Before migrating to the West Coast, I spent two decades working in the debt capital markets on Wall Street. Debt is a funny creature, primarily because it is generally poorly understood, there’s math involved, and people tend to become interested it in it only in the face of a crisis (“wait – I owe how much?).

At present, I spend a lot of time as a professional unpacking the mysteries at the intersection of finance and technology, especially when debt enters the picture.

So it was with no small amount of interest that I began to digest the headlines about the seemingly overnight implosion of Zirtual – a turn of events that clearly surprised and startled employees, customers, and investors.

The bare facts, as reported, were that 400 unfortunate folks unexpectedly lost their jobs overnight, the company suspended operations to look for a buyer, and that two recent capital raises (one in June, the other in July) clearly didn’t offset the operating losses at Zirtual – or, as CEO Maren Kate explained on social media, the “burn”:

A failed tech start up is not news – but the “surprise” of a company that disappears so abruptly, when it was apparently healthy enough to last raise money just three week ago, certainly is.

“Burn is that tricky thing that isn’t discussed much in the Silicon Valley community because access to capital, in good times, seems so easy. Burn is the amount of money that goes out the door, over and above what comes in… And at the end of the day… “burn” is what happened to Zirtual.”

The trigger for the fevered commentary is understandable: it’s just plain difficult to understand how a company that raised roughly $3.3 million in June and July, with a run rate suggesting nearly $1 million in monthly revenue, had to shut its doors in August.

A failed tech start up is not news – but the “surprise” of a company that disappears so abruptly, when it was apparently healthy enough to last raise money just three week ago, certainly is.

First, let me offer a slightly contrarian narrative: should this really have been a surprise?

As a former bond guy, I would suggest that what happened to Zirtual wasn’t necessarily either abrupt, or arbitrary.

And while there are still an enormous number of unanswered questions surrounding Zirtual, for anyone trying to make sense of this story, as it turns out there’s some very good information out there.

It’s publicly available, too: the Form D documents filed by Zirtual and signed by the CEO, with the Securities and Exchange Commission on June 15 (here) and July21 (here) of this year.

Form D is an exemption to sell private securities to qualified institutional investors, meant to provide smaller issuers with access to debt capital without having to endure the encumbrances and expenses of marketing a fully registered security.

But here’s the thing: it must be filed after an entity sells securities. In other words, you don’t file the form until after you’ve actually raised money. Further, you specify the amount you raised on the form.

The trick with debt is that it must be paid back, and because of that, lenders tend to want to see cash flows.

And for anyone willing to take the time to look at the From D filings from Zirtual, it quickly becomes apparent that the key to the story isn’t how much money the company raised in these past few months – it’s how much it didn’t.

Consider:

On Zirtual’s Form D, filed on June 15, in section 13, titled “Offering and Sales Amounts” we see that the Total Offering Amount was $2.75 million and Total Amount Sold was $2,563,475.

The second Form D, filed on July 21, describes a $3 million debt offering. But the amount raised was only $650,000.

In other words, Zirtual wanted $5.75 million in June and July – but it only got $3.2 million – or just over half what it needed, in total.

Think about the implications of this for a moment: we know the company wanted $2.75 million in June, and got most of it.

But we also know that 35 days later, Zirtual had been looking for another $3 million, and only got $650,000. That is a meaningful shortfall, an 80% difference between the money they needed and the money they got.

To put it another way, Zirtual’s filings show a company seeking a lot of money over a compressed timeframe, and not getting it – in one case, by a very large margin.

For any investor presented with this fact set (and for investors, and anyone else, it was right in the forms), I’d have to argue that while the company suspending operations in August would be disappointing, I’m not sure I’d let you say you’re surprised.

In fact, you might have concluded they were in for some kind of serious financing and operational problem weeks in advance, when you connect the fairly clear dots between two attempts to raise capital within a month of each other, and which are increasingly unsuccessful.

Which leads me to me second bond guy point:

We’re not talking about an equity financing here, we’re talking about debt.

The trick with debt is that it must be paid back, and because of that, lenders tend to want to see cash flows. This makes debt a very practical financial tool for enterprises with predictable cash flows, and by the same token, makes it a potentially dangerous tool for a company with volatile cash flows (or no cash flow).

It is also common practice for lenders to attach certain terms and conditions – referred to as “covenants” – to high risk loans. For levered companies with volatile cash flows, covenants can present just as significant a problem as the debt payments themselves.

Said differently, debt is a harsh mistress, especially for a startup tech company.

I have no opinion about Zirtual as a business, or its potential. And I also have no knowledge of what the actual structure or terms of Zirtual’s debt are.

But normally, it takes a little time for a company to run into financial difficulty that causes it to miss payments, or is meaningful enough to trip covenants, because at the time the debt is negotiated, lenders and borrowers alike want to make sure there is breathing room for the business to operate.

Time, however, was clearly in short supply.

But the deals were done. Working backward, I simply can’t help but wonder what the investment thesis of the July lenders was, with the round coming so close on the heels of June’s debt raise. I also wonder how the June lenders reacted to the outcome of the July round – which is to say, the huge shortfall – these are professional investors, after all, and the timing (and weak execution) would combine to present a fairly evident red flag.

I simply can’t help but wonder what the investment thesis of the July lenders was, with the round coming so close on the heels of June’s debt raise.

And, of course, underlying all this, there is the burn and its severity. It must have accelerated with unbelievable rapidity, because it clearly wasn’t significant enough in June to stop lenders from signing over $2.6 million, and caught everyone off guard barely six weeks later.

Finally, when things really go sideways for companies, equity has limited standing, but debt, thanks to its contractual obligations, has staying power (not to mention, seniority in the courts).

Reports suggest Zirtual has been sold, but the debt the company so recently took on is still, I presume, there. I wonder how the sale of the company will be (or was) impacted by its capital structure and the actions of the lenders (typically, in a distressed situation, the lenders will gain control of the company and handle its rehabilitation or sale – here, that doesn’t seem to be the case)?

There are a lot of questions here that need to be answered, and I suspect very strongly that central to understanding what really happened at Zirtual is going to be understanding, properly, the circumstances surrounding its debt.

Only then will we be able to give credit, where credit is due.

Featured Image: Jordi R Cardona/Flickr UNDER A CC BY 2.0 LICENSE

This entry passed through the Full-Text RSS service – if this is your content and you’re reading it on someone else’s site, please read the FAQ at fivefilters.org/content-only/faq.php#publishers.

See original article here – 

An Analysis Of Zirtual’s Reality And The Perils Of Debt