In “defense” of T+2 settlement

Since what the world clearly needs is another take on equity settlement times, I figured why not share my two cents. Over the past few weeks, there’ve been great threads and takes on what happened, why it happened, and all sorts of great minutia on margin requirements, NSCC and more. 

A few days out, it looks like folks from Balaji to Alex Robinhood’s CEO are all calling to move to real-time settlement. What I thought I’d offer here is a defense of T+2 settlement and pose some questions for those who believe RTS is the solution to all of our problems.

A bit of context

I first became familiar with equity settlement mechanics when looking at how we funded our Equities desk at JPM back in 2012/2013, following Dodd-Frank. In 2014, when my team launched the bank’s blockchain initiative, we further looked into it as we decided which asset class to “decentralize” first (Incidentally, we chose syndicated loans where settlement times could reach 50+ days, and that drove our investment in Digital Asset Holdings – good times!).

Why T+2 settlement system works

The way an institutional (hedge fund, mutual fund, dealer) funds a trade is very different from the way retail investors fund a trade. When I see people argue for RTS, they usually come from the retail world, where you are already pre-funding your trades ahead of executing them. In the retail world:

• T-2: You ACH funds to your brokerage account. Now you wait ~2 days for the deposit to clear and made available to trade.
• T: You buy your securities. (You thought you were done here).
• T+2: The trade settles. (It may have cleared the day before, but we don’t have to get into that).

In the retail world, you have already prefunded your trade. So the benefit of T+2 is nonexistent. As it is, you are already prefunding your trade, so there are no benefits to a longer settlement time.

Retail only accounts for 20% of volumes. The remainder comes from institutional buyers (hedge funds, pension funds, mutual funds) and dealers. And these folks don’t have “spare” cash lying around, as, generally speaking, cash doesn’t yield anything and thus lowers their returns. An institutional trade works very differently.

• At T, the buyer makes the purchase by calling their broker.
• At T+1, the buyer, knowing how much they need to pay for the security, goes and gets financing. Note, this is usually pretty straightforward and you do it via your prime broker, your funding desk, or the secured funding market, where you can pledge the security to get cash. If you are doing a cross-border transaction, this is also the time to go buy the foreign currency you need and hedge your exposure.
• At T+2, simultaneously the buyer delivers the cash, gets the cash, and pledges the security to whoever provided financing.

The key here is to understand that – unlike retail investors – institutional investors don’t have liquidity lying around to prefund the trade. This system is supremely efficient and optimized. It basically ensures at no point do you have idle cash (which, again, kills returns). It also ensures funding transactions happen just for the amount you need, without having to either fund more or come short. And, lastly, all funding here is done with a security on the other end as collateral, which makes the funding meaningfully cheaper and, you could argue, safer, as the lender can always grab the collateral.

In a real-time system, these benefits go away. A hypothetical trade would look as follows:

• T-1: Buyer wants to buy $SBUX shares tomorrow. Goes and gets financing today. They need cash in the bank ahead of the trade, so whoever funds them will take unsecured risk. Overnight LIBOR is at 0.08%, and since this is not a bank but a fund, let’s add 25-50bps on top. Now we’re at ~0.5% of funding costs. Likely, more, as I’m going to borrow more than I need in case $SBUX moves higher before I trade. 
• T: I execute the trade and get my SBUX shares immediately. But now I have some additional cash that I didn’t use, so I have to return that. I basically paid for overnight financing with zero benefit.
• T+1: I obtain secured financing vs. my shares and refi the unsecured loan I obtained to pre-fund the trade.

This is not as efficient as the current system. It also adds multiple sources of risk. First, you are now giving overnight unsecured funding to a bunch of funds with limited ability to respond in case there is an issue. Secondly, you are eating into the funds returns given the negative carry of pre-funding the trade. 0.5% may not sound like a big deal, but if your fund is returning 10-15% a year, that right there is 3-5% of your return. It’s double what Vanguard charges for managing an index fund. And that’s in a world with ultra low interest rates. If you look back 10-20 years, unsecured overnight funding would’ve been 4-5%. For your average index and mutual fund, that’s up to 1/3 of the return if you are trading daily.

This becomes even more complex if you are funding a cross-border trade. If you are an onshore emerging markets fund, which is USD denominated buy buys securities everywhere, now you have a bunch of problems. You first have to borrow the dollars, as in the example above, then you have to buy local currency and hedge the currency, all ahead of actually buying your shares. That’s crazy.

So T+2 settlement has its advantages, and it’s not just a vestige of an old infrastructure. In fact, Russia used to have real-time settlement, and they moved back to T+2 after they realized the impact on liquidity was such that it was preferable to go back to T+2.

So is the current system perfect?

No. The DTCC was a brilliant legal innovation to enable real-time trading in a world without decentralized ledgers and scalable technology. We can change that. I’m also generally skeptical of centralized clearinghouses’ absolute power, though they did come up as a result of the 2008 crisis. And I remain bullish on a decentralized future. I also think that in a world where clearing brokers are no longer massive institutions, figuring out how to manage margin requirements is also worthwhile. But, do I think that a “x”-sigma move in VaRs on marginal stocks should cause the biggest shift in equities market structure in decades? No.

However, what I’ve always appreciated about the financial system is that it is the ultimate work in progress. And usually every bizarre or seemingly antiquated rule had its origin on a legitimate use case. Joe Spolsky had a hilarious essay on why you should never refactor code. I think a similar approach here is worth pursuing. Things are there for a reason, and we should understand why before going ahead and refactoring the financial system.

A couple of asides to wrap up. As for JPM, in the end the focus of their decentralized efforts have focused mostly on payments with the IIN network, and in the repo markets, where they are doing some experiments. In a similar situation, a lot of people worried about the impact on bond market liquidity (Matt Levine had a recurring “People are Worried about Bond Market Liquidity”) after Volcker Rule made it difficult for dealers to hold inventory. Ten years later, the bond market continues to work OK, so maybe my worries are indeed overblown.

Some thoughts on debt and startup funding

Ever since Alex Danco’s excellent Debt is Coming post, there’s been a flurry of activity around non-equity financing in Silicon Valley. Pipe raised $60mm, Alex Danco had an interview with the CEO, and so on. I’ve written before about using debt financing to fund your company, and I still think that is an incredible alternative. In that post I focused primarily on “traditional” asset-backed lending (e.g., using loans and hard receivables as collateral that require equity to be produced in the first place). Today, the excitement comes around using new types of “assets” (e.g., software contracts) that do not require – at the margin – equity to produce.

