AI moats, venture debt and the $20M exit

Josh

If you are a wrapper business that's built on top of one of the major LLMs, right now the major LLMs are subsidizing almost every wrapper company. That model hasn't shifted yet, so we don't really know what's going to happen to the companies that are based their entire cost structure in what the world is today, but we don't know what that's going to look like in 6 months, 12 months, or 2 years from now. Software has mostly been secured by the fact that it was really hard to write code before. That's being democratized right now with AI and coding tools.

Krystyn

So, what I'm hearing is the bar is ever higher in terms of capital for companies.

Josh

So, are you one release, one GPT release away from being completely irrelevant?

Krystyn

Josh Axler has deployed over 200 million in growth stage companies. He's the managing director at Flow Capital, a publicly traded alternative lender, and his job is to decide, usually within weeks, whether a founder's business is actually worth backing with real money. He's not a VC, he's not a banker, he sits in the gap between the two, funding the founders who decided they'd rather keep their company than dilute it. Today we're going to deep into lending what the people writing the checks actually see when they look at your business, and why the 20 million-dollar exit might put more in your pocket than the 200 million-dollar one. Josh, welcome to the show.

Josh

Thanks for having me, Krystyn.

Krystyn

Let's dive into what we've been talking about behind the scenes. Andreessen Horowitz just published a piece around that arguing that AI is about to dissolve the one moat most software companies have been hiding behind. Switching costs. So, this is like when you have all your data, all your financial systems hooked up, all your integrations, it takes a lot of effort to switch. But, when your AI agent can handle the migration, vendor lock-in stops working as your moat. But, the one moat that actually survives in their perspective is brand. Because at the end of the day, agents still report to humans, and humans still need to trust someone. So, Josh, from your perspective, you've seen hundreds of founder cap tables and growth models a year from the venture debt side. When Andreessen comes out saying switching costs are dead in software and brand is the last real moat, does that match what you're actually seeing in the companies that are hitting your desk?

Josh

I think that might be a bit of an exaggeration today. I generally agree with that sentiment that the agents will be able to get in there, but as we stand right now, the human-in-the-loop side, I'm working with your agents and getting the agents set up, and for people to have that level of trust with agents getting into their data, they were still very early in things on that. With no doubts that that capability is coming. I think there are some really fundamental questions about what the moats are in software, specifically, you know, software has mostly been secured by the fact that it was really hard to write code before. You needed the top talent. It was really hard for small companies to attract top talent away from the largest companies. That's being democratized right now with AI and coding tools.

Krystyn

Let's unpack that a little bit because code was very expensive. I built a tech company. I had to raise a lot of money to hire engineers. I'm not technical. Now, we can vibe code, which is sort of write natural language to build software. Cool, but at the end of the day, as we talked about, there's very few people who have fully adopted this yet. So, we're kind of at the early adopter phase of this cycle with agentic AI. So, what do you see as the defensible moats in the kind of short-term, mid-term, and as we look ahead?

Josh

Yeah, so we tend to work with companies at the early growth stage. So they've started to show some signs of product market fit. They have revenue, usually multiple millions of dollars of revenue. So we're not working necessarily with the companies that are still in the vibe coding idea phase. But what it is doing is it's empowering everyone within an organization. For example, on our team, we had our marketing person vibe code an AI agent to talk to our CRM to make it easier to log. We see CEOs that are empowered and really being able to actually talk the language of code with their engineers.

Krystyn

Well, I'm curious, too. So the people side is one thing, but also we talk about like if you're getting into this There was a Ivan, the CEO of Notion talked last week about how he's not asking about ROI around this. He's basically saying like unlimited tokens. Now, this isn't a company that is scaling quickly, venture-backed. Like, okay, not most companies can really say unlimited budget, but from a compute perspective, too, are you seeing this sort of show up in fixed costs of companies as they scale beyond the human?

Josh

Yeah, well, what's interesting is I don't think people understand really where AI is going to land in the P&L. Like, is it Where does it land in costs? Where does it land as a fixed cost? What is your base layer amount of token usage or service providers? If you are a wrapper business that's built on top of one of the major LLMs, right now the major LLMs are subsidizing almost every wrapper company because they seem to have infinite funding from the capital markets. That model hasn't shifted yet, so you don't really know what's going to happen to the companies that are based their entire cost structure in what the world is today, but we don't know what that's going to look like in 6 months, 12 months, or you know, 2 years from now.

