How Arc Improves the Underwriting Process in Venture Debt

Don Muir of Arc - Podcast Transcript

Scott:	Hey, it’s Scott Orn, Kruze Consulting, and thanks for joining us on Founders & Friends for another awesome podcast. Let’s give a quick shout out to the Kruze Consulting accounting team. We’re very fortunate, we have a ton of people at Kruze who work on the monthly books for our clients and get them all set up, due diligence ready, rocking every month, answering all the client’s questions, making all those adjustments, and there’s no better moment for a founder, and for us really, when founder says, “Hey, I think I’m going to get a term sheet. Are my books ready for diligence?” And we get to say, “Yes, they are. Fire away. Send them over. Give them access.” That is a great feeling. It’s the feeling that lets us know we’ve done a job very well done, and nothing is better than watching that cash at the bank account. So, if you are a venture-backed startup, you’re going out the fundraise, maybe check us out. Check us out at kruzeconsulting.com. We love what we do. At taping here, I think we have 575 clients. Clients raise over a billion dollars a share, so we know what we’re doing, and hopefully we can help you be successful in your fundraise. All right, let’s get to the podcast. Thanks.
Singer:	(Singing) So when your troubles are mountain in tax or accountant you go to Kruze, from Founders & Friends. It’s Kruze Consulting, Founders & Friends with your host, Scotty Orn.
Scott:	Welcome to Founder & Friends podcast with Scott Orn at Kruze Consulting. And today my very special guest is Don Muir of Arc. Welcome, Don.
Don:	Hey Scott. Excellent to be here. Thanks for having me for having me.
Scott:	Oh, my pleasure. I should also mention, I’m a tiny, tiny personal investor in the company. I’m a believer, that’s why I wanted to have you on the podcast, just want to make that clear. Don, retrace your career. Tell us how you had the idea for Arc. I’m very excited about what you’re building.
Don:	Yeah, definitely. I think the inception comes back from the days at an undergrad at Cornell. I’ve always been a finance nerd, studied finance and undergrad. When I say finance, I’m not necessarily referring to what we’re seeing here, in Silicon Valley and the venture space, but I’m referring to fundamentally driven underwriting in valuation. Studied finance, took every finance course I could get my hands on. Starting an undergrad, involved in all types of finance clubs. Ultimately after graduation worked for a value oriented private equity shop in New York called Onex partners. It’s one of the oldest and largest publicly traded private equity funds where they care most about fundamentally driven valuation. So, finding value opportunities, buying companies for 8 to 12 times, EBITDA. It’s a little bit different from obviously what we’re seeing here in Palo Alto and San Francisco. But it’s really where I learned finance. And over time, my interest really evolved into a passion for the financial markets, and for the capital markets. And when I moved across the country to enroll at Stanford Business School and moved across the hall from what was eventually or who was eventually my co-founder Nick, turns out, we sat on the opposite side of the table in multiple leveraged buyout transactions in New York.
Scott:	That’s awesome.
Don:	Nick, Nick-
Scott:	You put it together. You’re like, “Oh, I did that one too.” And then you…
Don:	I kid you not. I moved in across the hall from this guy, Nick Lombardo, and we started chatting. I found out he was a VP at AEA and I brought up one of the deals that I… One of the most recent deals I’d been working on at Onex at the time, prior to enrolling at the GSB, and I said, “You’re not going to believe this, I was a VP on that deal.” Turns out, they won, right.
Scott:	Oh my God. Oh my God.
Don:	We spent all summer working on this transaction. All nighters, almost every night of the week, Nick pulls ahead, preempts the process, wins around and basically, we hated these guys for winning the deal and taking our full summer. So, when I moved in across the hall from him at Stanford, I immediately texted the MD on the deal. And so, you’re not going to believe-
Scott:	And you’re like, “This was the market clearing price we should have been at.”
