, for the performance to not be what you said it was going to be, which only then leads into a conversation of explaining why that’s the case.

And I think there’s definitely, in the deals that I’ve been a part of, there’s, I think, a very beneficial focus from the lenders where they’re focused on the performance metrics and they’re tying milestones, I think, as you described about what you need to pass in order to get access to perhaps the entirety of the package or certainly some excess part to the package. And I think that’s good diligence to place on the company at that point. So, it necessitates them having good historical tracking and then be able to communicate clearly and reliably about where they think the company will be 12 or 18 months from now.

And I think that’s just good governance practice, establishing that kind of thing. Absolutely. So, Adam, it seems like HSBC has a much higher profile now in the startup community than in the last few years.

What’s happening? Well, we think so. HSBC is one of the largest financial institutions in the world, been around since the 1860s, right? Even in the U.S., we just crossed our 160th anniversary in the U.S. But historically, so imagine all the companies that we support globally, millions, but not really focused on your earlier stage technology company or startup company. So, that really began in 2023, first with the launch of the innovation banking practice of which I am a part in the U.K. The U.S. was followed shortly thereafter, followed by Israel, followed by Singapore.

But we’ve expanded rapidly in the past two years and are now expanding into other geographies. And now we have over a thousand employees focusing on the innovation sector, as we call it, or startup sector, if you will. So, I just want to ask, when you look at the market in general right now and the sort of volatility or the, well, volatility combined with uncertainty, what does the bank see as kind of like the startup sector, and I guess worldwide, just to throw it very open, in terms of the opportunity in the next five years? Are you really looking at a significant growth or how do you think about, if you’re investing in that practice now, there’s a, I presume there’s some expectation of where you think things will go in the next five-ish years? Absolutely.

We are looking at it as a huge growth opportunity, right? That’s, hence, the investment in our team and our practice. But, you know, you just have to look at recent history, right? Everything is going in the direction of technology, right? When, you know, when I first moved to New York in 2007, I forget the cost of a taxi medallion, I believe, was approaching a million dollars, right? And, you know, now, with the advent of Uber and ride-sharing, right? So, it’s everything, these traditional businesses are being changed, and that’s accelerating with what’s going on in the acceleration in artificial intelligence. So, it certainly makes sense to focus on tech.

Yeah. And it seems like the New York ecosystem only gets stronger. It has.

I mean, if you go back to the 2000s, right? And there was, you know, kind of a pause between 2001-ish and really 2007. That start, you know, 2007 really started around the ad tech environment. And then, you know, enterprise software and consumer tech businesses that were backed by VCs all started, you know, creeping up.

And now every sector, naturally, fintech is going to gravitate towards, you know, New York, Bay Area, New York. But we even have climate tech here in New York, companies that finance, you know, climate tech companies, life sciences. There’s a ton of science that comes out of New York.

It’s often commercialized elsewhere. But we have a practice that supports life science companies, unsurprisingly. This is great.

A new avenue for founders, maybe who weren’t aware of it, as a way to combine venture debt along with raising their A round. And I love some of the illustrations that you gave. I think it makes a lot of sense to keep all those options on the table in this environment.

So Adam Millsom from HSBC Innovation Banking. Johnnie Walker, Rooled Outsource CFO in Accounting Services. Thanks so much for joining us today.

Thank you. Thank you very much, David. Remember, we don’t make or recommend investments at the Angel Nest.

And this program is for informational purposes only. I’m David Hemingway. We produce the Angel Nest with help from Rob Higley and Charles DiMantebello.

He’s at the controls of CDM Studios at the historic Art Deco Film Center building just west of Times Square in New York. Here’s hoping my fellow angels and the founders they support find their next great venture. So long until next time.