A Founder’s Guideline to Debt Financing
In the current startup/founder ecosystem, debt is a not a financial instrument that is commonly understood or discussed. The most common form of debt that founders and investors are familiar with is venture debt.
Equity is, of course, the most understood method of financing. This is because most startups have to raise equity to get off the ground. There are also many VCs around who can provide equity capital. The documents needed to run an equity round are straightforward with well-established templates for priced rounds, convertible notes and SAFEs.
There’s also plenty of education out there on VC blogs, Hacker News, Reddit etc. We don’t have as much education around debt. We thought we could provide you with some basic guidelines.
We started Mark 2 Capital to provide debt capital to technology companies whose business depend largely on securing lending/financing capital. Over the years, VCs have evolved to be more “founder friendly” and service-oriented.
It’s not just about capital, it’s about being a great capital partner who adds value beyond just money. Similarly, we see an opportunity to provide additional value as credit investors that deeply understand founders, your businesses and your financing needs.
Why Would You Need Debt Financing?
For this post, we are focusing on why you may need debt financing at the early stages of your company. A key reason for taking on debt financing (if you can), is that you aren’t diluting yourself in comparison to equity financing.
It can help your business reach the metrics needed to get better terms when you do raise more equity. These are some scenarios where it makes sense for founders to take on debt financing.
- Your company focuses on lending or financing. This is a prime example of an early stage company that takes on debt financing. This company has raised equity, but does not want to use ALL of it for lending/financing. — Affirm needed debt to provide their point of sale consumer loans. Opendoor needed debt to finance homes they’d put on their marketplace. SoFi needed debt to provide students with loans to finance their education.
- Your company is generating a healthy amount of revenue and cash flow and you want to use debt to bridge yourself to the next round of financing. When you have a healthy balance sheet, controlled burn rate, solid cash flow and a growing business (even early on), debt can be a better option for you to finance your business vs equity. It’s a cheaper form of financing that can save you from further dilution at unfavorable terms.
Why do you care about debt: An illustration
Take a company that does 10x in 6 years — effective cost of equity between seed and series A = 46 percent, per year.
Typical cost of debt = <15 percent, per year.
But remember, those numbers compound. To illustrate with actual, real world numbers:
1 million dollars of equity at a 10 million post, costs 10 million in dilution at exit.
1 million dollars of debt for 6 years at 10%* costs 600,000, and can be paid off or refinanced at any time.
In this example, thats a potential difference of 9.4 million dollars.
The founders, employees, and other equity investors pocket the difference in cost.
The Math is Clear, But Why?
Equity is, “for life” so to speak — whatever your company is ultimately worth, or whatever dividends it produces, are both shared pro-rata with your equity investors. In other words, equity capital has a very high tax on the economics of your business.
Equity investors take on a high degree of risk — they have the junior-most claim on the economics of the business, and need to be compensated accordingly. Equity funding is a critical and in-disposable component of a business, but it should be minimized when possible.
Debt, on the other hand, is a finite obligation. In many cases, you can use debt in the same way, or as a substitute for, equity, without the long term dilution of equity. However, it’s important to understand what debt entails.
A debt investor chooses to forgo the long term appreciation potential of your business in exchange for what is perceived to be a reduction in risk due to certain structural features of a debt investment. Namely, they have senior claim on the assets and cash flows of that business (or some predetermined subset of them).
What to Expect?
We’ve seen many times that companies can be unrealistic about their debt options and how much it costs.
Unless you’re a profitable company that has been in existence for at least three years, running a business with healthy financials, you’re mostly likely not receiving scalable debt financing at 4 percent to 6 percent. The earlier stage your company is, the more expensive the terms on your debt financing.
Why do equity investors want lower valuations and more ownership in your company in the earliest stages? It’s riskier, and therefore they want to be compensated for the upside for taking that risk. It’s the same for debt investors.
Besides being early, other factors weigh on the pricing of debt:
- What’s the collateral?
- Is the end customer a consumer or a business?
- What’s the credit quality of the borrower (ex. subprime vs prime)?
- What’s the geographic location you’re targeting?
- What is the seniority of the debt instrument?
- Are there regulatory, FX, or other types of risks?
- How much cash do you have on the balance sheet?
If you’re an early stage stage company (Seed to Series B) expect to be paying 10 percent to 20 percent (in addition to warrants, depending on the size of the loan). There is a high level of risk for a debt investor to provide capital at this stage, and a high yield compensates for that risk. As additional compensation, warrant coverage provides a small piece of the upside that an equity investor receives.