While I think there’s tremendous potential here, I also think the initial enthusiasm is missing some hard-earned lessons from traditional finance regarding receivables and, generally, asset-backed financing. In fact, some of these lessons explain why startups have been historically financed with equity, and why equity remains – in my view – the best form of financing for most startups early on.

Why startups are financed with equity

In my stylized and corporate-finance-influenced view of the world, startups have historically funded themselves with equity because they are incredibly risky endeavors. Why are they risky?

1. You may not get paid back. In fact, you don’t have a “right” per se to be paid back. You have a share in the future profits of the company, but if there are no profits and no value, you get zero. Most startups go out of business.
2. You don’t know when you’ll get paid back. If the investment works, it’s still unclear whether you will get paid back.
   

So you have both credit risk, liquidity risk, and timing risk. As a result, it’s highly unlikely that any debt instrument, no matter how expensive can create a return high enough to compensate the investor for the risk they are taking. Thus, you are stuck with equity.

Equity works, however, not just because startups are so risky that they are the only option. It works too because it aligns incentives between the investor and the founder¹. Neither of you gets paid unless the startup is successful, and you get to share proportionally in the success of the venture. This fundamental alignment means that you can negotiate a deal extremely fast, as investors know that more than any other contract or clause, you are both in the same boat. It also means that – by and and large – it’s not in the investors’ interest to kill the company to get their money back.

As a result, deal docs and negotiations are massively simplified. The legal and financial due diligence requirements are standard and, all things considered, fairly low. As long as the investor believes the founder is ethically sound, a lot of otherwise necessary deal terms get washed away. Incidentally, this is why debt investors who move into equity tend not to be competitive, and why equity investors who move into debt tend to lose their shirts. There are exceptions (including some well-publicized ones), but generally speaking this works like this). In the end, this means equity processes are simple and fast. You can close a process in 8-10 weeks, and, as the CEO, you can abstract away from most legal doc negotiations.

this matters because the most valuable resource you have as CEO is not your equity but your time. I always go back to one of myfavorite investor’s push to “maximize ROT” (Return on Time). A well run equity process can leave you funded in 2 months, and, critically, with simple docs, no obligations, and massive flexibility. Sweet.

Then what’s the problem with equity? The problem is that it’s insanely expensive.

How expensive can equity be? Take Veeva, a multibillion dollar company that raised only $7mm in venture funding in 2008 ($4mm came from Emergence . In 2013, Veeva went public, and that $4mm stake for Emergence was worth over $1bn. In effect, Veeva’s shareholders paid over $1bn to get $4mm of funding. That’s crazy. Even if Emergence had charged them 100% interest p.a., that’d still be meaningfully lower (like a billion dollars lower). This is a simple and outrageously successful example, but that’s why it works so well to illustrate how expensive it is.²

Enter debt as an alternative

Debt is not as expensive as equity, and, in fact, the more successful your startup is, the cheaper debt will be relative to your equity. Alas, and this comes from a debt cheerleader, debt has many issues. For starters, in the case of coporate debt, you must pay it back, on schedule, with interest, lest you lose control of your company. Furthermore, debt packages usually come with very specific obligations for the borrower in terms of activities, reporting, financial statements, etc.

As a result negotiating those items is critical and not something you should learn on the fly. Tech private equity firms have been doing this for years, and they do it quite well (see TCV, Vista, Thoma Bravo). Importantly, usually the PE Firms, not the company’s management or founding teams negotiate debt terms. As I said, debt negotiations are not for amateurs.

Venture debt is a friendlier alternative to corporate debt, as it has fewer or no covenants, much simpler conditions, and they are easier to negotiate. I’ve advocated for venture debt before, and I think that more startups should use it. Funds like PFG, WTI, and Triple Point have consistently become more and more startup friendly, and they are a phenomenal alternative and complement to equity. I’d say that more startups should use them, but the fact of the matter is that some of the most successful startups out there (now public companies) have used venture debt – they just don’t tell you.

The new debt-like financing that has emerged looks more like traditional asset-backed financing than venture debt (or at least I’d hope so). In particular,

• It’s backed by rights against a specific revenue stream (e.g., a customer cohort)
• Interest charged should be reasonable given revenue stream.
• It has limited recourse against the company as a whole if the revenue stream doesn’t pan out. This is really important. If you go through all the trouble of obtaining revenue-based financing, at least ensure it’s limited recourse.

Now we are cooking with gas. We’ve got ourselves cheap financing (vs. equity), we’ve protected ourselves and our future by limiting the recourse the lender has against other revenue streams or our venture cash, and we’re good to go. The issue is that now your incentives and those of the lender/investor are no longer aligned. You could decide you want to pivot mid-debt-facility and cancel your billings. You may decide not to collect anymore. You may decide to give your customers your current product for free to get them to move to a higher-priced product, and so on… Your reputation will be in tatters, you will likely not get financing, spend time in litigation, etc., but you can and will be able to do it. Similarly, your lender may decide to kill your business as well to get paid back, if they can use their recourse to drain your resources. Great lenders and borrowers never get to this, but the possibilityexists. Incentives are no longer aligned, and therein lies the problem.

Fixing misaligned incentives

The easiest way to fix misaligned incentives is to try to align them. Equity warrants are but one way in which both company and lender try to align incentives. Yet these are not enough.

Instead, the way you solve this is by negotiating extremely detailed contracts that contain high stakes rights and obligations for both the borrower and the lender. No longer the “boilerplate” of a Series A or B financing with NVCA docs, these contracts have clauses that can make or break the company.

If I were investing in a revenue-based financing deal off SaaS contracts, at minimum, I’d try to negotiate the following:

• Recourse to the parent in case the deal goes south.
• Limits to product changes and pivots while facility is outstanding. If there are, then I get to accelerate the debt.
• Control and oversight over revenue stream.
• Bankruptcy-remote structure, so I can protect my interests in case the company goes south. This means there should be a rider in customer contracts giving me rights to continue to work with them directly.
• Minimum SLAs for customers in deal.
• Covenants, including churn and NPS.
• Weekly/monthly reporting requirements.
  

This may sound like a lot, but this is fairly straightforward in an asset-backed deal. You include these conditions to manage your risk, given the limited upside and the fundamental misalignment in incentives between your lender and the company.

