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With Scott Orn

A Startup Podcast by Kruze Consulting

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Scott Orn

Scott Orn, CFA

Minimally dilutive debt for capital-efficient companies with Eric Gonzales of Montage Capital

Posted on: 08/17/2020

Eric Gonzales

Eric Gonzales

Managing Director - Montage Capital

Eric Gonzales of Montage Capital - Podcast Summary

Eric Gonzales of Montage Capital on offering minimally dilutive loans for capital-efficient companies. Montage allows early stakeholders to maintain control and ownership while obtaining capital for growth.

Eric Gonzales of Montage Capital - Podcast Transcript

Scott: Hey, it’s Scott Orn of Kruze Consulting and welcome to another episode of Founders and Friends. And before we start the podcast, let’s give a quick shout out to [Rippling 00:00:09]. Rippling is the new cool payroll tool that we see a lot of startups using. Rippling is great for your traditional HR and payroll. They integrate very nicely, but guess what? They did another thing. They integrate into your IT infrastructure. They make it really easy for when you hire someone to spin up all the web services and their computer, which sounds like not a huge deal, but actually we did the study at Kruze. We spend $420 on average just getting a new employee’s computer up and running and their web servers up and running. It’s actually a really big deal, saves a lot of money and the dogs [inaudible 00:00:43]. We see a lot of startups coming in to Kruze now using Rippling. So please check out Rippling, great service. We love it. I think we have a podcast of Parker Conrad. You can hear from his own words, but we’re seeing them take market share. So, shout out to Rippling and now to another awesome podcast at Kruze Consulting’s Founders and Friends. Thanks.
Singer: (singing). Founders and Friends with your host, [Scottie] Orn.
Scott: Welcome to Founders and Fiends podcast with Scott Orn at Kruze Consulting. And today, my very special guest is Eric Gonzales of Montage Capital. Welcome, Eric.
Eric: Thanks, Scott. Really appreciate being here.
Scott: Oh, my pleasure. We are talking about one of my favorite topics, which is venture debt and you are an expert and I can’t wait to have this conversation.
Eric: Awesome. I’m looking forward to it as well.
Scott: Awesome. Well, maybe you can tell everyone, just retrace your career a little bit, and then how you had the idea to start or join Montage Capital.
Eric: Sure. Happy to. So, I actually didn’t start Montage, but I did join nine years ago in 2011. So, retracing my career a little bit, probably the most relevant part of my business career was my investment experience at DCM, an early stage venture firm where I was there for six years, much of that time as either a partner or a general partner. And that’s really where I saw this opportunity that we’re pursuing with Montage, which is really to provide a less diluted, less expensive path for growth capital for entrepreneurs. One of the things I experienced on the venture side was that venture investors end up with a lot of ownership in companies when they make investments, especially in the early stage. And it almost seemed a little bit like a raw deal to the entrepreneur in many cases. And so that was part of at least my coming to terms with Montage and the concept of what we’re doing. My business partner, Mike Rose, though comes at this from a very strong credit and banking background. So, the two of us joined up in 2011 to essentially raise the second Montage fund together. And we bring the equity investing skills that I had, also some entrepreneurship experience and skills that I had, and Mike’s really strong credit and banking background. And together, we come at this in a fairly unique way. One more thing I’ll say on the introduction is that we actually don’t consider ourselves venture debt because we’re typically not following venture capital investments concurrently. We instead position Montage as an alternative to equity financing for growing companies. So, it’s really how we most distinguish ourselves.
Scott: That’s such a great subtlety there, and I’m glad you clarified that. And you guys have a really good reputation and a great brand and people are… I think your brand in the market is one of creativity and trying to make it put together a deal. Whereas the comparing… You know how we just said, you’re not a venture lender. The venture lending funds go by the book. They’re following the equity lead. They have a certain percentage they like to do relative to the equity investment. And you’re either putting a MAC clause and it’s cheap or no MAC clause and it’s expensive. You guys are very creative, almost like equity investors. You’re just using a debt instrument. And like you said, there’s a lot of founders who actually really like that. It really appeals to people.
Eric: Yeah, you’re absolutely right. And a lot of the bigger venture debt firms we actually partner with; WTI, Hercules, TriplePoint. We actually share a lot of deal flow with them because we don’t directly compete. We have a lot of respect for all those firms, but they are in a very different business. They’re managing much bigger pools of capital. Really to get that much capital to work, they have to have a relatively straightforward approach to how they do their deals. We’re just much smaller. And as a result, we’re able to customize every single financing for a company. So literally every time we consummate a transaction and investment in a company, it is not the same as any of the other investments we’ve done prior.
