Alt Startup Capital in Australia
**2024 Update: I now publish Aussie capital raising content on Substack here **
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I actually started this article a few months back, but put it on hold as I’ve had the fortune of getting to see alt startup capital distribution in practice by joining the Tractor Ventures team, which is scaling up rapidly.
The hypergrowth rocketship model of the venture capital world isn’t right for every business which has given rise to founders seeking alternative sources of capital for their startups, to retain better balance of control and sensible financial responsibility.
Basics
What is alt capital? In the startup world, alt capital is debt financing that doesn’t come from traditional lenders like banks.
What is debt financing? Borrowing of capital that must be repaid.
What is equity financing? Sale of a portion of equity/shares/ownership of a company in order to raise capital.
Types of Alt Capital Available to Startups
There are many different names for the types of financing that are popping up at the moment, they are all somewhat different but also similar. Some of the most common types are:
Revenue Based Financing (RBF): A loan that is repaid as a percentage of your periodic revenue.
Venture Debt (VD) aka Venture Credit: Borrow a lump sum and pay back in monthly fixed instalments.
Ad Financing: A loan specifically to fund digital advertisement expenditure.
R&D Financing: A loan secured against your R&D tax benefit claim.
Trade/Inventory Financing: Loans to bridge the gap between the purchase of inventory and the sale of that inventory.
Subscription/Accounts Receivable Financing: Loans secured against your customer’s future contractual receipts.
-> A full list is available here
Why use debt in a startup?
Growth: The main reason I have observed multiple debt providers allocate this type of funding is to accelerate growth by investing it into things that have a quick return on investment (like sales, marketing, inventory, operational capacity, hiring, tools etc)
Additional reasons to use debt:
- Cost: Cheaper than equity… but hang on, don’t you have to pay interest on debt? So how can it be cheaper than equity? My answer: I’ll explain soon
- Dilution: As lenders don’t typically take equity (but some may take warrants for various reasons but it’s still significantly less than selling equity), you will limit or eliminate diluting current founder/shareholder ownership. This is important when an exit occurs as well as for retaining control of your company
- Control: Typically no board seats are taken or voting rights ceded
- Opportunity Cost: Eliminate, skip and/or delay equity funding rounds
- Diversification: Diversifies funding sources which reduces reliance on one source of funds or investor/group of investors
- Speed: It can be really quick to obtain therefore accelerating growth earlier than equity which can take many months
- Tax deductible: Interest is tax deductible as it is an expense
Why not use debt in a startup?
- Cost: Must repay principle and interest which can dampen growth and profitability
- Risk: Failure to repay can put the future of the company at risk although failure to perform the way your investors expect can also result in this. See ‘What to Watch Out For?’ section for more info
- Purpose: If you are using the capital to fund long-term projects or overly risky projects then your repayments may become overly burdensome
What does a skipped and/or delayed funding round look like?
If you plan on raising or continuing to raise capital through the sale of equity then skipping and/or delaying a funding round is hugely beneficial to shareholders, founders and the company if you can accelerate growth and hit better milestones.
Hitting bigger and better milestones before raising equity will put the company in a stronger position to do one or more of the following.
- Raise at a higher valuation as the business is less risky
- Raise more capital to fuel growth faster than if you did a smaller round
- Attract a better class of investors
- Negotiate more favourable terms that will enable you to retain more control and run your company the way you see fit
- Eliminate an entire funding round which will reduce the entire round dilution completely (no selling 15% — 25% of your company)
Better yet, if you can fuel growth entirely from debt then you never have to sell equity resulting in a 100% of the value of an exit going to the founders and employees (if you have an ESOP) which makes *smaller* exits viable and life changing.
What’s the cost of capital?
You should really understand the cost of capital in your business but it should be considered in the context of what the capital will be used to fund. For example — If you have a good growth engine that returns something like $3 for every $1 you invest into it, then debt is likely the best option but for investing in long-term and higher risk projects like new product development then equity is likely the best option.