As the company, however, you want to minimize or eliminate these conditions as much as possible. Some of these conditions can severely ruin your business if they go south (e.g., recourse to the parent, limits to pivots). As a result, negotiating these items will require meaningful time and attention from the CEO and the management team. It will require the company to build a whole new set of skills and expertise around capital markets. (Yet another benefit of equity fundraising is that – at this point – it’s been very much ingrained in the job description for the founder and the CEO).

Taking this time and building this expertise is unavoidable if your business requires capital to operate (e.g., lenders), but possibly not worth it if you have a pure software business.

But wait, it’s not debt, it’s a “tradeable asset”

Beyond my traditional cynicism regarding any new time of marketplace or crowdfunding venture, in the end most tradeable assets can either be classified as equity claims or debt claims. If they are debt claims, as is the case on a claim against SaaS revenue cohorts, you will expect meaningful standardization and strictness in documents over time. Especially as the asset goes mainstream, I can only imagine the set of disclosures, representations, and warranties that the SEC would require from issuers of SaaS-Revenue-backed assets.

And even if you think that -as an issuer – you are golden, you might not be. After the financial crisis, investors holding worthless residential mortgage-backed securities figured out that the banks that packaged them had not been completely truthful in sharing borrower’s income and FICO scores, even though they had “represented” in the RMBS documentation that the scores and income were OK. In the end, and multiple billions of dollars in settlements later, this was the way investors managed to recover some losses, even if, in hindsight the misrepresentation was more a symptom than a cause of the financial crisis.

Looking forward

This reminds me a lot of the push to tokenize real estate we saw a couple of years ago. A lot of excitement, some of the same players, and not a lot of progress since then. I’m not sure we’ll see tradeable securities backed by SaaS revenue any time soon, but I’m looking forward to seeing more and more funds emerge with non-equity alternatives for the right types of companies.

Rather than a marketplace, I think we’ll see boutique specialists with clear sector expertise, an ability to move quickly, and “simple” documentation that can actually overcome some of the issues I’ve highlighted above. Later stage companies are best positioned to use these tools, as they have the time, the traction, and the leverage to get great conditions.

The cynical play, of course, would be to take advantage of the frenzy (see ICOs 2017, unicorn-hunting, etc.) to raise at ridiculously advantageous terms and let the chips fall where they may. But that has rarely worked.

It’s not all just a temporary frenzy. In a world of ultra low rates, increasingly larger markets, and justifiable excitement about tech companies, you can see how the cost of capital for parts of the market has gone down enough to justify non-equity alternatives.

¹ This is not entirely the case. The investors have preferred equity and a very different risk/return profile, as they play – at least at the fund level – a portfolio game where power-law distributed outcomes win, while founders may want/seek different outcomes.

²There is a well-known story about a founder who, when asked how much his Palo Alto house had cost, said “a little over $200mm.” Basically, the shares he sold early on to buy his house would’ve been worth well over $200mm.

What I’ve been reading and thinking about lately

It’s been a few weeks since I last posted (blame this on travel, quarter end, and some exciting happenings at ADDI), so I wanted to share a few links that I’ve found interesting as well as some early ideas that I plan to write on soon.

Some interesting links

• It’s not Debt – It’s better than that. This is a fantastic interview by Alex Danco about Pipe. Full disclosure: I’ll be writing about this tomorrow, and I’m skeptical of Pipe and what they are up to, but if you want to read the bull case, that’s the place to go.
• Building a culture of experimentation. Giorgio Giuliani introduced me to this newsletter, and I think it’s fantastic. So, so good. And so many great insights. The idea of a north star metric (go go GMV!), and the idea of data-driven design never get old.
• Are founders allowed to lie? Another great one by Alex Danco. I remember having a great conversation about this with one of our investors early on in the context of Bad Blood. The investor’s take was that every successful founder had, at some point, “pre-told” the truth to borrow Alex’s phrase.
• Inside the break-up of NY’s premier (?) injury law firm. A great read if you want to understand the importance of founder dynamics and also get to know why New York remains New York. A delicious story.

What’s been on my mind lately

• Software-based financing is real but overrated. I’ll be writing about this later this week, but I worry this will look like the next phase of Real-Estate-backed Tokens from two years ago. These things have been around for hundreds of years.
• Markets are 10x bigger. I saw Elad Gil speak last night, and his point about markets getting 10x bigger really resonated with me. E-commerce in the US has ~doubled in 10 weeks. It took seven years to double previously. What opportunities are opening up as a result? FWIW, this is what we are squarely focused on here at ADDI, and also how I’m thinking about a lot of my angel investing.
• Virtual community. I recently started the On Deck Angel fellowship, and I’ve been quite impressed with the level of community that they are quickly creating. Of course, these folks have been doing this for years, but this might solve the issue of “building from anywhere” if you can’t have a community of like-minded peeps supporting you.
• The LatAm founder opportunity. The first wave of LatAm entrepreneurs was, by and large, a bunch of business guys (yours truly included). How can we get technically minded folks to build the next great companies in the region? How would that look like?

You’re not the gravy – In defense of Robinhood

Note: I’ve edited the bit about the NBBO after a helpful twitter point by Matt Levine.

A couple of weeks ago the NYT published an article detailing in alarming tones Robinhood’s “higher-than-average” profits from selling their order flow. Following the article, the great folks at Margins also published a note equating RH customers with the gravy, drawing on Ranjan’s experience as fixed income trader.¹ I think Ranjan missed some nuances regarding equity market structure, which substantially change the picture.

A highly-stylized version of equity market making and market structure

At a very high level, the equity market has three participants: Those who want to buy or sell in the market (call them investors – e.g., pension funds, hedge funds, asset managers), those who make a market (call them market makers), and the brokers that sit in between and charge a commission – or not – for executing the trade.² To keep matters simple, we can assume that investors have either a structural or long-term reason to buy or sell stocks. A hedge fund may want to go long or short a stock, an ETF manager may need to rebalance her book to track the relevant index, etc. Importantly, they are buying or selling the stock because of an underlying view on its value – either price or index composition or whatever. The majority of these investors are institutional, and as a result their purchases can regularly be big enough to move the market. Keep this in mind.

At the other end, you have market makers. They buy and sell securities not because they have an underlying view about the stock, but because they can make a small profit by getting in front of the small movements that happen during the course of the day. In theory, market makers charge a spread for their service, but that spread only translates into profit if they are on the right side of the intra-day stock movements. Historically, the market makers were the guys in colored jackets you’d see on the floor of the New York Stock Exchange. Today, they are mostly High Frequency Trading firms. At times, the market makers hold a security for less than a second, buying and selling quickly and – ideally – making a spread in between.