Scott: Yeah. That’s awesome. And there’s something you said in the intro, which is when you were at DCM, you would see the portfolio of your deals and DCM, and not to pick on DCM, all venture capital funds would own a lot of those companies, and that works really well for the high flyers, but it’s the billion dollar outcomes, but for the folks in the middle, it’s not great because that’s expensive money and they’re forced to raise more money maybe than they want to. And so, I think it’s really smart that you come in and you’re looking for a certain kind of company out of those VC portfolios.
Eric: Yeah, exactly. That’s exactly right. And that’s why so many of the companies we invest in are actually not venture funded. They’re more or less bootstrapped. They could often raise venture capital or private equity, but they’re looking for a different path and what we feel like we do… Again, we have a very entrepreneur friendly approach. We put the power back in the hands of the entrepreneur. We’re letting them control their own destiny. Oftentimes when a company takes on a lot of equity financing, whether it’s venture capital or otherwise, it really becomes a relatively binary outcome. Either they’re going to hit it out of the park and be hugely successful, or as you pointed out, a lot of companies aren’t that successful and they may have ramped up their burn rates considerably. And that becomes really hard to unravel. We feel like when companies choose to work with us, they have a lot more control over their ultimate outcome. And since a lot of entrepreneurs aren’t necessarily interested in developing or building a billion-dollar company, we’re often a really good fit for companies that have more realistic and potentially more modest expectations.
Scott: That’s so well said. Yeah. Because when you take a lot of venture capital, you spend the money. It’s just human nature. And the equity preferences effectively work like debt, like the same debt you’re giving entrepreneurs. But I think when they’re, especially for bootstrap companies, they’re still paying close attention to their burn rate because that’s the inherent kind of DNA of a bootstrap company.
Eric: Right.
Scott: And they know the money needs to be paid back intuitively. So, they’re just more careful, but you do give them the capital they need to invest in things like marketing or development or engineering teams to help them get to the next level.
Eric: Absolutely. That all being said too, we really try to be helpful in every conversation we have with entrepreneurs that we talk to. And there are many cases where we will direct them to venture capital. Venture capital makes a lot more sense than working with someone like Montage when you are really going for it. When you really…
Scott: Yeah.
Eric: …when you have a concept that’s taking advantage of a humongous opportunity, we’re such a small firm and what we can do to help a rapid grower achieve its growth objectives. It’s just not even close to what a VC firm can do. So, we do actually refer a lot of entrepreneurs to venture capital firms when it’s appropriate. And again, we have that skill set, that expertise to really be helpful to literally any entrepreneur that comes to talk to us.
Scott: I love it. And you’re probably like me where you feel… I always feel like if I’m doing the right thing for the client or customer, kind of comes back to you in a certain way.
Eric: Absolutely right. Yep. That’s a core philosophy of ours is we figure if we just treat others right, eventually they’ll remember that and hopefully someday they’ll want to work with us, even if it’s not right now.
Scott: Yeah. It might be their next company.
Eric: Exactly.
Scott: And just talking about your target client, it sounds like half of them are bootstrapped and half of them are VC backed?
Eric: That’s about right. Yeah. About half we’re the first institutional investor in the company. Typical profile is at least 3 million in annualized revenue. I would say on average, though, the companies we’re investing in have about 10 million of annualized revenue. So, they’re often fairly far along and they’ve either self-funded or angel funded themselves to that level. And they feel like, in many cases, things are really going in the right direction. So, giving up a huge chunk of equity at that point becomes relatively unattractive. So, we are positioned very well for those opportunities.
Scott: You also said something earlier, it’s not just giving up the equity, but being able to control your own destiny.
Eric: Absolutely.
Scott: It’s like giving [inaudible 00:09:32], giving up not having a boss. We all have bosses, but when you give up that board seat, that becomes your boss. I think that’s a really appealing aspect of Montage.
Eric: Yeah. And it is the case. We don’t take board seats. We do try to be very entrepreneur friendly, very collaborative and positive in our interactions with the company. But that being said, as a lender, we do on occasion have to be a lot tougher with the company to ensure that they are on the right track. And so, when push comes to shove and this doesn’t happen too often, fortunately, but we know how to take care of our investors and protect their capital as well. So, it’s not the case. I certainly don’t want to mislead anyone to think that, “Oh, it’s all roses working with a lender,” because as you know, sometimes things aren’t on track and you have to do what you have to do to protect the investors. But that all being said, I would say that when we do have to step in and take more strict action with the company, call a loan default and such if necessary, we try to do so in the most professional way possible and often in full collaboration with the management team so that there’s no surprises for them. We really try to avoid blindsiding the team and instead work very collaboratively with them, even if it’s a tough conversation.