Don:	Exactly, we missed it by two turns, so whether it’s winners curse or not, time will tell, but that was how my relationship started with Nick, and we bonded over finance and investing. But what I quickly learned, or what we both quickly learned is that there’s a lot more that bonded us beyond an interest in finance. It was a shared interest in entrepreneurship. So, Nick was tinkering on a couple marketplace, vertical labor marketplace ideas. I was actually looking at the Amazon FBA roll-up space. This was pre, the first few winnings of the days. And I was looking at ways to apply my finance skillset to entrepreneurship and FBA aggregator market is one low hanging fruit. That was kind of the first taste of entrepreneurship. Being at Stanford is really an infectious entrepreneurial environment, like no other. Coming from the east coast, working consulting or investment banking and private equity. It’s really just a night and day life changing experience to be surrounded by all these incredible entrepreneurs and operators. So, for me, the idea of taking my skillset and my passion for finance and applying it in an entrepreneurial setting is what got me out of bed in the morning. And when I started working on Arc and we can talk about how the idea came to fruition, but we first started working on Arc, I decided that this is going to be the path for me, go back into private equity or work in entrepreneurship, decided to take the leap and ultimately never look back.
Scott:	Don’t you think it’s kind of freeing in that moment where you’re like… Its like a relief and then you realize you’ve got a lot of work to do, but it’s like that… I remember when I joined Vanessa at Kruze almost seven years ago as a third person and I was like, “I’m doing this.” And it was a really great feeling. And then life kind of clarifies, you become very focused, you know exactly what you need. Don’t know exactly what you need to do. You know you have to solve a lot of problems and there’s going to be more problems and things to come. But if you’re a problem-solving kind of person, it’s an incredible experience. So, I’m really happy for you, you found this, and that you made that clear decision, like you were going to do this.
Don:	Yeah, definitely. It really started with just talking to hundreds of software founders in and around the Stanford community throughout Palo Alto. The timing, I mean, it’s the peak of the global health pandemic. So, classes went fully virtual. Classrooms were literally boarded up. I was ultimately locked down in my house, my student housing with Nick and a few other Stanford students taking virtual classes with no travel, and really nothing else to do besides work on Arc. And so, we would dial in our classes in the morning and work on Arc throughout the entire day and all night talking to Stanford alumni and founders in and around the Bay Area. And it was really from understanding their major pain points as it pertains to capitalizing their business, that the idea for Arc was born out of.
Scott:	It’s kind of like dog years. Those COVID locked up and not being able to do anything thing. For every one month of that, you got seven months of progress on your startup. That’s really cool. And so, your epiphany talking to these founders who are running software companies was, “Hey, there’s a better way to finance your startup company.” Right? Your SaaS company.
Don:	So, bridging the experience in New York with the conversations in Palo Alto and Menlo Park. The idea is, working in investment banking and private equity, Nick and I, we raised billions of dollars of capital to finance large multi-billion-dollar transactions. And we saw how the processes at the late stage are extraordinarily slow and cumbersome manual offline. There’s literally armies of investment bankers and credit analysts who plug in to understand in a very backwards looking manner, the fundamentals of a business. And moving to Palo Alto, and then ultimately to Menlo Park and meeting with all of these early stage founders, we saw two things, one non-dilutive capital, just wasn’t available to these founders. They either didn’t know it existed or they didn’t have access to it. And so, they thought that venture capital and selling an ownership stake in their business was the only way to fund their growth. So that was one, and then two, like on Wall Street, New York where venture debt did exist, or when traditional sources of non-dilutive capital did exist, it was fully analog, offline manual processes that take months and are very distracting to management teams that simply don’t have the time to invest in raising that type of non-US capital.
