Debt Financing for Early-Stage CompaniesWednesday, March 9, 2022
Read online or download the full update here.
Early-stage companies typically first source capital through personal investments, friends and family, smaller investors, government grants, and subsequently through more arm’s length equity investors such as angel and venture capital investors. Historically, early-stage companies have foregone debt financing because they do not have either the collateral or adequate cash flow to secure a loan. However, when available to early-stage companies, debt financing can often be a better option than, or a great supplement to, equity financing.
Why Consider Debt Financing?
Fundamentally, if a company is experiencing high growth, debt financing can be a lower cost source of capital than selling equity on the simple math that the amount repaid to the lender will be materially less than the appreciation of the company’s value over the term of the loan.
By way of example, consider a company valued at $10 million that needs $1 million to finance its growth. Consider that based on projected growth rates and industry valuation multiples, with the use of $1 million, the company could increase its valuation to $15 million in two years.
The cost of raising $1 million through equity is 10% of the company today, but if that money were borrowed today and paid back in two years from an equity raise at the higher valuation, the company would only need to sell 6.7% of the company at that time in order to repay those growth funds.
At a $15 million valuation, that difference between the 10% value of the company and the 6.7% value of the company is $500,000. So long as the all-in cost of the debt to the company over two years is less than $500,000 (which it almost certainly will be), the company will be ahead.
As the valuation of the company continues to grow, the difference in having 10% equity sold versus 6.7% equity sold continues to rise over time. Of course, if the debt is repaid by refinancing it with other debt (as is often the case), the cycle will repeat itself, and as the company grows, the savings will increase.
Ideal Conditions for Debt Financing
There are a few different conditions where debt financing may be particularly suitable.
- High buyout multiples – High buyout multiples are good for both the company (as it makes the debt comparatively cheaper than equity as a source of capital), and for the lender as it provides a potential “off ramp” if the loan is under performing.
- Active interest in the sector for new equity raises and buyouts – Lenders will get comfort knowing that if things get difficult, the company can raise new equity to repay the debt.
- Company has revenue or assets – Lenders will offer better pricing to companies with healthy revenues and/or assets that can be pledged as collateral for debt. Recurring revenue is often valuable, and with the right lender intellectual property can have material value.
- Strong sponsors – Early-stage companies with strong sponsor support are often easier to finance with venture debt because lenders can take some comfort that the sponsor will help to bridge any tough times.
- Manageable leverage and a flexible plan – If an early-stage company is maximally leveraged (or will be after the debt financing) and any small deviation from expectations will have material negative implications for the company’s performance, debt financing and the potential for lenders to take control of the business may simply be a too high risk.
Additional Benefits of Venture Debt
In addition to the low relative cost of venture debt, it often provides some additional benefits:
- Voting control – Debt does not threaten the control of existing shareholders, unlike equity which introduces additional owners often with votes that must be appeased or at least considered. Further, when the debt is paid out, the lender leaves but it is difficult for a company to be rid of equity.
- Diversity of sources of capital – Early-stage companies that take on debt can reduce reliance on their existing equity network.
Drawbacks to Debt Financing
Debt financing does have its drawbacks.
It can take time to find the right lending partner as traditional underwriting approaches have difficulty assessing the risk of a cash burning company with few tangible assets.
Investors or company leaders may be scared (often irrationally) of the implications of a lender taking control of the business especially in the context where security is granted.
While there is great variation here, debtholders will set limits on how a company operates in order to increase its likelihood of repayment. A company is more likely to face difficulty if it does not materially follow the business plans and projections it provides to its lender. For this reason, minority equity can be considered “quiet money” and “along for the ride,” while debtholders have the ability to become active in the decision making of the business if promises to lenders are breached.
Features of Debt Financing for Early-Stage Companies
These structural features are more common in debt financing to early-stage companies than lending generally:
- “Sweeteners” – A lender may accept shares of the company or warrants (the right to buy into the company at a pre-determined price over a specified period) in place of fees or a higher rate.
- Financial covenants – Rather than more traditional financial covenants that often consist of leverage ratios or asset coverage tests, these debt deals will often set requirements around revenue and growth (for example, a monthly revenue target the company must meet) and sometimes provide for an exit on the company not reaching a target (e.g., the company raising amount “X” by time “Y”).
- Convertible features – Some debt deals employ a “convertible” structure whereby the debt advanced has the ability to be converted into an equity investment. The considerations for this structure are materially different from a “pure” debt deal, or a debt deal with a small equity sweetener.
Given the range of structures available, debt financing is a great option for early-stage companies under the right conditions.
If you are an early-stage company with questions about borrowing money, please contact Rachel Manno (email@example.com) or any other member of our Debt Products practice group. The author gratefully acknowledges the assistance of articling student Kassidy Doherty in the preparation of this update.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.
If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.