Scott: Yeah. And that’s going to happen if the company takes venture capital, if they take venture debt or your flavor of debt. So that’s not, it’s more like if they’re not taking care of business and [inaudible] going the right way, then anyone’s going to have to step in who put money in the company. But I think the positive, the good scenario where the company is doing well and it doesn’t need to change, it doesn’t want to change a whole lot. Just wants to actually invest more and things like that. Then that seems like the place where you guys really shine.
Eric: That’s absolutely right. I mean, we’re really there to support the existing team and the existing growth trajectory and execution plan as a company. We’re not there to really inform the company how they should maneuver going forward. I mean, we are advisors to the company and at their disposal to the extent that they want to use us, but we don’t impose ourselves on them. So, we’re really, it’s interesting. Some companies like to have weekly calls with us, others, we check in on every quarter. So, it really just depends on how experienced the team is, how well things are going and how much they feel like they need the help from us. And we’re at their disposal.
Scott: Yeah. The weekly calls. That’s a lot of meeting overhead.
Eric: Yeah. Luckily, there’s a balance. I mean, there’s only a handful that are like that. And often what will happen is we’ll do that for a while and they’ll get more and more comfortable and then move away from that as they realize they don’t need to do that as often. So yeah. So, it all works out and we’re very mindful of our bandwidth and making sure that the model scales.
Scott: Yeah. That’s awesome. Well maybe you can give the folks a flavor for your typical structure and ballpark pricing and things like that. So, they can visualize what this instrument looks like.
Eric: Absolutely. Yeah. So, one of the things that… We try to be very transparent in all of our discussions with entrepreneurs. And so, we’re very upfront about the fact that this capital is not inexpensive. Certainly, if a company has bank debt at its disposal and it’s roughly the amount that they’re talking to us about, we really advise them to go with a bank because we’re going to be so much more expensive than a bank. Our approach is really a hybrid of debt and equity. So, it’s a term loan structure on the debt side with an average interest rate of about 12%. I would say the range is 10 to 14. So, that’s fairly standard for a venture debt like structure. Where it’s not so standard compared to venture debt is more on the equity side because we’re really comparing Montage to an equity financing. So, we’re always mindful of how we are positioned relative to potential equity dilution. So as opposed to looking at work coverage metrics, we look at how dilutive is our warrant position relative to an all equity financing. And so just to boil it down, we usually end up with low single digit fully diluted ownership percentages, which tend to be much higher equity positions than the typical venture debt structure. But again, we think it makes a lot of sense because it’s often the case that there are relatively few debt alternatives when we’re talking to a company. Usually the primary alternative is equity. So, it’s always going to be a lot less dilutive than equity. Moreover, the way that we work with companies, and this is a really important point, we really view Montage, it’s not a single transaction, it’s not a single loan that we’re making to a company. It’s a long-term strategic relationship and partnership that we’re forging with our companies, or trying to with all of them. So, in many cases, our best performing portfolio companies actually come back to us for more growth capital, what we call growth debt over time. So, in fact, I’m currently working with a company that’s doing extremely well, that’s had multiple overtures to raise equity, venture capital, even take on bank debt, and they’re about to do their fifth financing with us.
Scott: Wow.
Eric: And so, it’s interesting. So, I mean we do have a number of companies that are like that, that continue to believe that this is their best capital option. And I think a lot of that, it’s not just because of the structure, but it’s because of how we work with the companies, how we collaborate with them. We advise them on strategic items, like capital formation, exit planning, various aspects of their business and whether or not they should grow faster or slower. And we have that experience to provide that advice as well as the bandwidth. And that’s another key point.
Scott: Anyone doing the back of the envelope on the equity dilution, a venture capital round is like usually 20%.
Eric: Correct.
Scott: But maybe if it was a small one, 10% or something like that, so that’s a pretty big delta on what you guys are offering…
Eric: Exactly.
Scott: …versus what a VC fund is going to do.
