This post is by Arman Tabatabai from Venture Capital – TechCrunch
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When starting a tech company, there seems to be a playbook that most entrepreneurs follow. While some may start with a bit of bootstrapping, most will dive straight into raising seed money through investors. In many cases, this is a great path. It’s a path I’ve taken twice myself, first with GroupMe, and then again with Fundera.
Ironically, though, my second venture-backed company is a business focused on helping entrepreneurs find debt financing—a process I’ve gone through only once myself. But after five years of building and scaling this business, it’s made me take a step back and consider the question of when and where debt financing might be a better option for a business than equity financing, and vice versa.
I view these financing vehicles differently now than I did half a decade ago, and think it’s time we start to think a bit wider and diversely about
we finance our growing endeavors.
After all, when entrepreneurs take venture capital, they usually sign up to provide a 10x return on an investor’s capital. This expectation ultimately influences how they operate their business in the short-term. Maybe they’re not always ready for that expectation.
Or maybe they know they need to focus on building a good business before a great one. In this case, debt may be the better vehicle, where the only expectation is to pay it back.
Whether it’s money to get your business off the ground, capital to fuel additional growth, or cash to cover a gap, and whether you’re guiding the growth of a burgeoning startup, a smaller business, or even consulting firm helping other entrepreneurs, you should think critically about how you finance your business.
Here’s what to consider.
The power of debt
For many business owners, the decision to pursue debt over venture capital is an easy one either because venture capital isn’t a viable path for them (as in, they’re not a hyper-growth business that can promise that 10x return on capital) or they don’t have the aspiration to sign up for a massive return on invested capital. In other cases, they just may not want to sell a piece of their company.
The data supports that most businesses fall into these buckets. By the end of 2018, the venture industry deployed $130.9 billion in US-based startups. That sounds like a lot, until you consider that only around 0.07% of businesses receive venture capital funding and that the whales of the industry inhale a lot of these dollars. On the other hand, bank loans to small businesses alone totaled nearly $600 billion in 2015—and that doesn’t take into account loans from online or alternative lenders, from OnDeck to Square to PayPal.
When a business does have some combination of profitability or predictable cash flow, positive unit economics, and working distribution channels, debt may actually be a better option than venture capital to hit the next series of growth milestones. It makes much more sense to scale profitable marketing with debt rather than equity as it’s non-dilutive and significantly less expensive.
But, that being said, getting debt financing isn’t easy. Lenders will evaluate a whole range of variables about your business, such as revenue, cash flow, assets, and personal credit. They’ll determine your ability to repay the debt, and extend credit based on their assessment.
This makes it very difficult for startups without a business model or revenue to receive debt financing outside of a business credit card or personal loan. That said, once a business is off the ground, and you have more of the inputs described above, debt becomes more viable for your business.
The calculus to use when taking debt is essentially, “Can I profitably repay this loan?” If the answer is yes, it may be the best capital tool to solve the problem or tackle the opportunity at hand. Examples might include having the ability to purchase inventory at a discount, buying a piece of equipment or other solution that will enable you to accomplish something new and strategic, staffing up for a specific project, renovating a location, or expanding your business with a proven model.
There are other practical concerns in play as well. If you have a small capital need (think anything under $500,000), a business loan is probably a better option than pursuing venture capital. Additionally, if your capital needs are immediate—you want to jump on that inventory deal, or make repairs following a disaster—then debt financing will most definitely beat out raising a venture capital round.
The opportunity of venture capital
For some businesses, the best path will be venture capital. For instance, if it’s either strategic or imperative to defer revenue generation or profitability for many years to come, venture capital is likely the only viable option, especially if there are ongoing capital and investment needs.
Similarly, companies operating in a competitive winner-take-all market are likely to raise massive sums of venture capital, knowing the most viable approach is to burn cash to achieve market dominance. Once they’re the market leader, they can then focus profitability.
Tread cautiously, of course, if you think the above describes your business. While these are the companies that take up major real estate in the headlines, they are often the exception, not the rule. More often than not, companies that pursue the venture capital route either go out of business or fail to return capital to investors.
That’s the risk venture capitalists assume, but is it the risk entrepreneurs should assume?
My belief is it’s a risk worth taking for some businesses. (Again, I’ve now done it twice.) But all too frequently, this creates an incentive to continuously scale at all costs—which means raising more venture capital, further raising the bar for producing a 10x return, and trapping companies into a cycle where their next milestone is not viability but the ability to raise more venture capital.
So, if venture capital sounds like the best path for your business, it’s important to have a plan to get off the hamster wheel of venture capital. That can very well mean that venture-backed companies should focus on when to transition to debt as a vehicle for growth.
What about venture debt?
Venture debt is often a powerful complement to venture capital. Venture debt can be used similarly to a traditional medium-term loan or line of credit, with the added bonus of not needing to show meaningful revenue generation at present. This kind of debt can also act as a bridge to the next round of funding.
When early-stage companies receive venture debt, banks normally underwrite the investors, not the company itself. They want to ensure its investors won’t let their companies run out of cash. At a later stage, providers of venture debt will take a more traditional lending view, assessing a company’s ability to repay through the revenue it generates. Many venture debt providers may receive the purchase rights (known as warrants) to company stock in lieu of classic equity, further sweetening their risk exposure.
Keep in mind that debt is always senior to equity. If something goes wrong with the business, the venture debt firm will liquidate everything they can to try to repay themselves. If you don’t pay back your debt, they could basically own your company.
Venture debt should really be used for things with a predictable, short-term payback. (This is good policy for all debt financing, of course.) Your current investors will worry if this isn’t the case, and raising equity to pay it back shouldn’t be your plan.
Venture debt is only available to companies that have already raised venture capital. And interest rates for venture debt loans are higher than for some of the leading traditional small business loan options, such as SBA loans. But when you need a longer runway in between funding rounds, you can join the likes of Netflix and Spotify in taking on venture debt, accelerating your company’s growth without additional equity dilution.
Firms such as Silicon Valley Bank and Square 1 Bank have robust practices in this type of financing. There is also an emerging crop of companies targeted at venture-profile businesses that require additional growth capital, but don’t want to be diluted. Lenders such as Lighter Capital and Clearbanc also provide debt as an alternative or addition to venture capital, targeted at SaaS and commerce companies. Keep an eye on these models, as there is plenty of room for innovative debt tools to fuel growth.
Debt and equity, not debt vs. equity
In the end, this is not simply a question of which singular option is best—it’s about understanding how you can use equity, debt, or other types of financing throughout the life of your business as effectively as possible.
Both debt and venture capital are viable tools for growth. The uses cases vary, and are highly dependent on the type of business, entrepreneur, and situation. The most important thing to understand is what you’re truly signing up for.
Expectations will change as your business grows, your needs fluctuate, and as you take on funding. You will also gain ancillary benefits from both options: For debt, you’ll build a strong credit history you can use to take on bigger and better debt funding options, such as an SBA loan; for equity, you’ll gain the advice and insight of your investors, who will have an active interest in guiding you towards success.
No matter the type of capital you take to grow, you’re taking money that is not your own. You will become a steward of that capital—and it’s the discipline with which you manage that capital that will ultimately determine success or failure