In between the end investor and the market makers sit the brokers. The brokers execute your trade on your behalf or through an execution partner. Importantly, unlike the fixed income market, equity brokers have a legal obligation to give any customer *at least* the best available price in the market – the NBBO (Nationwide Best Bid Offer), though in practice you can do better. In fixed income or foreign exchange, you will likely never get the best pricing you can if you are a retail investor. In the equity markets, you will always get the best price. It’s as if you were to buy $100GBP at the airport and you got the same price the bank buying $100mm GBP from their own FX desk would get. Beauty!³

I think this is where most folks go wrong in their assessment of Robinhood. Since RH makes so much money selling its flow, its customers must necessarily be getting a bad price. However, the US equity markets work in such a way that – regardless of your broker and platform – you will always get at least the best possible price (NBBO). As a thought experiment, assume I want to buy 1,000 shares of AAPL at 2:01pm on the dot. My price will be the same no matter what platform I execute my trade on. In this case, using Robinhood or Fidelity or even the Goldman Sachs institutional trading desk is utterly irrelevant. You get the best price in the market (the NBBO referenced above), or maybe even a better price :).

As Matt Levine has repeatedly said, the emergence of HFTs was the best thing that could happen for retail investors! They drove down commissions and bid/ask spread, and you can even say they made zero-commission trading economically attractive.

Why are market makers paying for RH flow if the price is the same?

Since every customer always gets the best price, why are market makers paying so much for Robinhood’s order flow? The answer lies in how they make money. Suppose I’m a large investor selling $50mm of AAPL stock. The market maker will buy it at the best possible price (NBBO), and then hope to sell it again, as quickly as possible, at a slightly higher price. Most of the time, we’re talking about holding the stock for a couple of seconds at most and selling/buying for a few pips more/less (a pip is $0.0001). A classic “picking pennies in front of a steamroller” business.

And in this case, large and institutional investors are the steamroller. When fulfilling the $50mm sell order above (that is, buying the stock from the investor who is selling), the market maker has no idea whether more sell orders are coming. Maybe Warren Buffet has decided that he’s going to liquidate his multibillion dollar Apple position. If that’s happening, you don’t want to fulfill that order, as the price will likely not go up as the order goes through, and you may even have to sell at a loss.

The market maker doesn’t want to be on the other side of the trade not because Warren Buffet is a great investor who knows which direction AAPL is going, but because in the process of fulfilling the trade, the market maker is operating blind and may be caught in a falling market for the next seconds/minutes while the order goes through, losing the market maker money. This is worsened when the investor is not Warren Buffet all the way out in Omaha but a large institution in NYC with very chatty traders and investors.

Meanwhile, you can be almost sure that Robinhood investors are trading: a. Out of their own volition without necessarily coordinating with the large institutional investors; b. In small enough amounts that you won’t get run over by a large multi-billion dollar buy/sell order after you fulfill your own small part. This means you can fulfill their orders with a much higher likelihood of making a profit in the transaction. What is more, as long as you are hitting the NBBO, you can even internally match those orders with those of your institutional clients without necessarily going out to the exchange and moving the NBBO in the process.⁴ Technically speaking, what you’re looking for is uncorrelated order flow, and it’s hard to think of orders less correlated with Wall Street’s institutional wisdom than those from Robinhood.

I share a lot of the concerns about Robinhood while I admire their brilliance in making stock trading a gaming endeavor vs. a financial endeavor. However, at least in this case, the beneficiaries of zero-fee trading are clearly the retail investors. And not just Robinhood’s. Thanks to its success, even those of us who trade on Schwab or E-trade benefit from zero-commission trading as well.

1 For the record, I love the Margins newsletter and encourage all of you to subscribe.
2 This, again, is highly stylized. I’m assuming custodians, central clearinghouses and other margin players away.
3 This wouldn’t actually be the case, as it’s likely that there is not enough supply at the NBBO to execute the full $100mm GBP. However, for the first $100GBP, both the bank and the guy at the airport would get the exact same price.
4 For what is worth, both market makers and institutional investors share the same worry about information asymmetry. If the market knows that a big trade is coming, it’ll move down in anticipation of the trade. Hence, large institutional investors invest a lot of money and resources in hiding their trading intentions as well. Black Pools are an extreme end of this, where buyers and sellers meet outside the exchange and get matched without having to go through the exchange moving the price. Black pools will even use retail order flow to match against institutional orders.

Building for the Latin American Market

As we have worked through the implications the pandemic will have on our business, I’ve been thinking about what it means to build great products and enduring venture-backed companies in Latin America.

Market size

One of my hard-earned lessons as a newish angel investor and founder/CEO is that venture-backed companies require massive markets to win. It doesn’t matter how good the product and the team are, if your ultimate market is small, you will not generate VC-style returns. What that means is that if you are planning on building a venture-backed company in Latin America, you must operate in either Brazil or Mexico very quickly, and ideally in both. Of course, companies like Rappi, Frubana, Liftit, and even ADDI got their start in Colombia, but they all either have operations in MX and BR, or are opening them up (hello Brazil!).

I expect this trend to continue, and I think it’ll be increasingly harder to get venture dollars if you are not already operating in one of those markets.¹ In the past, companies such as ours (and a few of the aforementioned ones) benefited from using Colombia as a test case before going abroad. I’m not sure that strategy will hold true much longer, and indeed I now advise founders to set up operations in Colombia and at least one of the two other countries at the same time, or, if they want, skip Colombia entirely. The pain of setting up a multi-country operation is worth it to fight in a venture-feasible market.

This is not as easy as it sounds, however. Brazil, Mexico, and Colombia are different countries with different legal, institutional and regulatory regimes. For every Rappi or Liftit there are multiple examples of companies who failed to expand. Hence why you’d rather start sooner than later.

Note This is not to say that you can’t build an awesome company in Colombia, Chile or Peru. It does mean, however, that you should think long and hard before funding it with venture dollars, as it’s unlikely the market will bear the growth and valuation expectations your investors have. As an example, as of today the largest bank by market capitalization in Colombia is worth ~$6bn, compared to over $50bn for Brazil. (The relative size of the economies is only ~1/5, so that doesn’t explain it).