Scott:	I have a couple comments on that. The first one about how venture capital seems like the only way to do it. I mean, there’s a reason why Sand Hill road is located about half a mile away from Stanford’s campus, right? That and Berkeley… I went to Berkeley, but those two universities and probably more Stanford in the last 20, 30 years have really fed the entrepreneurship and the VC industry. So, it paid for venture capitalists to be close. And it becomes like this self-reinforcing thing where, maybe someone a year or two ahead of you at Stanford Business School took venture capital, and that’s someone you know. And so, it seems like the normalized approach on how to do things. So, you’re totally right about that. In debt, you know this, for the audience, I used to work in debt, I was a partner at a venture lending fund. I know all about it. And it’s just a lower profile thing. And in the style of venture debt, which we’ll talk about later, is more of a follower tool. It’s a tool that follows the VCs, and so the venture debt folks are not going to be out in front that much either. And so, I think it’s really interesting that… I bet you, if you pulled your classmates at GSB, you’re probably right. 70% of them didn’t even know there was… Or 80% didn’t even know there was a debt component to venture capital and that it was even possible.
Don:	NVC is the largest distribution arm for venture debt. And they have proprietary relationships for introductions are made to portfolio companies, they follow on with the same VCs. The reality is, when I think of finance, I think of fundamental valuation and investing and analysis of cashflow. And that’s exactly what we’re doing, and we’re doing it faster and better with technology. So rather than following on to a venture capital investment, we can look at the fundamentals of a business. We can look at trailing historical cashflow, how it’s trended over time, relative to gross margin, to revenue, to month over month growth. And that to net revenue retention, logo churn. We can look at these metrics in a fully automated manner and come to programmatic funding decisions and deliver that capital to startups through consumerized enterprise technology experience, that founders have come to expect in every other aspect of their business. So, I think there’s really two disruptive components to this product. One is the financial product itself, which is converting future revenue to upfront capital. And the other is delivering it in a seamless consumerized enterprise technology experience.
Scott:	I love it. I love it. And you’re making it… On that second point, the consumerized experience that everyone wants to have, like the Facebook, Google experience, but you’re bringing it to a world that’s pretty slow, and you used the word analog earlier, which I would totally agree with, very analog… When I was in venture debt, I would do a phone call, do a meeting, write something up, go back to our partnership, very qualitative underwriting. We would definitely look at the financials and cared about the financials. But a lot of it was like, “Where’s this company going? What’s our vibe? Does the management team know what they’re doing? Who’s a syndicate?” All that kind of stuff. And in fairness back then there wasn’t as much data, and it wasn’t as easily accessible as it is now. So, I think that’s also… You’re kind of in the… Kudos to you and your team. You guys recognize right place, right time, this stuff is available, why aren’t people using it?
Don:	Definitely.
Scott:	But it’s really powerful. And to make it a friendly, easier process so that the founders don’t get totally distracted and have to take a week off just to do all the meetings and all this kind of stuff. Like that’s actually pretty valuable for them too.
Don:	Oh, absolutely. And the goal is to make it as frictionless as possible. So, it’s not structured as debt. We are not a lender, right? We’re advancing a company’s future revenue, pulling it forward to times years, they can use it to inject in the business today to accelerate growth or extend the runway ahead of their future funding round, so that we don’t have the same covenants and leans on assets as a traditional lender would take.
Scott:	I was going to ask that. So, when you’re doing, maybe kind of walk through some of the details on the proc… One thing’s very clear when you’re on the Arc website is, it’s focused on SaaS, software companies. The same companies that you interviewed to come up with the idea. That sounds like a conscious choice. And then what are some of the… Is it for C stage companies? Is it pre-investment? Is it for series A or does the VC round even matter because you’re not really paying attention to the equity capitalization anyways.
Don:	Yeah. So, the one real eligibility criteria for our core product today is that you’re revenue generating. So, we’re purchasing the future revenue and we’re pulling that forward and giving it to companies today, to invest in the business, to invest in growth without dilution, without debt. So that’s really what we look for. Now, when a company onboards Arc, they get two things. First, they integrate their backend of their financial stack, the backend. So, I think banking, billing, accounting, API integration, sometimes additional data can be integrated to make a more educated underwriting decision. We take that data and we run it through our fully automated underwriting model. So instantaneously we’re producing a preliminary Arc score.
Scott:	Wow. That’s cool. That’s super cool.
