I am in the process of advising an early stage startup that has raised already a Series A. They are at the moment looking at their options while putting the fundraising strategy together for a potential Series B. They are a Saas busines.
During our fundraising discussions the possibility of doing a financing round via debture debt seemed to be a viable option. The argument was that venture debt is cheap as it does not dilute the equity of the stake holders. The only issue or concern here is that the business is not profitable yet and being on default could be the death of the business.
With the above in mind, is raising a venture debt round a good idea for early stage companies? What are the pros and cons? Thanks for the guidance.
Capital structure needs to be considered on a portfolio company case by case basis but there are plenty of instances where venture debt makes sense. The most obvious pro is that venture debt can reduce dilution while extending a company's operating runway and valuation creation prior to a Series B round. It is best used in situations where the company has assets and cash in the bank. You never want to negotiate venture debt from a position of weakness in a distressed situation because the lender will negotiate for a high rate 10 - 15% and significant warrant coverage given the risk profile. Another consideration and risk is to ensure that the business can service the debt or repay it out of proceeds during future rounds. You never want to be so overlevered as a start-up that you discourage future equity investors from coming on board. If you have a business with inventory and A/R you would be better served going with a more traditional ABL or line of credit but many start-ups can benefit from venture debt and it has become more widely accepted over the past 10 years.
Hi Neha. If you can get any type of debt financing, venture debt or otherwise, it is always preferred (if you are coming from the equity perspective). As long as your business is generating significant cash flow to pay down the debt in a timely manner, you would maintain more equity using debt than equity financing. I always recommend to any of our clients at Xcelerate Financial that you should always take debt when its available as you keep more equity. Equity financing is deemed the "most expensive" financing that exists.
Owning a smaller share of something is better than owning 100% of nothing. I have seen too many founders avoid dilution to their detriment. They either fail to maximize their growth potential or they raise debt capital and end up dealing with compliance issues and/or loose their company. If you client isn't ready to roll the dice, then accept some dilution and make the new capital count. There is usually a way to maintain effective, if not absolute, control of the company post investment. Good luck.
I believe that too many entrepreneurs have drunk the Kool-Aid that founders must go through multiple rounds of funding in order to be successful. One has to remember that this advice typically originates with investors. in most cases, from day one investors' interests and Founders' are not aligned. They want you to grow fast and strive to have as large a stake in the company ownership as possible. You want to build a business where you can keep control and reap the greatest financial (or other) result. The main reason investors push for fast growth is that they know that most of their startup investments will fail so they need to make their money on one or two that survive with outsized growth. As an advisor, I recommend that you talk about how to find a problem worth solving so the company needs as little outside investment as possible. Barring that, I think that a founder should do everything s/he can to avoid 3rd party money. Greg Crabtree talks about this in his breakthrough book - Simple Numbers, Straight Talk, Big Profits. Here are some simple truths; growth sucks cash, profits are the precursor to cash flow, cash is king in any business. The only reason to grow fast is that you are in a market where capturing as much of it as fast as you can is the ONLY way to win. There are plenty of examples where this is not the only path. Good luck with your client.
There is now a solution for SaaS companies to get debt funding which does not disrupt the cap table meaning the annual subscriptions of the SaaS customer can be leverage to access the capital as an advance vs. working with the MRR as working capital. I can help get SaaS companies this type of funding from $50K to $10M, or other type of debt solutions. 416-669-9763. Jeff
My comment is a singular additive point as you have many good opinions already.
The only thing I would stress is that, if you can attract a bridging loan, do not automatically assume that a later equity investor will allow use of their funds to pay off that bridging loan. Whether or not there will be a later equity round, your company needs to have confidence that it can service that bridging loan.
The fact that the business is not profitable, which I am assuming also means it is not cash flow positive, makes one wonder why a loan is being considered.
It is can have its draw backs particularly as you pointed out the stage of the company. The company would need to know the terms of the venture debt and how much wiggle room do they have to miss their numbers and still not be in default. Will the venture debt be converted to equity in the event of default or will the security pledge kickin on the founders? Does the venture debt require a personal guarantee from the founders? On the company side, how well have they been tracing in their forecasts? What is the forecast for when they are profitable? What are the critical milestones and likeliness to achieve them? All of these questions really will shape the type of debt. Generally debt is better than equity. It will typically cost the company and founders a lot less. On the other hand if the debt is structured so negative to the founds, it may cost them more.
Obviously there are a lot of variables and other factors when considering such a move but a "bridge deal" based upon a combination of debt and equity that is not too imposing upon revenue just might provide the startup with the capital that it needs to reach the next level revenue targets and/or profitability.
1. What is the current capital structure?
2. What will be the capital structure post debt? Post equity?
3. What is the cost of the debt?
4. How comfortable you are servicing the debt? What is the probability you will not be able to? What will happen then?
Answer the above and the answer will present itself