Avoiding the “it’s just like Asia” trap

Spend enough time with investors and entrepreneurs and someone will mention that Latin America is just like Asia, only a bit smaller, but still a gigantic market (usually in the context of a discussion around capital-intensive businesses or building a “super App”). The biggest similarity is how cheap labor is, which makes tech-enabled companies not only feasible but potentially even profitable. Cornership, Rappi, and pretty much any marketplace you can think of have meaningfully better unit economics than their US peers (though, pre-COVID, they still faced serious profitability challenges). Beyond marketplaces, logistics, lodging, and fintech ideas become feasible and attractive given lower labor costs. It also means you don’t need to build that much technology. You can have folks in the background, while you focus purely on UX and customer acquisition. Harder to do in areas where the minimum wage is $15.

Where I think the biggest difference lies is on the degree of institutional and technology development. For better or worse, Latin America has a strong if inadequate payments infrastructure, and some experience with web 1.0. The existence of a payments infrastructure means visa and MC are prevalent and doing well. The two most successful consumer-facing fintechs in the region have both leveraged the networks extensively (Uala in Argentina and NuBank in Brazil). Companies that have tried to build Alipay-style wallets have fared much worse, as they miss out on both acceptance and interchange fees, and they have to invest heavily on merchant acquisition. Absent the networks, then wallets and alternative payment methods rock. Given that the networks are already here, the value of a totally de novo payment system is much less clear.

As a result, the most successful companies figure out how to build on top of the existing infrastructure to gain an advantage before going out and expanding access through their own solutions.

There is no hacker culture

If we’ve spent any time together, you probably know my favorite company is Stripe. Fuck those guys are good. Solid execution, amazing product, and, yes, a developer-focus that permeates everything they do (even Stripe press!). When we started building our online POS solution, we took a page out of Stripe’s book and built beautiful and delightful APIs with great documentation. Nobody cared.

Instead, we found ourselves meeting with super talented marketing and sales teams who were the ones driving the purchase and integration decision. It turns out, at least for now, hackers don’t rule the roost down here. If you look around at every major tech company, you’ll find that most founder-CEOs do not have a tech background.² While some of the companies down here have built awesome technology, I’m not sure the next Kafka, Hadoop or Spark will come out of any of them. We take what works and apply it really well in our market. Alas, that looks like it’ll be the case for a while (compared, for example, with Israel, where there is a strong tradition of technical excellence).

Hence, building hacker-friendly products, a recipe for success in Silicon Valley, is unlikely to work down here. You could argue that when Stripe started their “market” had not yet developed. While that is true, even at that point you had multiple examples of hacker-built companies worth billions (e.g., Apple, Google, Facebook, Twitter, MSFT). We still don’t have those down here. Hoping that we will suddenly become a tech-first culture is a risky business strategy. Instead, partner with integrators, build products that work for your customers today, and build the future alongside them.

Wrapping up

If I were to summarize this post in unsolicited advice to new Latin America founders, it’d be:

1. Build a company that serves Brazil or Mexico (or both) from Day 0.
2. Get inspiration from Asia, but recognize we have more similarities (and infrastructure) with the US and Europe. Mix and match your patterns.
3. Build for the customers today. Do not expect a hacker-first culture down here.
   

1 As always, Argentina is the exception that proves the rule, and I think that’s because it has a deep well of technical talent, and it’s just big enough to make sense as a first market.

2 E.g., Marcos Galperin (MELI), Simon Borrero (Rappi), David Velez (NuBank), and so on.

Unit economics and lending

One of the most surprising things about our recent fundraise was how often we found ourselves explaining why we were using return on equity to measure our unit economics. This was the case even when talking to investors who had previously invested in multiple lending companies.

Since three posts a trend make, I want to continue exploring how important it is to assess capital efficiency when evaluating a startup. I’ve already discussed why balance sheet matters, and also why funding matters.

When looking at unit economics, capital efficiency is paramount. While that sounds obvious, the challenge lies in that most off-the-shelf analytic tools used to evaluate tech companies assume that you are evaluating pure-play software companies. In that case, they are already so efficient that you can just assume capital away.¹ The moment you start employing real assets to create value, or, in the case of a lending startup, money, the whole thing goes out the window.

Consider these two hypothetical lending companies, and for the sake argument, let’s assume they lend one time, and their only source of income is a “lending fee” at the beginning of the deal of, say, 20%.

Table 1.

Just by looking at this, Company B is the clear winner. 5x LTV/CAC. This might even rival a SaaS business. Alas, this is not the whole story. If now add some additional data, here’s how this table looks:²

Table 2.

Company A still looks worse under the LTV/CAC analysis. We now understand the reason. Company A decided to get some debt to fund its loan and that costs money. That brings down the “profitability” but means Company A has to use a lot less of its capital to fund that loan.

As a result, Company A is getting a much higher return on its capital than Company B. Basically, for every dollar that Company A puts to work in a loan it gets 40 cents back. Meanwhile, Company B gets 13 cents for every dollar it puts to work. The difference is staggering.

This becomes even more worrisome as both companies scale. For Company A to get a dollar in profit it needs to put a little over two dollars to work. However, for Company B to get a dollar in profit, it needs almost ten dollars of its own capital to get there!

These two simple observations (how much profit do you get for every dollar you put to work and how many dollars you need to get to a certain absolute level of profit) explain two things in lending:

1. Lending company multiples are not that great, even for a bank. Translation: Valuations suck for lending companies (a topic for a different post).
2. Lending companies need a lot of capital to scale, as they need to put equity to work in every single transaction.³

This is why looking just at LTV/CAC or any income statement measures alone will not get you the full picture for a lending company or any company that has to use its own capital to transact. Return on equity incorporates the income statement and also helps you measure the profitability potential of a company. As with any other unit economics analysis, you can adjust for stage, potential for scale, etc.

As an early stage company, you should be aiming at least for a 25-35% return on equity for your lending product. In real life, this won’t happen with your first debt facility. What you want is to make sure that as you scale your funding and your cost drops, you can and will get there. As you get more data on every aspect of the equation, including income, expenses, losses, and repeat behavior, you can adjust accordingly.

One final note: You will sometimes see folks use NPV instead of ROE when computing unit economics. This is just a different method to arrive at the same idea we just covered here.

Footnotes:
1. Of course, this is not always the case, as you have investments in R&D, data centers, etc. However, these are usually platform investments. The capital necessary to do a single transaction for an enterprise SaaS deal is pretty close to zero.
2. This is highly stylized. I’m assuming a one-time balloon payment, and I’m ignoring prepayments, delinquencies, and losses. You can add all of that and the basic point still applies.
3. Again, simplifying a bit.

Negotiating your first debt facility

Perhaps the most important job as a startup CEO is to raise money. For most companies, that just means raising equity, and thankfully there is plenty of great advice on the internet on how to do it. Unfortunately, if you are building a lending startup, equity is not even half the battle. You also have to raise debt. And, unfortunately, there is very little information on this topic.