Don:	It’s a fully automated process. We use machine learning, data enrichment to strip out financing from operating cash inflows and outflows from the banking transaction data. So, we look at 24 months of banking data, we pull out financing charges, inflows, capital injections from equity or debt investors, interest payments. And we get a true sense of net cash burn for the operating cash flows business. So, using that versus cash on balance sheet net of other debt obligations, we can get a sense of the true runway of the company. And that gives us a comfort around, will this company be around in 12 months to ultimately earn the revenue that we’re purchasing? Will it be a viable entity in 12 months-time? That’s a check in the box that determines sizing of the ultimate Arc advance. The next component is what we’re calling the Arc score. It’s analogous to a FICO score for a consumer. In that, we have about 40 metrics that we benchmark a given company against. We look at gross margin, month over month revenue growth. We’ll look at net cash burn and how that’s trending versus top line growth. We’ll look at net revenue retention and customer level concentration. I’ve built one of this underwriting model myself. And then we have a world class engineering team who automated the process and built it into our technology. So, we’ll produce this Arc score in a very automated manner. We’ll convene our underwriting committee to the extent to large check size. So, our average check is getting close to a million dollars and we’ll do a quick sanity check with our underwriting committee. And then within two business days, we make the capital available to a startup.
Scott:	Wow, so it’s up to a million dollars. That’s a big check. And it sounds like, you’re highly focused on that 12-month timeline because you’re essentially pulling their revenue forward. And so that’s basically length of the financing agreement, right? 12 months?
Don:	Yeah. So, we’ll do anything from 6 to 12 plus months. The more runway a company has, the more capital will be available to them, and the higher Arc score they’re going to earn. So, for some of our repeat customers that are in the six-month runway range, they’re backed by, the Sequoias and Tigers and a16zs of the world. They’re looking for some additional capital injection ahead of their next equity round. So, they can extend the runway. They’re getting term sheets thrown at them every day, right? A lot of these B2B SaaS companies, in today’s fundraising environment, they could raise double digit millions tomorrow. The reality is by working with Arc, they get an extra one, two, three months of cushion. They’re burning a million bucks a month. They get another three months by funding with Arc, a million dollars per month over the quarter. Their revenue is 50% higher by the time they do that equity [inaudible]. Reading their 50% higher valuation, they’re preserving more ownership for existing shareholders and the founders of the business and [inaudible] for everyone.
Scott:	That makes so much sense, and I like how you’re doing three months of runway extension or some shorthand for that, because that way, Arc isn’t completely financing the company forever because then the equity investors are out of the picture or whatever. You’re keeping everyone, the founders, the equity investors and Arc all aligned and keeping everyone’s attention on the company.
Don:	Definitely.
Scott:	It’s not a free lunch kind of thing.
Don:	Absolutely.
Scott:	That’s really cool. And you’re right. The VCs in the Kruze portfolio, like the client portfolio, there’s a lot of velocity in revenue growth and the market. This is the most aggressive, I’ve seen the financing market in a long time in probably 20 years. So you’re right, companies are getting term sheets thrown at them constantly, but waiting those extra three months can have a material benefit, as long as they’re heading milestones and continue the growth on their valuation. It’s pretty exciting.
Don:	Exactly. And we can make that determination algorithmically by looking at their historical and projected revenue growth, by looking at invoices that they have, new bookings. We can determine that in three months-time, this company will be able to raise at a 20, 30, 50% higher valuation and I’ll result in X million dollars of savings for existing shareholders [inaudible] business.