Krystyn

So interesting when you look at that. So okay, we'll dive into the early side of this hype cycle where we are because it's still time to be to be seen, but those are some known unknowns for the future. When it comes to this whole like, you know, headline of SaaS is dead, you see a bunch of companies come across your desk. What's your reaction to that?

Josh

I mean, I think there's some truth to it. I think that a lot of the rules of venture as relates to SaaS are being questioned as AI comes into the mix. You know, as a financer of technology and SaaS companies for the last 10 to 15 years, if you saw a multiple million-dollar ARR business with gross retention of 90%, net retention over 110, growing at least 40% year-over-year, that company would have tons of funding options available to it. Now it's not so clear necessarily if that's enough, which is crazy to think. Fundamentally, that is an unbelievable business.

Krystyn

So what I'm hearing is the bar is ever higher in terms of capital for companies, even with those phenomenal traditional metrics like you talked about. Can you give me an example of some of the metrics that you would sort of say, "Hey founder, this is what you really want to be hitting before you're ready for our kind of venture model?" And by venture model, I mean lending model.

Josh

Yeah, venture debt. So I mean, if a company comes to me with the vent with those metrics that I just presented, I'd be thrilled to talk about financing them. I think we look at certain metrics and then we also want to understand what those metrics mean for the business. Like, what's underlying in their business process, who are their end customers, what is a sales cycle. You talked about switching costs before. So, a lot of those things factor into the numbers in and of themselves, but certainly growth rate is important. Things like capital efficiency, so how much are they spending on sales and marketing in order to acquire a new customer.

Krystyn

We talk a lot about optionality, and we mostly work with founders who do not have venture backing, and we talked a little bit about this, too, is there's a trend that you're seeing related to seed strapping. Can you define what that actually means, what that looks like, and sort of is this a recent thing? Has this also been compacted by the fact that AI is making it less expensive for you to access and build code? What's your perspective?

Josh

Yeah, absolutely. I mean, seed strapping, fundamentally, is a founder or founding team raising a seed round, getting themselves to, you know, that minimal viable product or to product market fit or a certain level of revenue where they feel like they can be a sustained company without needing any additional funding or looking at alternative sources of funding other than venture capital to continue their growth. So, it's kind of flipped the model. A lot of Historically, a lot of companies would say, you know, go get revenue and then you might be eligible for, you know, venture capital, and then you might continue to do lots of rounds to finance that growth. Now, we're seeing tons of founders who are, you know, raising a little bit of money to kind of get the team together, get a salesperson, get someone to help them with marketing, get the team that they need to get themselves off the ground, and then really filling the gap with their own profitability and no longer needing venture dollars to continue to scale.

Krystyn

What's different about a deck, do you think, in that example than someone who is kind of continuously believing they need to be on the treadmill of raising continuous rounds? And I raised money, I went through the process, I was in San SF doing 150 pitches to venture capitalists, and many unsuccessfully. Like it was it was a crazy ride. But I was spending more time on that when I really should have just been selling my customers and expanding my enterprise revenue. Like it was a focus question. So I'm curious for you, what's the difference in sort of the strategy and the vision of a deck that is thinking more sustainably about the build?

Josh

I think that the fundamental question is like how fast you want to go, and then what or is more capital really unlock for you? The end market that you're in, how competitive is, how well funded are your competition, and are they doing things fundamentally differently than you that if you don't have that capital, you won't be able to compete. Primarily the companies we work with are not growing, you know, 100% month over month. You know, they're typically in a 40% to 100% year over year. Unbelievable growth. We love working with these companies, but they may not necessarily be attractive to venture, which means if they go out to raise equity, it's going to be at a lower valuable valuation, and so they're probably going to have to give up a lot of their company in order to do so. So it comes down to what they're trying to achieve with their company, what their goals are, and what capital really unlocks for them.

Krystyn

What is it about that that makes them unattractive to traditional venture capital? Cuz that sounds like ridiculous growth when you're describing 40% to 100% And obviously if it's small numbers, it can be it can be wild. But I'm I'm kind of curious what you see there.

Josh

Yeah, I mean in the world we're living in right now, you have companies like Fixer and Lovable that have gone from, you know, zero to 100 million ARR in a year. So, when you start talking about going from a million to a million five in a year, it just doesn't get certain investors excited. But it's a great business.