I’ve seen this lack of information first hand as a startup CEO, advisor and investor. I’ve spoken to 15-20 startups on this topic, and I’ve negotiated a few facilities myself. In this post, I want to share some of the lessons learned and also how the process works. If the last financial crisis is any guidance, after the crisis is usually the best time to lend, and I expect we’re going to see a new crop of fintech lenders emerge.

Topics:

1. Intended audience
2. Why debt facilities matter
3. When to raise your first debt facility
4. Goals for your first facility
5. Choosing the right partner
6. Negotiation considerations
7. Path forward
8. Note on crowdfunding

Who is this post for?

This post is for new entrepreneurs building a lending company in an emerging market and looking to raise their first “institutional” debt facility (fund-backed, and say at least $15-20mm). US-based founders looking to obtain their first $30-50mm facility will find it useful as well.

This post doesn’t cover a potential “micro” line from your existing bank, which is likely a venture debt facility. I plan on covering these in a future post on return on equity and optimizing the capital structure.

Why debt facilities matter

Increasingly, most people know the answer to this question, but it bears repeating because, depending where you come from, the answer may sound counterintuitive. You want a debt facility because your equity is incredibly expensive, and your loans are not that attractive (yet).

Let me illustrate this with an easy example. Assume you need to lend $3mm over the next 12 months, and you need cash to do it. If you raise those $3mm at – say – a $15mm post-money valuation you gave up 20% of your company. If that’s the entire amount you ever raised, and then let’s say you sold the company for $100mm a few years later, then instead of getting $100mm, you only get $80mm. In effect, you’ve paid $20mm to lend $3mm. That’s an awful, awful trade. Venture investors know this cold, and they will not want to finance an ever growing book with expensive equity dollars.

More formally, the return expectations of your investors (and, you hope, yourself) are such that your equity will cost somewhere around 30-40% per year. This is not a cash cost (as it is with a debt facility), but it’s a real cost (see example above). The sooner you can get cheaper funding, the better it’ll be for your business.

As an aside, think long and hard before you start a lending business. These are tough, capital-intensive, and highly-competitive businesses. This is a topic for a future post.

When to raise your first debt facility

Until 1-2 years ago, the playbook was very simple: You’d fund your initial loans out of equity to prove and refine your business model (underwriting, customer acquisition, etc.). Once you had 3-4 profitable cohorts, then you would then go and raise your series A alongside your first credit facility.

This is no longer the case. We now see seed rounds that have a debt component to them, especially in emerging markets. In theory, this sounds great: you can save your equity to fund high-value activities (product development, marketing) and use debt to fund your loan book. Everyone wins. In practice, the devil is in the details. Depending on your loans’ duration, rate, and term you might be better off funding your first 2-3 months with equity and then getting meaningfully better terms for your first debt facility 2-3 months down the road. This is very important. Locking expensive capital now is not as attractive as it might sound.

While the answer depends on what people offer you, I posit that in most cases you are better off first lending out of equity and then grabbing a debt facility. Facilities are expensive, a bit cumbersome (even the best ones), and are a great 1 to N tool.

Going from 0 to 1 with debt is rarely a good idea. No matter how aligned you can get your debt provider (more on that below), and how flexible they are (ditto), they will have to worry about the downside. That’s their business. If you are still refining your model and fine-tuning where to go, the mindset of fast iteration and evolution may not match with a debt investor’s duty to ensure they don’t lose their capital. Debt investors worry about the downside. Venture investors only care about the upside. Once you get the facility in place, you’ll have to manage both mindsets and – at times conflicting – priorities.

In the end, consider getting your first facility after you have a little bit of data that validates your model and assumptions. Importantly, the data must show two key proof points for your debt investors: That you won’t lose money beyond reasonable expectations and that you can scale quickly. The more data you have, the more leverage you’ll have in the negotiation and the better terms you will be able to get.

Goals for your first debt facility

Raising debt is a never ending process. In fact, raising debt is part of a key capability for any lender: Funding and liquidity. Over time, you can move on from debt to other sources of funding including direct loan sales, securitization, and, of course, deposit-taking.

You should aim to accomplish three goals with your first debt facility:

1. Lever your balance sheet, so you can scale your business and prove out your model.
2. Align incentives and maintain flexibility.
3. Market and signal to venture investors.

That’s it. Don’t overoptimize or overengineer in your first facility. It’ll likely only bring trouble further down the road.

Lever your balance sheet

The objective for your first debt facility should be to lever your balance sheet. All that means is to fund your loans not just with equity (scarce and expensive) but with your new debt dollars. This should allow you to originate more loans, scale your business and prove out your unit economics and model.

A good first facility will minimize your equity outlay, enable you to lend for 12-24 months at most, and allow you to fine-tune your business model. A good first facility is not necessarily the facility that will allow you to make a lot of money. Don’t optimize for interest rate at this point, and all else being equal you should pay a higher rate to put up less of your hard-earned equity. At this point, your advance rate is all that matters. The higher the better. If your first facility does well, it’ll open the door to lower cost of funding alternatives with the same advance rate.

Align incentives and maintain flexibility

If all goes well, your first facility will have the “worst” terms you’ll ever get. You will pay a high interest rate, give out equity, and a less-than-optimal advance rate. Hence, minimize the amount of time that you will have those terms. Ideally, target 12-18 months and no more. Longer facilities may sound great (“look! I have my debt sorted for the next 4 years!”), but they aren’t. If your book is performing, you will likely always get a better facility once you have more data. That said, if you can find a debt provider that has the option to upsize the facility, that is great. Now you know you can count on them if the business is growing faster than you thought.

Avoid the temptation to get a huge facility at all costs. While they look great in the press release, you will get stuck with higher-than-you-need-costs. Better to start small and flexible and grow over time. There is a balance, here, and make sure you have at least $10-20mm in committed funding, as legal fees will kill you otherwise. Of course, if you have locked product-market fit and can get great terms, then you are the exception that confirms the rule.

Finally, I strongly encourage founders to give out equity to their first capital providers. At this point it’s fairly standard, but it doesn’t mean you should be unhappy about it. Giving equity to your debt provider ensures that – while not entirely aligned, their incentives and yours are less misaligned if things go wrong. This provision will save your ass when shit hits the fan, and ensures that everyone is working towards building a lasting company and not just running the first $20-50mm through. Even better if the participation comes in the form of an investment and not just warrants.