Scott:	Yeah, that’s cool. At Lighthouse, one time I did an experiment where I try to quantify the amount of dilution companies were saving by doing data and… But again, the market was not as frothy as it is now. And I think, a lot of companies weren’t growing, I mean, the reason why the market’s kind of frothy in venture capital is, companies seem to be growing kind of at an all-time high speed. I think it’s the interconnectedness. I think, the world’s adopted SaaS. People understand it. It solves a lot of problems. And because those metrics are a little bit easier to access, it’s easier for everyone to appreciate, “Hey, this company right now is on a trend to be an IPO company in two or three years,” really truly. And so, people can get behind them a little bit easier. That’s really amazing. Hey, it’s Scott Orn, and we’re going to take a quick break from the podcast to give a shout out to the Kruze tax team. Gosh, it’s so nice to have an in-house tax team, I can’t even tell you. We have some really amazing professionals on team. I think it’s 13 people now, and we do everything from your federal state income tax return, state franchise tax filings, R&D tax credits, those are pretty popular these days. And guess what? They’re there for you when you go through diligence. A lot of people don’t know this, but you actually go through tax diligence, not just operational kind of financial diligence, but you do go through tax diligence. So, it’s nice to have Vanessa Kruze on the phone with your VCs in with the accounting firm they hire to diligence all your stuff, and the law firm, they hire to diligence on your stuff. Vanessa knows what she’s doing. She’s done this a million times. And it’s not just Vanessa, we have a really great team of tax professionals that will do those calls too. It’s sometimes the difference between getting around close or having it take another two weeks because something was disorganized and the tax compliance wasn’t done correctly. We hear those horror stories from clients that come to us. So, hey, if you want Kruze’s tax team on your side, we’re here for you. Check us out at kruzeconsulting.com, thanks. Now, in terms of the… You talked about some of the security aspects, liens and things like that, how does the company think about like, “Okay, I am making this promise to Arc. How do you collateralize it or what’s it backed by?
Don:	Yeah. So, we’re purchasing unscheduled future receivables of a software company. So, whereas some of the more traditional lenders will do receivables factoring or collateralize assets on balance sheet. What we’re effectively doing is we’re purchasing future unscheduled receivables, and we’re pulling forward that future revenue stream that we can project out based on our underwriting model, and we’ll give companies that capital today and we’ll take some nominal haircut off the top, that’s our take rate. The company will repay us on a monthly basis, straight line over the 12 months, they would’ve realized that revenue. So, to give you a quick example, a company B2B SaaS company, with a million dollars of financeable, ARR, they have a 95 Arc score, that implies a 5% take rate, and it’s priced algorithmically.
Scott:	Oh, that’s how [inaudible] rate works too. Yeah. Okay. Interesting.
Don:	So, we’ll give them up to $950,000 at times zero, they inject that in the business, accelerate their growth and pay us back $82,000 a month over 12 months, which is the full one million of revenue we purchased.
Scott:	That’s amazing. You said something that really caught my attention, which I love, which is the unscheduled invoices, right? That’s important to talk about because it actually opens the door for a lot of companies that think about receivable factoring in a very traditional way. Like I provide a service, I send an invoice and I can take that invoice and factor it often at a pretty high cost of capital. And so, what you’re saying is… But a company like Kruze, for example, we have a 30-day cancellation, like on purpose, because we want our clients to be happy and can move on when they outgrow us. And so, we don’t have a 12-month contract to factor or finance, right? We have unscheduled invoices, like that’s the rest of two that we’re recording this in January, 2022. The rest 2022 is just unscheduled of invoices that will go out on the first of the month, whenever we’re supposed to get paid, that kind of thing. And so, you’re opening the market. I think this is really big. You’re actually making this available to companies that have high retention and know they’re going to have their customer base, but haven’t actually sent that piece of paper to the client, commemorating that they owe them money. Does that make sense?
Don:	At Arc, finance is in our DNA. We went to market very intentionally, lending off of our balance sheet, spitting up a large credit facility and owning a relationship end to end. We want to own the customer relationship. We want to understand your business inside and out so we can get comfortable not doing traditional receivables factoring, but literally pulling forward future receivables that aren’t necessarily scheduled yet and advancing that capital today because we believe in you, we believe in your future growth, we believe that your business will be successful and we want to back you, we want to do that without dilution
Scott:	And you can do it quickly because it’s automated and you understand the market you’re lending into the SaaS software market. So, I like that. I mean, obviously I liked it because I wrote a very small check. But to me, the eye opener is, there’s a lot of people out there who want to finance receivables. That’s from the time banks were invented, that’s what banks like to do. And so, to me, you’re using your technology and industry expertise to unlock a different financing vehicle for people who don’t have receivables, but have the same traits, like the same consistent customers, they know what they’re going to pay, all that kind of stuff. So that’s what’s so cool about.