Eric: That’s right. A very typical scenario will be something like we’re proposing say 2 million in growth debt to a capital efficient business where that’s really all they really need. And their alternative that they’re considering is a 10 million or more venture capital financing, which is very tempting, but they’re struggling with how do I utilize all this capital that’s at my disposal and so it becomes a very interesting decision tree for them because, and that’s why we get to so much lower, fully diluted ownership position because often we’re presenting the company with a term sheet where it’s the actual amount of capital of their business needs, as opposed to what, in many cases, is a situation where VC funds, a lot of them, have minimal minimums that they have to conform to, to even look at a company. And for many of them it’s 10 million or more. And so that’s why that scenario comes up so frequently.
Scott: The other unsaid aspect of that $10 million VC term sheet is it’s probably 20% ownership, which means that it’s a $50 million valuation and you can’t sell the company for less than 100, 150 minimum, you know? And so, I think one of the other things you guys do is really free the entrepreneurs up to take an exit opportunity that’s maybe not what a VC would love, but it’s going to be a win win for everyone around the table, including you.
Eric: That’s exactly right. And in that scenario where a company is considering taking a large slug of equity financing that they may not need, what ends up happening in many cases is they are encouraged to ramp up the burn very rapidly, bring on a lot of head count. And if things end up not going so well, this is where this binary outcome comes about, where it can be a real problem for the company and frankly, really threaten the company’s viability. And so, we feel like often we’re a very good alternative to that scenario where the company isn’t quite sure they need all that capital.
Scott: Yeah. That’s a really nice offer and the other side of the equation for you guys is making sure your investors are happy and people don’t always understand this, but at [Lighthouse 00:00:18:32], where I worked, we have the same thing, which was institutions and high net worth individuals invest in the fund. And they’re getting a return that it’s higher than a normal debt fund or debt in general and maybe, but a little less risky.
Eric: Correct. Exactly. Yeah. Yeah. Our investor base, there’s about 150 investors, mostly high net worth individuals, some small institutions, some family offices. They’re very supportive of us. We actually distribute income every quarter.
Scott: Wow.
Eric: So, they love that. And so, they’re used to getting regular distributions. In fact, we’ve distributed every quarter since the second quarter of this current fund.
Scott: That’s huge.
Eric: And so, yeah, it’s really a situation of income generation that’s pretty steady and nice with the fairly frequent equity upside that comes about when we realize equity exits in the portfolio. And we currently have in our main fund 50 or so unencumbered equity positions whereby we’ve already been paid off on the loan and there’s absolutely no risk. And so, there’s only upside that remains in those equity positions. So, it’s a really nice situation to be in with a fund like this.
Scott: Yeah. Do you guys recycle capital or how do you… For folks who don’t know, for lending funds, you can either recycle a capital like redeploy it after you’ve been paid back or sometimes they take a debt note on top of, or basically leverage on top of the fund value. How do you guys do that?
Eric: That’s a good question. We’re unleveraged funds. So, no leverage at all. We do recycle the capital. And in fact, beyond that, we’re an evergreen fund structure. So, we’re not a traditional 10-year life fund where we make a bunch of investments and then return capital after 10 years. Instead, we allow… Believe it or not, we allow our investors to withdraw in any given quarter.
Scott: Wow, really?
Eric: Investors love this because…
Scott: That’s crazy.
Eric: It sounds absolutely crazy. I agree. Most people that we talked to about this…
Scott: [crosstalk 00:20:48], I mean crazy good for the investors.
Eric: Well, yeah. I mean…
Scott: [crosstalk] little harder though.
Eric: Yeah. For an investor, it’s a great situation. They feel very comfortable and in a lot of cases where it’s someone who’s not so familiar with what we do, it helps them get comfortable that at least they can get out when they need to. But we’ve been very fortunate. We have very few withdrawals. In fact, there’s way more demand to come into the fund than there is to exit.
Scott: Wow.
Eric: And so much so that we actually closed the fund to new investment capital in Q4 of last year, which ended up being very fortuitous, given that we then experienced this current crisis.
Scott: Yeah.
Eric: So, we’re very fortunate and yes, it’s an unusual model, but it really works well because it gives us a lot of flexibility. So, when we do reopen the fund for new investment capital, we have a lot of pent up demand from our existing investors, as well as new ones to provide additional capital. And it’s relatively straightforward for us to do so. So, we basically revalue the portfolio every quarter to fair value.
Scott: That’s cool. Well, it’s also, I feel like the COVID situation recession may end up… You may actually see a lot of opportunities now because companies took a bump, but they still have really great fundamentals. It might open up that opportunity for you.
