Regrets suck

Home sweet home

Never underestimate the creativity of the financial industry when it comes to finding new ways to repackage risk and returns. Recently, an American start-up called point.com has provided a new way to finance your home. Their slogan: Regrets suck so let’s avoid them. The basic idea is as follows. Point.com buys an “equity stake” in your home, you can use the money they pay for whatever you want, and you don’t have to pay any interest. Isn't that great? When the contract ends after a predetermined number of years, you pay back the equity stake, interest free. If the value of your home has gone up, you additionally pay a percentage of the home’s value appreciation.

For example, it could work like this. You sell a 10% equity stake in your home which is valued at $ 200,000, in exchange for 20% of the home's appreciation. This means you get $ 20,000 from point.com, which you have to pay back at the end of the contract. Let’s assume the estimated value of your house will then have gone up to $ 300,000. You pay back the original $ 20,000 plus 20% of ($ 300,000 - $ 200,000), i.e. the share of point.com in the value appreciation of your house. The total amount you pay to point.com is therefore $ 40,000. If your house has gone down in value by that time, you only pay $ 20,000. According to the point.com website, you can cancel your contract and pay back at any time before the agreed term.

This is definitely a very smart idea. Not surprisingly, point.com is backed up by an impressive list of investors including Andreessen Horowitz, one of the most prestigious VC-firms in Silicon Valley (*). However it is also a dangerous idea. If this new way of financing homes takes off, it is going to create a lot of trouble. First, the use of the term “equity” is very misleading. Point.com don't buy an equity stake in your home. Rather, they give you a loan (without interest) which you have to pay back. In return for not having to pay interest you give point.com a call option on the value of your home. If the home value goes up, point.com get a significant share of the appreciation. Basically, you sell a convertible loan to point.com. They are actually rather vague about how high the share they get will be. The only indication I found on their website was an example, in which the home owner has to give 20% of value appreciation in case of a 10% equity stake. This call option implies that the higher the value of your house, the more you have to pay to point.com.  If you’re cash strapped, it is therefore likely that you will have to sell your house, unless you have become substantially richer by the time you have to repay point.com. But if the value of the home goes down, you might also be in trouble. Point.com always gets the full amount of their loan back. If you have borrowed $ 20,000 from point.com and the value of your house declines from $ 200,000 to $ 150,000, you still need to pay back the full amount of $ 20,000 to point.com. If you don't have that money, you will be forced to sell your house at a substantial loss.

From a macro point of view, this seems like a new “trick” to make money out of people who can't afford to buy a house and will have to sell their home when the loan expires. It creates the illusion that you don't borrow: you don’t have to pay any interest! But in the end, you always pay.

(*) I recommend Marc Andreessen on Twitter; Ben Horowitz has written an interesting book on start-ups: these are very smart guys.

Start-up financing: it's the banks, stupid!

When an entrepreneur starts a new firm she often need external funding. For this, the entrepreneur will typically rely on equity, provided by the "three F's" (Friends, Family and Fools), by business angels, and/or by Venture Capital (VC) funds. At least, this is a popular perception of how start-up financing works. For example, Aswath Damodaran describes the financing decision in the start-up phase of a firm as "Equity funding optimal, debt only if desperate". Desparate. Do entrepreneurs really need to be desparate before they use debt finance? Not in the real world it seems. In a recent study that covers basically all independent Belgian firms founded in the period 2006-2009, Tom Vanacker and I find that bank debt is the most important finance source for new firms. More than two thirds of the Belgian start-ups in this period used bank debt at the time of start-up. For the start-ups with bank debt on their balance sheet, it was a (much) more important finance source than equity, trade credit or other debt types. These findings of Tom and me are not unique for Belgium, not even for Europe. Studies of start-up financing find that bank debt also plays a crucial role in the financing of start-ups in the US and Australia.

Access to bank debt is important for start-ups, because it allows them to finance investments, increase their growth and avoid bankruptcy. In our study, Tom and I distinguished between new firms founded before and after the 2008 crisis. During this crisis, many banks got into serious financial troubles and evidently had less money to lend. Not surprisingly, we find that new firms in this period had less bank debt than new firms before the crisis. The reduced access to bank debt negatively affected the growth and the chance of survival of these firms. Start-ups invested less, had a lower growth, and were more likely to go bankrupt if they ware founded during or after the crisis, compared to start-ups before the crisis. Furthermore, this effect was significantly stronger for start-ups in industries which depend on bank financing and start-ups with a lack of equity. This suggests that reduced access to bank debt during the crisis harmed many start-ups.

Where does the idea that start-ups only rarely use debt come from, given the evidence of the contrary? Research on start-ups tends to focus on high-tech start-ups which, due to the nature of their assets (intangible growth opportunities), indeed have limited access to bank debt and rely much more on business angels (I love that word, I wonder who invented it) and VCs for external funding. However in the real world, most start-ups are not about "cool" nerdy guys and girls wanting to become billionaires when the app they are creating is going to conquer the world. Most start-ups are about hard working people in many different industries, for which bank debt is very useful. These start-ups are still very important for our economy. More important than the guys and girls trying to invent new apps. Just not as sexy.