Don:	And it’s really the technology. It’s the increasing data accessibility that unlocks the opportunity for us. It’s the ability to layer in, machine learning data enrichment by pairing that with readily available cash flow data and making it a very educated, fundamentally driven underwriting decision. That’s how we get comfort. And that’s what we’re doing at scale.
Scott:	I also like that you’re doing the quick little credit committee check-in for two reasons. A, it’s smart risk mitigation and that kind of stuff. But also, it’s like a teaching tool to the algorithm to the tech team, cause you’re still in the early days. So, there might be some like, “Hey, wait a second. This is an edge case. The tech algorithm doesn’t quite understand this kind of company yet, but here we have a lending expert who can actually teach the algorithm or teach the engineers are going to tweak the algorithm.” So that’s good product development to me too. I think that’s pretty.
Don:	Yeah. And that’s exactly right. Ideally years from now, when we fully trained the algorithm, it can operate in its own without any human oversight. Today, we’re being a little bit more cautious and we’re adding best in class underwriting talent from Wall Street, where we have people coming from principles at private equity funds to a multi-billion-dollar fintechs who have underwritten tens of thousands of software companies. They’re coming together and training our model, and we’re continuing to iterate on that and build that out and make sure that we have the best possible automated technology and best model that’s been back tested with a human touch.
Scott:	That’s really cool. I got to be respectful of your time, so we’re going to wrap up here in a second, but you talked about kind of owning the customer and providing the customer other services and just being there for those SaaS companies. You can maybe tease some of the stuff you’re working on. I don’t want you to spill the beans. So, I don’t want your PR person getting mad at me here. If there’s other cool stuff coming down the horizon from Arc, maybe share that with the company a little bit or share that with the audience.
Don:	Absolutely. So, we’ve now met with hundreds of software founders since we started Arc. And what we learned is that there is demand in the market for a one stop shop, full service finance solution for the SaaS, purpose built for the SaaS founder. So, Arc will be the full-service solution where founders can borrow, spend and save all in one place. And by verticalizing, focusing specifically on the SaaS founder, we can derive specific insights around burn, retention, growth and help founders preserve capital and grow efficiently and build this ecosystem around them. So, I’ll spare you the specifics so PR doesn’t get upset. So, we have a really exciting roadmap ahead and excited to share the vision with you.
Scott:	I’m excited. I can’t wait. Kudos to you and your partner for the guy in the dorm across the hall, who you were secretly tracking all these years and I’m excited for the team and I’ve seen some of the technical hires. One of them came from one of our other partners, that I know very, very well and very, very highly thought of person there. So, I’m excited to see what you guys build. And again, I think that unscheduled invoice financing is really, really powerful and kudos to you for just recognizing the opportunity and then again, taking the leap and committing to it. So maybe tell everyone where they can reach out, how to get hold of Arc, how to get a hold of you. If they want to be a partner, if they want to try out the service.
Don:	Definitely. So, check out our website, arc.tech. You can onboard in literally sub five minutes on average, and we can turn around funding terms in 48 hours. Definitely add us on LinkedIn Arc Technologies and follow us on Twitter at join Arc.
Scott:	Awesome. Don, thank you so much. Give my best of the team. Thanks for coming by. Appreciate it.
Don:	Will do. Thanks for having me. Great to see you. Have a good one.
Scott:	Bye buddy.
Don:	Bye
Singer:	(Singing) So when your troubles are mountain in tax or accounting, you go to Kruze, Founders & Friends. It’s Kruze Consulting, Founders & Friends with your host, Scotty Orn.

Don Muir of Arc talks about how Arc improved the venture debt underwriting process

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