Signaling to VC investors

The last goal behind getting a debt facility is signaling to VC investors. Raising debt has become a test/requirement for lending startups. If you cannot raise debt, equity investors will be very skeptical of the long-term sustainability of your business.

The quality and approach matters as much as whether you raised debt or not. In particular, who you are working with, how you think about capital, and, critically, what your long-term capital strategy is are important considerations.

Raising the facility

Conceptually, raising the facility is not unlike raising equity. You prepare your materials, meet a bunch of folks, get term sheets, choose a partner, and then close. In reality, there are some important differences.

Preparing materials

Generally, the earlier your company is, the more you can just use your equity deck as the starting point. No matter how early you are, however, remember that the questions your investors are trying to answer are fundamentally different. Your equity investors care mostly – if not entirely – about the upside potential. Your debt investors care mostly about getting paid back. Of course, they also want to see an exciting equity story, but their capital – unlike VC capital – must come back for their business to work.

Given that, your materials and presentation must reassure them that their capital will come back. Important sections include:

1. Underwriting model and philosophy.
2. Detailed unit economics.
3. Servicing and collections approach. How are you collecting? In-house or outsourced? etc.
4. Team background. Who knows about credit? If nobody does, how are you fixing it?
5. Historical cohort/vintage performance.
6. Loan tape.

Any credible debt investor will want to see all of this. It’s a lot, and way more than what VC investors usually ask for. That’s normal, and it’s all about downsize minimization. Fortunately, any credible debt investor will sign an NDA with you, so you can have more reassurance that they won’t share the data with other folks.

Expect your debt deck to be longer and more detailed than your equity deck.

Meet a bunch of folks

Once you have your materials, go and meet a bunch of funds. Unlike VCs, the market for debt investors has grown but remains limited and well-known. Between your angels and advisors you should get the right intros. If it’s helpful, I can give you my views on who to speak to based on geography, asset class, and stage – just ping me! Unlike an equity raise, avoid the temptation of running a gigantic process. The market for debt is fairly standard, so find 3-5 funds you like and go with them vs. trying to micro-optimize the interest rate to the nth degree.

After the first presentation, you can gauge their interest and share the materials discussed above (especially cohort performance and the loan tape).

At this stage, it’s really important for you to be clear on what you care most about. Since this is your first debt facility, you don’t yet have a proven and standardized product that investors can line up and bid against for. As a result, you will have to give somewhere. The interest rate is going to be high (no matter what your NYC banking friends say), and you’ll likely have to put some of your equity, but it’s important that you share what you are optimizing for with investors at this point.

This is all people need – usually – to be able to prepare and share a term sheet with you.

Get term sheets

You will be surprised at how quickly you get term sheets, especially if you have only done equity raises before. That’s because equity term sheets and debt term sheets are very different. In most cases, getting a term sheet from an equity investor signals the end of the process. Once you sign, you know the transaction will close and be as good as gold. VCs know this, and they know that their reputations depend on this.

Debt investors are different. Given the amount of capital they will provide (2-3x more than a VC), their limited upside, and their exposure, they will need to do a lot of confirmatory and closing due diligence. As a result, a debt term sheet is not guaranteed to close. When you receive your term sheet, pay attention and look to optimize the following terms:

1. Advance rate – How much is the lender giving your for every $100 of originations? As an example, a 50% advance rate means the lender will fund $50 of every $100. Typical advance rates for first facilities go from 60% to 80%. Anything lower than 60% absent some very specific conditions is not worth your time. At the same time, I’d happily pay a higher interest to get a better advance rate. For sure. Equity dollars are that expensive, so feel free to sacrifice near-term profitability to put up less of your cash. An easy way to think about the tradeoffs here is to figure out the return on your equity you’ll have (a topic for a future post).
2. Interest rate – Easy to figure out. How much you pay the lender for the debt. Expect mid-teens rate for your first facility.
3. Fees – These are very tricky. Most folks just look at the interest rate, but make sure you look at all the fees. In particular, any structuring fees and commitment fees. Additionally, pay attention to unused commitment fees and prepayment penalties, as these are likely to be triggered. Model them carefully. I can assure you your lender has.
4. Eligibility criteria – The advance rate is useless on its own. You have to know what loans will be eligible for funding and what loans won’t. This will be highly specific to your business, and you are likely not going to get it all done before the term sheet. However, at least figure out how delinquent loans are treated and whether you can get partial credit for them.
5. Exclusivity and ROFO (and, god forbid MFN) – Most lenders will ask for exclusivity – that is, you have to commit to financing your loans through them. That’s OK (and fair given how much time they’ve spent on your facility). However, make sure the exclusivity has an expiry date. The ROFO (right of first offer) basically means that the lender will have the right to finance any new loans and match/pre-empt any better financing option. This is key, as it may deter cheaper sources of capital from even coming to the table. Avoid and limit as much as possible. In general, the right principle here is ensuring at all costs that you can graduate into cheaper/better funding.

Make sure you take advantage of the leverage you have before you sign a term sheet. All term sheets have exclusivity, so once you sign with a debt partner, you have to stop talking to everyone else. Do this gracefully and thoughtfully in case you have to go back to them. In the meantime, if you have multiple term sheets, use that to improve the conditions to your advantage. I’ve seen companies get bigger facilities, higher advance rate, lower equity and even lower interest at this stage if they have multiple options. Importantly, get as much negotiated as possible before signing. Advance rate, ROFO, accounts and money flow are all critical pieces that you can and should negotiate ahead of signing a term sheet.

IMPORTANT Get a great lawyer, who is different than your equity lawyer (though may come from the same firm). This is nonnegotiable. A great lawyer will save your company. A great lawyer will make sure you don’t sign something stupid. A great lawyer will get you the best deal possible that is a win-win for all. Do not for a second think of this as negotiating a VC deal. The complexity and technicalities are orders of magnitude higher. Get great counsel.

Once you’ve chosen your partner (more on that below), sign, celebrate and get back to work. You still have to close.

Close

IN VC land, once you sign a term sheet you are usually done. Not so here. In general, 50% of debt term sheets fail to close You should expect to close 90-120 days after you sign a term sheet and spend $400-500,000 in legal fees, especially if you have multiple lawyers working in different jurisdictions.

Closing a facility will become a top 1-2 priority for the CEO and/or one of the founders. It’s just that important. Do not outsource or disengage from the details, as your company’s fate will hinge on them. Expect to negotiate every single aspect of your relationship with a lender: reporting obligations, accounting standards, money flow, legal structure, as well as covenants (i.e., things you have to either commit to do or commit to never do), and eligibility criteria (exactly which loans qualify for what).

