Scaling Up: 5 Funding Options for Your Early-Stage Startup

The pros and cons of venture debt, revenue based financing, traditional bank loans and more

If you’ve looked at funding options for your company, you know that money is never just money. It comes with strings attached, complexities, pros and cons. The funding option you choose for your company today will have repercussions for the entire life of your business.

At Lighter Capital, we work with hundreds of entrepreneurs who take their funding decisions very seriously. They know that it pays to understand what’s out there and how it will affect their company as it grows and scales. This post will take you through the pros and cons of five different funding tools for revenue-generating early-stage companies.

1. Venture capital

When most people think startup funding, they think venture capital. VC rounds get the attention and the press coverage, and there’s no better way to fund a company that’s growing fast.

Pros

• If your company has the potential to scale to a huge market cap quickly, or if you’re entering a large market with a disruptive product, VC is your best (and potentially only) funding choice. There’s simply no other funding mechanism that can get you the capital you need to scale at the speed you need in order to take the market.
• Venture capitalists have usually been around the industry for a while, and when you get VC funding, you also get the firm’s know-how, advice, and industry connections. This can be invaluable in shaping the future of your company.

Cons

• VC can feel like free money. It’s not. A Series A often requires giving up 20–40% of your company, which will dramatically lower your upside when it comes time to sell the business.
• Taking VC money also means giving up control. VCs typically get a board seat, voting rights, and protective provisions that allow them to weigh in on decisions your company would have previously made on its own.
• There’s a time tradeoff involved with raising VC. Pitching investors and working through their due diligence processes is a full-time job that lasts 6–9 months. That’s time you could spend being a full-time CEO.

2. Venture debt

Venture debt is a debt funding mechanism available only to venture-backed, early- and growth-stage companies. It’s provided by tech banks and dedicated venture debt funds. Venture debt typically has a three- or four-year term and interest rates in the 10 to 15 percent range.

Venture debt lenders take warrants in either common or preferred stock to help combat the risk of offering low interest rates to early-stage startups. Should your company have an exit, they walk away with a small slice of equity and a big upside.

Pros

• Adding venture debt after a VC round is easy if you have a reputable VC firm, and it can extend your runway for comparatively little.
• Venture lenders don’t take board seats, and venture debt dilutes your equity less than raising another round.

Cons

• Venture debt often comes with financial covenants. If you don’t meet growth metrics or minimum net income requirements set by the lender, they can demand repayment of the loan.
• While interest rates aren’t high and equity kickers are limited, taking on venture debt does mean repaying a loan and diluting equity. To some entrepreneurs, it represents the worst of both worlds.

3. Traditional bank loans

If you can get one on favorable terms, a bank loan can be a great way to fund your company. However, small business loans can be challenging to secure, especially for early-stage tech companies..

Pros

• Banks are usually able to offer the lowest interest rates of any debt funding especially if you go through the SBA.

Cons

• It is extremely hard for early-stage SaaS companies to get a bank loan. Banks use underwriting methods that look for a long, favorable financial track record (which early-stage companies don’t have) and/or assets like property or equipment that can be used as collateral. ISVs may have a great IP, but a bank won’t loan against it.
• Still, they might be willing to loan to your company if you sign a personal guarantee. This means if the worst happens and your company fails, the bank recoups its loss from your personal assets — your house, your property, your investments.
• Many loans will include complex financial covenants that your company has to meet in order to stay in good standing. If you don’t maintain growth rates or cash-on-hand limits dictated by these covenants, you run the risk of defaulting on your loan.
• Banks will often limit your capability to take on further debt, including convertible notes.

4. Revenue-based financing

For companies generating at least $15K in MRR, revenue-based financing can be a good option. Revenue-based financing is a type of funding in which a company agrees to share a percentage of future revenue with an investor in exchange for capital up front. The loan payments are tied to monthly revenue, going up for strong-revenue months and down for low-revenue months.

Early-stage ISVs often have lumpy or seasonal cash flows, and revenue-based financing is designed to accommodate that: smaller payments in tight months, bigger payments in flush ones. Several traditional banks, tech banks, and lenders (including Lighter Capital) specialize in revenue-based financing. Find out more about this funding mechanism here.

Pros

• Provides the benefits of a significant injection of capital without the need to give up equity or control in the early stages of your business.
• Many revenue-based financing providers require no personal guarantees or financial covenants, making it less risky than a traditional bank loan.
• Payments fluctuate with your monthly revenue, so you’ll never have a massive payment due in a month you can’t afford it.

Cons

• Your business needs to meet certain requirements. At Lighter Capital, we look for at least $15K in monthly revenue, customer diversity, and high gross margins.
• Revenue-based financing places a consistent (though small) drain on your operating capital.
• Effective interest rates are higher than traditional bank debt.

5. MRR line

Some lenders have realized that SaaS businesses with contracted MRR and low churn tend to have a good credit profile, and they’re willing to lend between 3–5X of your MRR to help you accelerate your growth. If you have more than $2.5M annualized revenue, you can consider getting debt financing from SaaS Capital, a firm that specializes in providing long-term debt capital for SaaS companies. If you have $5M annualized revenue, many tech banks like Silicon Valley Bank will have products that are similar to MRR lines for you.

Pros

• This funding mechanism is tailored specifically to SaaS companies and their revenue dynamics.
• MRR lines can provide relatively cheap, safe money when your business needs it.

Cons

• Most lenders will require a personal guarantee. Make sure you understand the risks before you agree.
• The high annualized revenue requirements mean this type of funding will be inaccessible to ISVs just getting traction.
• MRR lines often contain financial covenants built specifically around churn. If your customer success department has a rough quarter, even if your company is still growing, you might find your MRR line gone or significantly reduced in availability.

It pays to have as much information as possible about potential funding sources for your company. Make sure you understand how the funding you take today will impact your company in the years to come.

Lighter Capital is a fintech company revolutionizing the business of startup finance by providing tech entrepreneurs with up to $2M in capital to grow their startups, while retaining equity and control.