Commercial Paper in 2008
On September 16, 2008, the Reserve Primary Fund, a $65 billion dollar money market fund announced it had suffered losses of $785 million on its Lehman Brothers commercial paper positions.
This announcement triggered a bank run in the commercial paper market and was one of the main causes of Lehman’s collapse and the Great Financial Crisis.1
If you’re in the startup world, you may have never heard of commercial paper. The definition of commercial paper is a series of short term loans to fund working capital needs in large corporations. It was touted as a cheap and easy source of liquidity for corporations looking to minimize their cost of capital. What could go wrong?
The mechanism for the market was effectively a rolling capital source for these corporations. They could access cheap funds, but they would need to go back to market every few weeks to roll-over the maturity. This is very effective during a healthy market, but what happens when investors are no longer willing to roll-over the maturity? There is a sudden rush for capital to meet the maturity which can lead to default.
I am not trying to be a doomsdayer but I do want to note that if you are primarily funding your business with short term debt that must be rolled over frequently, you may be taking more risk than you realize. If the investment partner is no longer willing or able to fund further advances, you could default on payments.
The other element to consider is matching your sources and uses of funds. If you are able to spend funds on ads that drive sufficient cash flow to offset the cash drawn from your short term capital provider, that is great! You are matching the duration of capital with your investment process and are appropriately managing risk.
However, if you are investing in longer term initiatives like a sales team or product, you should consider looking for longer term sources of capital to better manage the roll-over risk.
Before we dive into what those products are and how to incorporate them into your balance sheet, we should more deeply understand the concept of Duration.
What is Duration? How can I get it?
Financial products are all about timing of cash flows. When do you receive the cash and when / how much do you send back to investors.
The way to measure the duration of a capital product is by using the weighted average life (WAL) formula2. Essentially, you will plug the expected cash flows into a spreadsheet and calculate the weighted average of those cash flows. The result will be the number of months the cash will be yours for a given capital product.
You can then take all of your capital sources: short term debt, long term debt and equity and calculate the WAL of your whole balance sheet.
This is a key metric you can use to understand how much risk you are taking with your balance sheet and work towards optimizing it along with the cost of the capital.
Here are 5 examples of WAL calculations:
|Type of Investment||Scenario||WAL (months)||Cost of Capital|
|1-Month Credit Card||Use a credit card to buy ads and payoff the balance monthly||1||0-20%|
|6-Month Payout||You traded 6 months of MRR at a discount||3.5||14%|
|12-Month Payout||You traded 12 months of MRR at a discount||6.5||18%|
|24-Month Payout||You traded 24 months of MRR at a discount||12.5||22%|
|Equity||You received an equity investment that paid out 4x|
after 4 years (no dividends before then)
A few takeaways from the above examples:
- WAL and Cost of Capital are correlated – Capital providers moving further out in duration and allowing for lower payments are taking higher risk, the cost of this capital reflects this.
- Duration is shorter than you may expect on debt products – a 6-month deal doesn’t give you 6-months to deploy and return the capital, it’s much shorter at ~3 months.
- Equity is a very expensive source of capital – You will notice the WAL of equity is much higher than the non-dilutive products. This is due to equity investments not having a cash return component until a liquidity event down the road. This is great for the WAL metric but the cost can be significant and there are governance and control considerations.
Build the Balance Sheet of Your Dreams
There is more than one way to slice the pie. You are not limited to one source of capital and can use multiple sources at the same time. This can be an amazing thing as you think about building your balance sheet to find a balance between cost, dilution and duration.
Perhaps you use a combination of equity and short term debt to manage the risk of rolling over the debt in a turbulent market. Alternatively, you can opt for a partner that can extend out to 24 months producing WAL without dilution. A good rule of thumb would be to aim for 12-24 months of WAL across your capital sources, this will give you the duration required to invest in high return opportunities. Unsurprisingly, this lines up with healthy CAC Payback periods of 12-24 months for SMB to Enterprise SaaS.
Founderpath is a great option for founders who are not on the Venture Capital path and want to be more selective with their equity investor base. With a product with WAL of 12+ months, you will need much less equity to build a strong durable balance sheet for the long term.
The last point I will leave you with is capital is not a commodity. It is a direct connection to the people behind it and they are just as, if not more, important to align yourself with.
Get into business with people you can trust, who understand the risks and challenges of the business you are looking to build with a team agile enough to support the different phases of your growth.
1When Safe Proved Risky: Commercial Paper During the Financial Crisis of 2007-2009