In the process, you must prepare to share even more data: Financial statements, additional cohort and loan-level performance, servicing and operating policies, etc. In a number of cases, you’ll have to create these documents and policies as part of the process. That’s OK.

During this process, build up your patience and do not despair. Progress will not feel linear. You will agree on a number of things, and then slow down. It’ll feel like you are 90% of the way for about 80% of the time. Everyone feels that way.

An important thing to note while you are closing is that you have more leverage than you think you do. From the outside, it doesn’t look that way. You are a new company that desperately needs this facility to grow, and you’ve turned down all other options. So you have to just lay down and take all new terms? Well, no. For starters, you can if need be wait until the end of exclusivity to go find someone else (of course, assumes you are careful with your equity $). But you should also be aware that your lender is invested in this deal. They cannot look at every deal, and if they’ve spent 60 days working on this, they want to close. Hence, you have more leverage than you think you do. Use it.

Choosing the right partner

Who is the right partner for your debt facility? The answer obviously will depend on your specific situation, but there are a few important considerations:

1. Unless you are 100% absolutely sure you’ve found a deep and large market and have almost perfect product-market fit, prioritize flexibility. This means product flexibility, but also terms as your data proves itself out. This is easy to miss, as you have probably just raised an equity round on the back of great traction.
2. Fund only the next 12-18 months. If your book is doing well, you will always get a bid (almost). As my cofounder likes to say, premature optimization is the root of all evil. Avoid a large facility that you do not yet need. A good compromise is a fund that can give you a smaller amount but can upsize if things go better than expected.
3. Get the FX situation sorted and hedged. It’s tempting to go with a USD-denominated facility (I’ve been there myself) but avoid it if at all possible. We now have enough lenders willing to offer a hedged or local-FX-denominated facility. Take that. You’re not in the FX business, and you won’t regret having a local facility when your currency of choice moves 20/30% against you as happened earlier this year with most emerging market currencies.
4. Do not overlook the operational details. You will live with this facility every day. Larger institutions can bring a lot more capital at cheaper rates, but they are likely to require more reporting and procedures, since they tend to have their own regulators to answer to. Smaller outfits are more expensive / smaller ticket, but less stringent around these items. It’s easy to miss this, as you focus on the headline terms (advance rate, rate, etc), but it’s a real cost that can be meaningful for a small outpost.

Path forward

If all goes well, after 90-120 days you’ll be done. Congratulations. This is but the beginning of the journey, as you’ll then look to build your capital markets team, diversify funding, and even go beyond wholesale debt lines. But none of that will happen if you cannot get your first facility in place.

A note on crowdfunding

It may be very tempting to go the crowdfunding route. Avoid it if at all possible. Every business struggles with acquiring, maintaining, and delighting customers. All crowdfunding does is double the effort. Now you need to get customers on both sides of the loan, keep them happy, retain them, etc. Don’t do it. Even LendingClub, which pioneered crowdfunding gets less than 10% of all its funding that way today. Only after they got institutional backing were they able to scale the way they did.

Thanks to Nick Huber, Rob Pfeifer, Ross Fubini, and Ross Davisson for their comments. All errors are my own, of course.

Why balance sheets matter

Fred Wilson had a very interesting post a couple of weeks ago on how margins alone don’t tell the story. In particular, he picked up both Macy’s and Ayden as two examples of “low margin” companies with different futures, economic prospects, and, yes, valuation multiples. For reference, last year, here were their revenues and margins.

($millions)	Adyen	Macy’s
Revenue	2,657	25,331
Gross profit	497	15,171
Margin	18.7%	40.1%

As Fred points out, it certainly looks as if Adyen is the worse business. However, there’s more to the story, and the money sentence is here:

“That is because Macy’s expends enormous amounts of working capital and operating expense and effort in its $15bn cost of revenue where Adyen expends very little working capital and operating expense and effort in its $2.1bn cost of revenue.”

Fred rightly points to “working capital,” “effort” and “operating expense” as the reasons that Adyen may be a better business. That got me thinking that we could do a lot better than that, by looking at the companies’ balance sheets and figuring out how much capital they need to get the margins they get. Using data from Adyen’s annual reports, and Macy’s 10-K, we can get their working capital stats:

	Adyen	Macy’s
Current assets	EUR561	USD6,810
Current liabilities	EUR1,627	USD5,750
Working capital	EUR(1,066)	USD1,060

Note: I’ve assumed away ~90% of Adyen’s cash as non-working capital.

Note the staggering difference here, Adyen’s business has negative working capital. That is, once it’s up and running, Adyen doesn’t need to put money to get its business to operate. In fact, the opposite is true. The business literally spits out cash. Meanwhile, Macy’s, while being incredibly optimized as a physical retailer (e.g., their receivables are less than their payables) still has to do “physical retail things.” Critically, over $5bn of current assets are in merchandise inventories. 

We can go even further by adjusting working capital to also include the capital you need to make the business work. Back at McKinsey, and if you were just looking at mature companies, we would take equity and long-term debt. As more companies raise more cash than they need (optionality, growth, etc.), this is less useful. Instead, let’s make some adjustments. 

	Adyen	Macy’s
Current assets	EUR561	USD6,810
Current liabilities	EUR1,627	USD5,750
Working capital	EUR(1,066)	USD1,060
Plus PPE	EUR30	USD6,633
Total capital	EUR(1,066)	USD7,693

There you go. Adyen is a business that literally needs negative cash to work and produce returns. In fact, once you have the software and the rails in place, you can sit there and get your ~$500mm/year of gross profit with literally zero marginal investment. Meanwhile, at Macy’s you have to deploy close to US$8bn to get US$15bn in gross profit. Talk about differences in capital efficiency.

That’s why balance sheets matter. Historically, if you only invested in high margin enterprise SaaS companies it was easy to just “assume away” the balance sheet as the business was – almost definitionally – capital light. As you start backing marketplaces, tech-enabled companies, fintech companies, etc., understanding the company’s balance sheet and capital strategy must become a core part of your investment analysis. Otherwise, you might miss great businesses that look “low margin,” and vice versa – investing in “high margin” businesses that gobble capital.

 

Welcome

After much hand-wringing, I’ve decided to move from Medium to WordPress. I expect this to become a place for regular posts on technology startups, financial markets, finance in general, all with an emphasis on emerging markets. Feedback welcome.