Written by A CFO’s Perspective (Part 1 of 4)
As a CFO responsible for the financial well-being of a software company, you have to balance the pros and cons of the various types of debt financing as an alternative or supplement to equity capital. In this multi-part series, we dive into the understanding debt and discuss the pros and cons of debt financing, taking into account factors such as the cost of debt, interest rates, and the implications for the company’s weighted average cost of capital (WACC).
Understanding Debt financing involves borrowing funds from lenders, such as banks or financial institutions, with the agreement to repay the borrowed amount along with interest and/or collateral. There are no shortage of folks ready to lend a growing software company money (for a fee of course).
For startups, debt financing can be an attractive option as it allows access to capital without diluting ownership or giving up equity in the company. However, lenders will require a solid business plan and a favorable credit history before extending loans. They will scrub your financial model to ensure you can service the debt.
Obtaining Debt Funding for Startups
Typically we use debt to fund in enhancing GTM machine that is working. For example, the sales teams are executing and hitting their numbers so we can add more AEs to grow the business. Or it can be to add to a refined marketing engine thats working well. In terms of the amount, it is typically based on forecasted ARR of your startup.
Securing debt funding for startups can be a complex and time-consuming process (especially post the SVB event). It requires a focused understanding of their business model, cash flow projections, financial statements, customer profile, and credit history of the company and its existing customers. Get ready to get all your due diligence documents ready.
The first step for entrepreneurs is to determine the most suitable type of debt financing for their specific needs. Several options include:
- venture debt
- convertible debt
- bridge loans
- asset-based lending.
Each debt option has its own pros and cons including varying costs of debt and interest rates, which should be carefully evaluated and modeled in the financial statements before making a decision.
Venture debt (many out there)
A popular choice among startups as it provides access to capital without diluting ownership or surrendering equity in the company. Typically, venture debt is secured against the company’s assets or future revenue streams and often comes with lower interest rates compared to traditional loans. This makes it an appealing option for startups looking to minimize borrowing costs.
By choosing debt financing options with lower interest rates, your company can effectively manage its cost of debt and contribute to a lower WACC. Now most software companies will not have hard assets so typically, there can be claims made on the patent portfolio or even the future receivables. Most of the time its about the future ARR for software startups. I’ve had a great experience working with the team at Columbia Lake Partners. They are based in Europe but work with Silicon Valley Startups all the time.
Convertible debt
This type of loan has the potential to convert into equity if the startup achieves predetermined milestones or raises sufficient capital from investors. The interest rates for convertible debt can vary but are generally competitive, reflecting the potential for future equity conversion. It is important to consider that if the company’s creditworthiness improves, it may be able to negotiate lower interest rates.
Remember however that convertible debt does not eliminate the dilution of ownership; it only delays it. When the debt converts into equity, the startup’s ownership and control will be diluted to accommodate the new equity holders. Furthermore, the terms and conditions associated with convertible debt can be complex and require careful negotiation, potentially leading to disputes between the startup and investors if not well-defined and agreed upon upfront. The uncertainty regarding the final ownership structure and the exact number of shares also introduces ambiguity, making it difficult to predict the future equity outcome for both the startup and its investors. At that count there are over 800 firms providing convertible debt:
Bridge Loans
Bridge loans serve as short-term financing solutions, “bridging” the gap between financing rounds. Although these loans often carry higher interest rates compared to other forms of debt financing, they can be valuable for startups in need of immediate funds to support operations or expansion plans.
However, bridge loans often have higher interest rates compared to other forms of debt financing and bridge loans are designed as short-term solutions. If you cant secure the next round of financing or hit the necessary milestones, that would not be good news so something to consider.
Asset-based lending
Asset based lending utilizes the company’s assets as collateral, giving lenders the right to seize those assets if the loan is not repaid as agreed. The interest rates for asset-based lending can vary, and they may be higher compared to venture debt or convertible debt due to the collateralized nature of the loan. Most software companies will not have hard assets so sometimes it might be tied to the receivables or even the patents of the startup. It’s not something that I recommend and think about the difficulty in valuing IP, patents, or even customer contracts. And if you do get it, the rates and the associated costs will be a lot higher as lenders will consider you “high risk”.
Your Comfort Level
I’m not a big fan of debt and if I do get it I try to pay down some extra principal every month. Nonetheless (depending on the cost of debt), it can make sense for your startup. Definitely do shop around to get the best deals, comparing different lenders and loan terms, including interest rates, repayment periods, and any associated fees (the fees can add up quite a bit). And don’t forget the warrants, fees, and all the little extras that lenders will tack on.
Be Prepared and Do the Math
Have all your financial records in order before applying for debt funding so you dont waste time. Furthermore, entrepreneurs should consider their long-term goals when seeking debt financing, as it can impact their ability to raise future financing rounds and scale their businesses effectively. Future equity investors might not like all the debt on your balance sheet.
Lastly, do the math on the WACC and balance the cost of equity and the cost of debt. When the fed funds rate was so low, it made sense to add debt to the balance sheet. In the current environment, it might make less sense but it depends on the confidence of your future cashflows.