Eric: It is. Yeah, for sure. We’re having a lot of great discussions right now. We’re very much talking to a lot of companies that are looking to put money to work. And fortunately, because of our capital efficient approach with our companies, our portfolio is in very good shape overall. While initially we had to spend a lot of time making sure everyone was okay, the PPP loan program really helped a lot of the companies. And so now they’re getting used to the new reality and our focus is primarily back to putting money to work in new investment opportunities. And you’re absolutely right. So, what’s happening currently is in the current crisis with equity being relatively unattractive to raise right now, we’re actually having more than our usual number of conversations with venture backed companies. So, a lot of venture backed companies that have been considering raising their next round of equity are really seriously considering an alternative like us at this point. And so, it’s really interesting.
Scott: That’s awesome. It’s a little bit of, it’s nice to be the person at the party who has the deep pockets and cash to spend. So good for you guys. I’m really amazed that you’re able to balance that, “Hey, if you want to withdraw, you can withdraw.” I helped run a debt fund. That’s a really hard thing to manage.
Eric: It is. It was daunting at first. We were really concerned initially about how complicated it could be, but we’ve actually gotten so used to on a quarterly basis, revaluing the fund and handling the one-off withdrawals that do occur that we’ve got it down now. I think it’s really, it’s a competitive advantage for us, honestly, because we’ve really developed an expertise on how to run a fund like this, that very few fund managers have. And we think it’s really better for our investors. Our investors overall are extremely happy with how things are going at Montage and they appreciate the way that we deal with them in a very transparent and open way.
Scott: Well, I was involved in a lot of those recycling capital spreadsheets at Lighthouse, and I remember everything. It is really hard.
Eric: Yeah.
Scott: I also think tip of the cap to you for not… It would be very easy to raise a really big fund and charge a 2% management fee. Obviously try your best to deploy the capital, but not worry about returns quite as much. And you guys seem to be doing the exact opposite of that.
Eric: Yeah. Yeah. It’s a really good point. I mean, one of the things that Mike and I were completely aligned with when we launched the second fund, the main fund now, is really trying to ensure that we maintain a high level of LPGP alignment so that we felt very strongly if we focused first and foremost on our investors and on our portfolio companies, then everything else will get taken care of. We will do just fine. It is easy to get sucked into the trap of just raising as much money as is thrown at you. And we certainly could be managing a lot more capital than we’re currently managing, but we think it’s even more important to stay true to our core beliefs that let’s remain focused on our investors and our portfolio companies and make sure that we don’t diminish the near-term financial returns to our investors by taking on too much capital too quickly. So, as you might imagine, what that does is because it’s unusual to behave this way, our investors want even more so to put more money to work with us.
Scott: Well, I love the model. I’ve known about you guys for a long time. It’s great to do the podcast. Maybe you can just remind, just do the quick, “Hey, this is our target. This is how we invest and how to reach us at Montage.”
Eric: Absolutely. Yeah. So, our target again is revenue generating capital efficient companies. Our main fund is currently $60 million in capital. So, our sweet spot average investment is about 2 million. We’re comfortable investing about a half a million to about 5 million per company because we do recycle the capital.
Scott: Yeah.
Eric: So, we’re looking for companies that are at least 3 million annualized revenue. There’s really no cap on that. We’ve invested in companies that are over a hundred million in revenue. On average, there are about 10 million of revenue. I would say, growing 20 to 40% a year, they certainly do not have to be cashflow positive nor profitable. Almost every company we invest in has a manageable burn. What’s really key for us though, is that the burn is being managed very carefully, such that with relatively minor adjustments looking ahead, the company can drive to cashflow positive if needed on our capital alone. What we’re not doing is bridging companies to the next equity raise.
Scott: The historical, yeah. That’s why you guys are so unique.
Eric: Exactly. Yeah. And so, what really makes us unique is our comfort in investing in companies without concurrent equity or even prior equity investments that really differentiates us from many debt funds. And then because of our small size, we’re focused on relatively small deal sizes that are frankly relatively uninteresting to the bigger debt funds. And that’s all the more reason why we share deal flow with the larger debt funds regularly, because again, they don’t see us as a direct competitor.
Scott: Yeah. I love it. It’s a great, it’s just a great strategy. You guys have a great reputation. I really recommend people work with you. And how do they get ahold of you? Just reach out to Montage Capital?
Eric: Yeah, so montagecapital.com is our website. There’s a bunch of information there. I’m certainly willing to hear from people on email. My email is on the website or I’ll just give it now. It’s EGonzales, E-G-O-N-Z-A-L-E-S@Montagecapital.com.
Scott: I love it.
Eric: I’m also on LinkedIn, of course.
Scott: Yeah. Eric, thank you so much for coming by. It’s a great story. Thanks for sharing the Montage Capital vision and how you guys execute it. Really appreciate it.
Eric: Yeah. It’s been a lot of fun, Scott. Thanks for having me.
Scott: Awesome. Thanks so much.

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