Krystyn

And this is where enter space for this. And this idea of, hey, equity in the long run, and I didn't realize this when I was building my first company, it's very expensive, especially as the enterprise value of the firm goes up. And more founders aren't really thinking about enterprise value. Why do you think that is? That we don't think about that? Is it a lack of education about it? Cuz frankly, we went to business school together. I don't really remember learning about enterprise value all that much from a founder perspective. What's your take?

Josh

Yeah, I think people don't recognize the cost of capital spectrum, and they don't realize that it is the most expensive cost capital that you can put out there cuz they think cost of capital that means there has to be an interest rate to it. So, if I'm not paying interest or I'm not paying a real cost of capital that comes out of my pocket every month, does it cost you anything? They don't go to an scenario where we get to an exit and they gave up 20% of their company, and that was two years ago. And so, that 20 million over two years, that's pretty expensive money, no matter how much you got for it. So, um those are one things to consider. We really try to simplify it to our founders in this way.

Krystyn

And so, how do you think about expansion? And if you were to sort of put this in like third-grader language for me, like how would you define it and how do you actually see that show up? In terms of revenue multiple expansion, like where is enterprise value created? Yeah. Is that because you're bringing in the capital to accelerate and that's where you're seeing expansion or is it because they're building more fundamentals with that capital that enhance the quality of the earnings or the revenue? What sort of drives that leap?

Josh

Typically Casey. I mean, then a lot of the times in venture, you're trying to pull forward the future earning potential and bring it back to the present to get to a valuation, like a company today that's only generating 5 million of revenue is not being valued at 100 million because of revenue today. It's being valued because of the potential of the, you know, the overall enterprise in the future and then discount it back to today. So, an investor will look at that business fundamentals and they'll look at things like their growth rate. They'll look at the health of their customer base.

Krystyn

So, you're taking a very similar lens, but as a founder, how do I think about working with you, Josh, as kind of like what's the tool that you're giving me that, let's say, alternative sources of capital are not? And one is, you know, you're not taking equity, so this is inherently less expensive from an ownership perspective. You're giving me an option and more optionality cuz I own more of the business. What is this really good for?

Josh

Yeah, so at Flow Capital we're venture debt providers and the reason we caveat that with venture and debt is you don't think of us as a bank and don't think of us as equity. We're somewhere in between. So, we work with venture level companies, companies that are growing, making investments as I mentioned before. They're not yet cash flow positive because they're looking to continue to invest in growth. And what we give them is we lend them money. So, we give them money to go and invest in company, get a return on that, increase their enterprise value and then they pay us back in two three or sometimes longer than that. Years.

Krystyn

Okay, yeah, that's what I was curious about just for what's the length of that typical term, but sometimes longer.

Josh

You Yeah, sometimes longer. If it makes sense for a company to continue to maintain what they have or to take more capital from us, we have the capabilities to extend with them beyond the two or three year term. Typically, what we find at the stage company that we work with, most of our borrowers are in the two to 10 million revenue, still working towards cash flow positive. We're helping them get through that early growth inflection point. So, they're trying to get their company from a maybe they're at a 20, going to trying to double or triple that in the next two to three years and they're going to have optionality in terms of their next level of growth capital, an exit and all of those are ways that we get repaid. We typically get repaid through a lower cost lender like a bank or as part of the next round of equity proceeds, whether that's growth capital from private equity or strategic or full M&A of that.

Krystyn

So, I really really think founders need to understand that there's more than just venture that they can access. There's more than just purely bank debt. Like this is a very interesting space in between. And so, if you have the desire to continue to preserve your ownership, but you've hit a certain level of traction where you're very attractive to Flow, for example, to yourself, Josh, it's a very interesting opportunity. Now, I'm curious, when you see this sort of seed strapping kind of piece and then, you know, see folks come through, are there any blind spots or common mistakes that you see in companies that try to do this and fail?

Josh

Yeah, absolutely. I mean, we have a really high bar for the companies we work with and there's a pretty strong reason for that. I mean, debt is also commonly referred to as leverage and leverage works both ways. It's a really powerful tool, so it accelerates when things are good, but it also puts a lot of pressure when systems are not as strong or ready to support a level of capital.

Krystyn

Covenants need to be met.

Josh

Like covenants. So, there are some of things like covenants, but fundamentally the debt puts pressure on systems before the covenants. The covenants are a way to track a company's performance, but what we look for even before we get to funding or sign term sheets is the fundamental systems and a lot of that shows up in the financial management of the company. So, do they have a solid financial picture, rear view picture? So, do they really understand how they got here, what their unit economics look like, how they actually track their revenue and billing? And then we're also keenly focused on how they think about the future, so their forecast. We want to understand things like how do they build up their revenue forecast, do they have a really good understanding of their cost base, and how much capital do they really need in order to get to that sustainably cash flow positive place?

