Debt in the world of startups
Demystifying the types of debt and their suitability for Frontier Tech companies at different stages in their life cycle
The path to being a successful entrepreneur is long and tough. Most set out on a mission to solve a problem through ingenuity, technology, and hard work. Few undertake such an endeavor thinking about what “pari passu” on a term sheet means or when the best time is to take out a line of credit. Things often come out of nowhere that can cause an entrepreneur endless headaches and, at worst, cost them their company. Working in SVB’s Frontier Tech group, I see this all the time. The effort required to understand all the different financing options available and how to access them can cost valuable time and resources, which for a startup are in short supply.
In my role as head of debt solutions for the Frontier Tech group, I felt it would be useful to share my experience and thoughts on the best financing options for the different life stages of a startup. Debt can be very beneficial, depending on the company’s needs and the founder’s preferences. Of course, the most obvious benefit is that debt is non-dilutive (or, in a couple of cases, minimally dilutive). The founder can keep their ownership intact and does not have to give up control in the form of board seats. The key to debt financing is getting the right amount at the right time, so let’s dig into that.
Lending to very early-stage companies is a tough ask for any bank, as startups typically lack fundamentals or a track record to help with due diligence. At SVB, we recognize the need to support all players in the innovation economy, which is why we are working to provide access to revenue-based financing solutions to these companies. Typically, the point when debt starts to come into play for a startup is around its Series A financing. Frontier tech companies tend to still be in R&D mode, refining their product and business model.
A good illustration of this is the robotics companies that we work with. Financing needs for these companies usually involve buying equipment and building inventory. Given that typical round sizes equate to 12 to 24 months of runway, companies will look to add growth capital to provide an additional runway of three to six months. They also look to SVB for equipment financing so that equity dollars need not be used to buy depreciating assets. This extension allows the company to hit additional milestones and complete one or more proofs of concept (POCs), enabling it to have a better opportunity to raise the next round at a higher valuation. Using debt for financing equipment is also appealing to equity investors, who prefer that equity dollars go to R&D or other growth initiatives.
Debt Is Underused by Frontier Tech Companies as Shown by the Debt-to-Equity Ratio over Time
By the time a company reaches its Series B, it is starting to generate meaningful revenue from a handful of contracts and/or POCs. As with earlier-stage companies, growth capital and equipment financing can certainly play a role at this stage, but increasingly customized facilities structured around signed contracts can be very helpful. For example, SVB is working on new financing structures for companies employing a hardware-as-a-service (HaaS) model. I give an overview of HaaS here. Also, this is the stage when accounts receivable – and purchase order — based facilities are often very valuable, as they can smooth out working-capital cycles and provide management with confidence that they have financing if they have to agree to extended payment terms, as is often the case when a startup is dealing with large corporations.
Take semiconductor companies for example. The industry is experiencing a renaissance due to the emergence of startups working on application-specific integrated chip designs, such as bitcoin mining and machine-learning. Startup semiconductor companies often have elongated working-capital cycles, as they have to provide cash up-front to the foundry to produce the chips; yet they also have to accept longer-than-normal payback terms because of the buying power of their large customers. This leaves a significant period when a company needs to find capital to fund the timing difference. So what would I recommend? First, a purchase order facility can provide up to 50 percent of the financing for a contract upon purchase order issuance. This structure would typically be enough to cover the cost of goods sold related to the order. Once the chip is delivered and the company is waiting to collect cash, it can leverage its receivables base with a line of credit to get roughly 80 percent of that amount to fulfill the remainder of the capital required.
One of the unique aspects of SVB is that we work with companies at every stage of their life cycle. This does not stop at a company’s IPO. Not many frontier tech companies have gone public; however, it is without a doubt that over the next several years we will see a wave of these companies achieving that type of scale. Once they do, their financing needs will vary.
Many pre-IPO companies are trying to minimize equity dilution while simultaneously looking to maximize growth (which requires cash). Mezzanine debt is a good option for companies at this stage. Raising debt can supplant or at least supplement a final equity round prior to an IPO. Typically, mezzanine debt comes at one-third the cost of equity and avoids further dilution and potentially messy ratchet activation (depending on the valuation). Companies at this stage need large credit facilities, whether in the form of term debt or an open credit line (a “revolver”). Oftentimes, the amounts required are larger than any single bank can hold, so sharing (or syndicating) this responsibility with other banks is necessary. SVB’s robust syndications desk is a key differentiator for us. Given our market leadership here, we are able to confidently work with companies on debt financing structures that we know will be attractive to the broader bank market. We also make it a smooth process for the client, as we work directly with all the participating banks on the client’s behalf, so the client has just one point of contact.
As with most things in life, the real-world situation is nuanced and more complicated. To advise on debt is to understand the unique needs of the company, the industry, the technology, and the venture life cycle. This is where SVB has a real advantage, and we pride ourselves in sharing our experience; so if you have a question, please reach out.