Yes, it sounds expensive, but it’s why you should be realistic about financing your company with debt early on. If you haven’t figured out unit economics or product market fit, or generally aren’t producing enough revenue to cover interest payments, taking on debt may not be the right decision. Equity’s purpose is the additional flexibility that it provides at this stage, but of course that has a cost.
Friends & Family/ Equity
If you’re raising capital for a company you know will be dependent on debt financing (lending, financing, inventory), equity will be the first thing you will be using. Sometimes founders raise $250,000 –1 million from “friends and family” to finance initial origination.
If you have a good network and a solid product, you may be able to repeat this process. However, it doesn’t scale and the unsophisticated nature of such a financing structure does not prepare you for institutional capital. Plan your fundraise accordingly and carve out a portion of that equity raise to be used as a debt replacement.
That equity will be used to test your underwriting model and collect early data. This data can then be used to raise outside debt capital. We understand that equity is used to run operations and you need runway, so consider this an important part of your cash needs. Debt investors will be sensitive of the amount of cash on your balance sheet and your current/projected burn rate.
It’s important that we address venture debt before we move on. As mentioned, this is the most commonly recognized from of debt in Tech. That doesn’t mean it’s the most understood form of debt. Fred Wilson wrote a great post about Venture Debt a few years back.
Venture debt providers like Silicon Valley Bank (SVB) will provide debt to companies based on future financing rounds. It is also highly dependent on who is leading those financing rounds and how much money you have/will raise.
Typically you can use the debt for whatever you want. If you’re confident in your future fundraising and if the price is right, venture debt can be great to take on to shore up liquidity and extend your burn, or to finance investments in certain assets.
Case in point, Facebook used venture debt to fund the growth of their computing and server infrastructure. Others have used venture debt to increase runway in order to fulfill certain milestones which allowed them to raise their next equity round at better terms.
- The size and rate of the debt capital is totally dependent on the stage you’re at. If you’re a company that just raised a Seed round led by brand name VCs, you may be offered a small amount venture debt, but the rate will be higher and will likely include warrants.
- If a fund like Sequoia invested $10 million in your Series A, chances are you’ll be able to get an offer for venture debt. It’s based on the underwriting that Sequoia has conducted on your company and the fact that you have an investor who is a long term capital partner.
- Depending on the stage of your business and how well capitalized you are, rates on venture debt can range from 4% to 12%.
- Venture debt is typically not scalable as it’s related to the amount of equity you have raised or you will be raising.
- Venture debt is senior on your cap structure, meaning that any other debt capital you pursue will need to be subordinated (junior) to your Venture Debt. This can cause problems, so before you take venture debt, make sure you understand your other financing options and timeline. Another lender will not want to be subordinated to Venture Debt, and if they do, that capital will cost you more.
A bridge loan is a loan made to a company to help them get to from one stage of their business to the next. Usually, you would seek a bridge loan to give you more time to reach the necessary milestones to obtain new equity financing, or to execute a sale or other liquidity event.
Your company has a few months of burn left but you need to finance inventory for your hardware product. Once you procure this hardware, you can sell it and it will increase your revenue significantly. This jump in revenue hits the milestones you need to get equity investors excited about the business.
- A low cash position suggests you haven’t been able to secure equity financing and is close to insolvency.
- Y company doesn’t have enough cash to operate at its current burn to achieve those milestones and will run out of capital if you don’t receive some form of bridge financing.
- Even if your company reaches its milestones, raising more equity is not guaranteed?
- Interest rate with such risks will be very high, with added warrants.
In a lot of cases, companies will have to secure financing from current equity investors, as it will be difficult to achieve a bridge from a sophisticated debt investor.
However, that isn’t always the case.
A company that has a significant cash cushion and top tier (long term) equity backing will usually have an option to use venture debt to extend its runway. This would allow the company to achieve larger milestones and metrics before receiving new equity financing at much preferable terms.
Facebook secured a bridge loan prior to their IPO to use for corporate purposes (pay employee tax etc.) to maintain the level cash it had prior to the expenses. Everything is subject to having the right partner.
Fintech lending or financing companies need debt capital in order to originate loans or allow customers to finance assets, like property or machinery. In most cases, it’s not ideal for a startup to take on large amounts of debt in comparison to equity financing.
If you’re a lending and/or financing company, this can be a bit different, because you are in the business of producing assets (loans, receivables, etc.) against which money can be lent. Companies in this subset can create a number of different financing structures, such as on balance sheet collateralized facilities, off balance sheet warehouses, forward loan purchase agreements, and other special purpose entities. Imagination is the only limitation.
