June 22, 2020
When entrepreneurs seek growth capital, they have traditionally focused on venture capital (selling a portion of their company to VCs); however, they are now increasingly considering debt as an alternative to venture equity.
Venture debt (as opposed to venture equity) has become a popular alternative for growth funding, especially for later stage companies looking to minimize dilution.
The outdated stigma against debt faded long ago as entrpenuers and VCs learned to appreciate the many benefits of financing late stage growth with debt. If you’re getting a flashback of being buried in never ending student loans – this is far from reality.
Assuming your business has a steady revenue stream and a proven business model, you should be able to reasonably plan for your future repayment obligations.
Growth debt is often an attractive way to avoid a highly dilutive equity raise while still being able to invest in growing your business.
While growth debt may not be the right choice for everyone, it can be a wise move for founders who have already gone through several rounds of financing but need additional funding to reach their next milestone. Companies with high growth potential or companies that are preparing for an exit (IPO, acquisition, buyout, etc.) should consider using growth debt (over equity) so its owners and investors can maintain a larger stake in the company – ultimately, more money in their pocket.
Unfortunately, some entrepreneurs opt for venture capital funding without considering alternative financing sources, unaware how much it could cost them in the long run if their business prospers.
Growth debt (aka venture debt) is an alternative source of funding for fast-growing late stage startups.
It can be a replacement for or a complement to equity financing. When used in the right situation, it can help businesses grow without its founders and investors having to incur unnecessary dilution nor give away control of the business. Typically structured as a three to four-year term loan, proceeds are used to fund working capital, growth initiatives and acquisitions.
Unlike traditional bank lending, growth debt is available to companies that do not have positive cash flows or significant assets to use as collateral.
First and foremost, using debt to fund your business will be cheaper for companies that expect significant growth. To compare the cost of debt (a loan) to the cost of equity (ownership in your business), you need to look at two factors: (1) the interest you’d pay the lender over the duration of the loan and (2) the portion of profits you’d potentially give up to an investor upon exit of the business. Our cost of capital calculator can help you compare your options. In most situations where you anticipate a significant increase in valuation, debt will be less expensive than equity – and the smart decision.
When you use equity financing, it often requires giving up seats on your board. This means, there will be more opinions on how the business should be run to meet its growth goals and new sets of expectations. Now, if you’ve been through multiple rounds of equity raises and have added a handful of new board members, you may be in a situation where you are no longer the controlling voice of your company. If you disagree with the approach of your fellow board members, they can overrule you and in extreme cases, oust you from your own company.
On the flipside, most growth debt lenders do not require a seat on the board.
They generally don’t get too involved in your business as long as you’re making on-time payments and meeting pre-agreed upon performance metrics.
One reason many companies choose to use debt is that it can lower the after-tax cost of financing their businesses, depending on the taxable income of the business. Most interest and debt financing fees are tax deductible for federal income tax purposes and reduce the amount income subject to taxes. Dividends and other distributions paid to shareholders are not.
For a company with a 21% federal tax rate, a 10% interest rate has an after-tax cost to the company of 7.9% versus a 10% dividend on equity which will have an after-tax cost to the company of 10%. Most interest is tax deductible; dividends paid on equity are not.
If you’ve raised previous rounds of equity financing, then you know how long it can take – and also, you may have experienced the disappointment of having invested so much time only to have things fall through at the last minute. Unlike raising a VC round, which typically takes between six and nine months, raising debt financing can be done in as little as 4-6 weeks.
The benefit here is not only quicker access to funds, but more time for you to spend where it matters most – growing your business. Debt saves you time both at the onset and throughout the duration of the loan.
As you can see there are many benefits to using growth debt – but it may not be right for everyone or every situation. It is important to explore all your financing options before making a decision.
What you decide now, will affect your business later.
At Runway, we are committed to providing flexible debt solutions to borrowers, particularly in this time of uncertainty. We have significant dry powder to partner with the best companies and enable them to capitalize on growth opportunities. Our expertise lies largely in technology, life science and consumer industries and we have a proven track record of successful exits – a few examples can be found among our portfolio companies Drawbridge, Mobius and eSilicon.
If you would like to learn more about growth debt, please feel free to get in touch.