Krystyn

Let's talk about this. I mean, literally

Josh

It's for us.

Krystyn

Critical and the interesting thing is and I see patterns across cuz we're talking to folks who are kind of ready to sell. They've been preparing their data rooms for liquidity events, some who are in like growth equity raises, like across the spectrum. But what I hear is to be ready for a buyer, you also need to be in the same exact mindset to be ready for a lender. It's the same sort of principles I imagine you're looking at the business. How attractive is this looking backwards? How much can I trust that we can sustain these continued results all the way? First of all, do I trust the historicals? Whole other can of worms. But I was talking to a CFO the other day and she came on the podcast. She's fractional.

Josh

That's our number one That's the number one breakdown for us in our process. Literally thousands of companies at this point, specifically in my role here at Flow, and I can't tell you how many calls I get off with a founder and on paper or on Zoom, however you want to picture it, seems like a good fit, and then we open up the data room, and there's just such a far gap between what they feel like is a forecast and their ability to tell their story financially and what we're looking for as a venture debt provider. I think sometimes companies mistake raising venture debt as being lumped into raising venture equity. So we'll get these forecasts with them which show huge hockey stick growth.

Krystyn

That level of detail, and outbound is very expensive as an example, and really understanding the unit economics of that. Like, how long is your sales cycle? What is your expected velocity? How many are you actually going to close? Do you have a pod? Do you have like a BDR and ISR? Like, what's the setup? There's so much detail in it, and I do think founders struggle cuz we're so close to it, we're so in it? There's really, if you break down businesses, you see tons of companies, tons of patterns. If you break down what drives growth, do you think you could boil it down to like two to three things for each company they need to nail to get it right? Like I think we tend to overcomplicate these things when really I think we need to understand the fundamentals, right?

Josh

Yeah, I mean, when we kind of look through the things that we focus on, there are three things that we at a high level focus on. So, the first is we want to feel reasonably confident they have product market fit. Most of our borrowers, a lot of that is retention. So, are their customers not only continuing to buy, but looking to buy more? Your customers tell you the story, right? So, that's really important. The second is on that go-to-market side. Do they have maturity in their go-to-market in terms of really clearly being able to articulate who their ideal customer is? But then also how they find them and how they win them.

Krystyn

Let's dive into that just for a moment and the contribution margin conversation. So, I've seen founders across the board and when you're looking to sell VC, the three to one is kind of the golden rule of, you know, your lifetime value, which is the revenue you earn over the life, however long they stay with you. Usually, it's like three years, three scenario, to the cost it for that individual. So, that's the unit economics we're talking about. But a lot of founders aren't fully loading their costs.

Josh

Right. And that's right.

Krystyn

Which I see a lot. And so, what do you see this a lot? Is this a It's a bit of a vanity metric otherwise.

Josh

With seven to one LTV to CAC and then the then that is their gross revenue and then they don't layer in that they actually have a gross net margin because they you know, they have a distribution partner. So, that what actually hits their P&L and their net is even lower than So, that seven drops to five. But then what's really important is your contribution margin LTV to CAC. What's the lifetime value of your contribution margin? It's cuz it's very different if you have $100 of revenue and you make 80% margin on it versus 20. So, understanding those components is very critical for really viable LTV to CAC.

Krystyn

And I would say founders, if you're not fully loading your CAC and looking at your unit economics on a per channel basis, you're not able to make decisions on where you should continue to reallocate and change, right? And I think it's so important. I think we're almost afraid to look at this stuff. When really like we should just shake it out and be like where where is it cuz someone like yourself or a future buyer is going to start asking those questions and you would rather be in a position of strength. Which is what we are stoked about.

Josh

Yeah, and we, you know, as venture lenders, you know, we understand we live up the risk for So, there are certain risks that we can live with and understand and actually our model is even, you know, another important, you know, unit that you look at or metric you want to understand is CAC payback. So, not just how much does it cost you, but when you look at your margin and how often your customers are paying, how long does it actually take you to recover what it cost you to spend?

Krystyn

Ooh, so that's really interesting.

Josh

You into another portfolio company or we have the right introductions to another channel and we can shorten that payback through upsell with some of our portfolio companies.