Weighted Average Cost of Capital (WACC): The weighted cost of your company’s debt and equity funding.
Cost of Debt: What debt costs your company (interest rate or multiple) over the fixed period of time it is borrowed for.
Cost of Equity: What the sale of equity costs the company (and founders) perpetually (until shares are bought back or an exit occurs). Typically, this is easier to calculate for public companies but in the startup world it is much more difficult. At its essence, you are calculating what your shareholder’s return expectations are because if shareholders don’t get or likely to get the return that they expect then they will likely lose faith in the company which results in investors ceasing to fund you, shut the company down and/or they replace management to try to turn it around.
If you are reading this article and considering raising debt, then you are probably at an equivalent of Series A or greater therefore your likely cost of equity is ~25% — 50% p.a. Also to note, equity is a perpetual cost as it is unlikely you’ll ever buyback those shares sold (hopefully return expectations decrease overtime as the company matures). This wonderful article explains this logic in detail.
How to use debt?
- Borrow only debt
- Raise a mix of debt and equity (Zoomo just announced another debt and equity raise, article here)
- Use it to fund growth with a quick return on investment
- Don’t over leverage (get too much debt) as it will not be serviceable
What to watch out for?
- Payment holidays — These are really useful as they allow you to deploy the capital and start seeing a return before you have to start repaying the loan.
- Serviceability — Make sure you aren’t taking on too much debt and ensure the repayment terms aren’t too onerous… can your cashflow support repayments or will they hamper growth.
- Duration — Some provide short-term and others longer term, so consider what is most suitable to your business’ needs.
- Early repayment — Find out what happens if you want to repay the loan faster.
- Security — Enquire about who exactly is responsible for the loan if it doesn’t go according to plan, is it just the company or is it the directors, board and founders too.
- Support — As you’re a startup, it is likely you’ll need some mentoring and expert advice to fine tune growth, expand into new markets and navigate unexpected situations. Will your lender help with this or are they just capital? Both are fine, just be clear about what you want and need.
- Just debt? — Some lenders may want the option to buy warrants in the future — ask why, what the terms are and what you get in return. However, it is likely they will ask for a significantly lower % of the company than an equity round would require.
- Interest Rates and Multiples — This one is a bit tricky as in our personal lives we are used to interest rates but some alt financing use multiples instead as they have unknown repayment periods. I’d love to give you specific rates but given the mix of solutions in this article it is practical. In future solution specific articles I will cover it though.
For example: Revenue-based financing providers quote a multiple. It may seem like they are being tricky but it’s actually because the interest rate isn’t a known thing until the end of the loan, therefore think about what $1 costs you (multiple of 1.5x = $1.5) and if you can generate more than $1.5 in value from that $1. I might do an article on this in the future as I have only just got my head around the logic too.
What’s right for my company?
As you probably suspected, the answer is that it depends. It depends on what type of business you are running, how you want to run it, your traction and vision as well as macro and micro factors.
But the chances are that you won’t be able to use debt unless you have reasonable revenue with some providers offering it to companies with as little as $10k MRR.
Who provides it?
My understanding is that debt financing has been happening informally/privately between equity investors and their portfolio companies for a while but it is finally becoming formalised and accepted with the rise of alt capital providers in Australia.
Search a detailed comparison list of finance providers here
I hope you found this summary of alt capital in Australia useful. Talk to a few different providers to familiarise yourself with the various different options and their nuances before making a decision.
As always, I’d love to hear any feedback, questions and/or suggestions for future articles. I’m thinking of going deeper into each financing product for future articles.
Founders, investors and startup newbies: Feel free to add me on LinkedIn, I love meeting interesting people!
Check out my list of 100 Aussie startup investors and debt providers on startup-funding.com.au
I’m the Aussie Startup Capital Nerd… My name is Warwick Donaldson and I specialise in Australian DeepTech and FinTech Seed and Series A capital raisings. To date I’ve worked on over 150 Pre-seed, Seed, and Series A fundraises. Hit me up if you’d like to chat.