- You will need to use early equity capital to fund early lending as you develop your processes and underwriting models. We typically see this range between $250,000 and $3 million. This of course depends on the size and term of your loans and cash on hand.
- Soon after, your company can raise debt onto the balance sheet. This is a loan to your company backed by the collateral (loans, receivables etc.) That amount can range between $500,000 and $10 million.
- This is highly dependent on how much equity your company has raised. The more cash on your balance sheet, the more debt that can be supported.
- Interest rates typically range from 10%to 20%+.
- As your company grows origination volume, you will need a scalable capital source to keep up with demand, which is often enabled through an off balance sheet financing facility. The typical size such a facility starts at $5 million and grows to $100 million plus.
- As the facility size increases, capital costs fall to low-teens, which typically occurs when the facility has surpassed $50 million in assets.
- Warrant coverage tends to be larger when a facility is provided earlier in a company’s life and will depend heavily on the amount of debt provided and how significant that is for a company’s success.
- Warrant coverage can range between 1% to 7%, depending on the company’s stage, the size of the facility, the cost of capital, and the competitive landscape for debt financing options.
Examples of companies that have used debt facilities to grow their businesses.
- Principal- The original sum of money borrowed that is to be repaid at the end of the term or paid down through amortization.
- Rate- The interest rate that you’re paying on principal. A fixed rate is a rate that is agreed upon and does not fluctuate. A floating rate is a rate that adjusts with the movement in some benchmark borrowing rate, typically LIBOR.
- Term/Tenor- The length that you are borrowing for. We typically see anything from 2–4 years. The earlier your company is, the the shorter the term may be because of the uncertainty associated with the company’s existence.
- Interest Only- You are only paying interest on the principal borrowed for the length of the term. If you borrow $100,000, and your rate is 10%, you will pay $10,000 annually, but not pay any principal down till the end of the term.
- Amortization- In addition to scheduled interest payments, you are paying down principal on regular basis, often in equal payments.
- Collateral- The asset that a borrower provides to a lender to secure the loan. Collateral can be form of receivables, property or other assets.
- Advance Rate- The percentage amount that a lender is willing to lend against the value of a particular asset. In other words, a 90% advance rate means that a lender is willing to lend 90 cents on an asset that is worth one dollar.
- On Balance Sheet- This is a loan that is made between a lender and the parent company borrowing the money. On balance sheet loans are typically secured by a pledge of all of the company’s cash and assets, and is senior to equity investors.
- One must be careful about much debt they borrow on balance sheet. Too much debt in comparison can raise red flags and create obstacles for raising equity in the future.
- Off Balance Sheet — When a company is in need of large amounts of capital for lending or financing operations, an SPV (Special Purpose Vehicle) can be formed as a subsidiary of the company or the lender. This SPV is generally structured to be bankruptcy remote from the company and is serviced by the company, the lender, or by a third party.
- The purpose of an off balance sheet facility is to allow the company to obtain scalable debt capital to finance assets that it is originating, without encumbering the company’s balance sheet and subjecting itself to recourse from the debt, which is otherwise an issue for raising equity. This structure can also give lenders more comfort, in that the assets they lend against are separate from the company originating them, which means that if the company goes out of business or enters bankruptcy, the lender still has direct access to the assets in the SPV (this is the definition of bankruptcy remote).
- Warrant Coverage- This provides the option for a lender to participate in the equity upside of a company. The term warrant coverage is a percentage, which can range anywhere from 1% to 10%. Example- a $10 million loan comes with 10% warrant coverage. 10% X $10 million= $1 million. The lender has the option to purchase $1M of equity at the most recent financing round’s valuation, prior to the warrant issuance. The lender will then either exercise those warrants at an exit (acquisition or IPO where the price of shares is higher than the pre agreed price of the warrants), or will let the warrants expire if the company dies.
Please Reach Out
We hope this helps to provide a higher level understanding of the debt options available to early stage businesses. This is a lot of this information — and the information is general so please use it as a reference only.
Most debt transactions are bespoke and are subject to change on a deal by deal basis. If you have any questions or want us to dive deeper on a subject please feel free to reach me at mesh(at)mk2com.
I’d like to thank my partner Rennick Palley for co-writing this post with me. I’d also like to thank Dave Eisenberg, Brent Beshore, Aaron Harris, & Alex Pack for their feedback.