Krystyn

This is why knowing your unit economics, what it actually at an individual customer level, is so powerful cuz it unlocks how you should think about capital and where you need to use it as a tool and who the right partner is for you. Cuz to your point, you're only there 2 to 3 years, that may not make sense versus someone who has more of that longer tail, kind of permanent view, not all of them, especially if growth equity has like a window, but they're typically longer than the 3-year window.

Josh

It gives you a really strategic understanding of like, "Okay, maybe I have too many products. Maybe I'm trying to sell too many things to too many different types of customers and I need to focus on where we have so much capital available." That might be a really great product that's solving a lot of problems for our customers, but we can't sell it efficiently. So, we need to move on actually works for us at this stage of our company life cycle.

Krystyn

Such a great call out. So, let's talk about what you sort of have a point of view on this, I know Josh, but around how pure software founders may not be thinking about this, but you've talked about how services and hardware kind of start to become more real retention modes as AI starts to really commoditize software. And I've seen this as well. I've seen a lot of venture studios who are going, you know what, we're going to start as a services company and then we're going to lock in and build the platform around it because it's harder really and I know this having led services, it's very difficult. But back when I was raising money, if I had a services component, it was like, "Oh, that's not scalable. That's not interesting." So, I'm curious, are things flipping? What are you seeing related to services and software coming together?

Josh

Yeah, I mean, that's not wrong. Like it there is some scalability issues with service businesses. However, AI is allowing you to effectively get a lot more leverage on the service components of your workforce. So, if it's all knowledge workers and you had to think about like look at the consulting business. I know you came from consulting, so you know that all too well. How many hours do you spend putting together PowerPoints and models? A lot of that is going to come down substantially, so you could focus on really the strategic work that your customers and clients would would have been hiring you for. A lot of that changing.

Krystyn

Oh, I love that. Now, I think one question for you, one of the things we talked about was just sort of the headline of, you know, sell my company for 200 million, but you know, there's a deal structure, of course. How much does equity does the actual founder have? What is the deal structure in terms of how much of that is cash versus earnout? For founders listening, why would it make sense for them to come to you in that scenario as they're thinking about, "Hey, I want to work towards a strategic sale over the next 3 to 5 years. I've got an asset. I know I can spin this up. I want to accelerate it." What was sort of what are they not maybe thinking about blind spots related to the path to that strategic exit?

Josh

Yeah, I mean, there's a number of things to consider here. I mean, just fundamentally, if you think about a $20 million exit versus a $200 you have to understand who's on the cap table and what their kind of return waterfall is. So, in many cases, if you raise from venture capital, you might have things like a liquidity preference that may be participating and not participating. So, they get paid and get the return of their capital before the common shareholders, which is the founders. Other things to consider, too, are, you know, not just necessarily the dollars and cents.

Krystyn

Here's my question, last question to you. And also, I raised through a family office and it was a phenomenal experience. It's completely different experience and one that was more patient, I would say, in terms of capital. So, knowing the capital landscape, know the capital game you're playing, know whether you need to raise money. Here's my last question. Is capital abundant still, even in this time? And secondly, should every business What makes a business one that requires outside capital versus continuing to bootstrap? What is sort of that decision set?

Josh

Yeah, capital is abundant. There's tons tons of people looking to deploy. I think, you know, it's going into certain pockets and everything goes in waves. You know, there's a lot of venture dollars. You know, they always said record year in venture last year. But most of that money went to like the top seven companies in raising venture dollars. So, but there's lots of great capital providers out there into deploy capital. But the bar is the bar has gone up a lot. Specifically at the growth rate, you know, risk profiles have come down. The whole market shifted you know, in 2022 when rates went up for the first time in the 10 years, which we coming out of undergrad and you know, 2010 2011 haven't really seen a world like that. But you know, when money stopped being free, return expectations changed quite a bit. So, that made it harder to access capital. But it is still there.

Krystyn

That's a really good framing and especially if you're in a space where you do need first mover or second fast follower kind of advantage, especially in tech when things can be built so quickly. That's a really helpful perspective. Well, thank you so much, Josh. Where can people find you? Where's the best place to reach out if they are a founder listening and thinking, I need to talk to Josh.

Josh

Yeah. You can check me out. I post daily on LinkedIn. So, just look me up Josh Axler on LinkedIn. I'm posting lots of stuff about venture debt and AI. You can reach us at flowcap.com or my email is josh@flowcap.com.

Krystyn

Awesome. Thanks, Josh.

Josh

Thank you.