Why Founders Should Embrace Debt Alongside Equity
By unleashing loans and other alternatives to VC funding, new forms of growth can be unlocked.
As the threat of a global recession looms, tech valuations are being cut, and the venture capital (VC) funding slowdown continues, there is a need to finally reconsider the deprioritisation of debt-based funding. For tech companies in particular, equity-based VC funding has often been preferred for the credibility it implies, beyond the financial capital.
In the current fundraising climate, however, debt funding can be perceived increasingly as a sign of control, as founders will have more company ownership and securitised runway. With debt funding now available to companies that are not yet cash-positive, a new growth model will be birthed from this, where equity as the only mainstream model will be a thing of the past.
Entrepreneurs must understand the options available to them.
When building a new business here in Europe or abroad, it's no secret that cash is king – a staggering 82 percent of startups fail due to cashflow issues. This is why so many founders seek external investment early on, rather than bootstrapping, so they can scale further down the line.
Software-as-a-service (SaaS) companies often begin to generate revenue and profitability much earlier than other tech startups, which means they're usually better-placed for bootstrapping – but bootstrapping will only get a founder so far. Eventually, eschewing fundraising means limiting growth.
VC funding has been the most popular fundraising method for a while now; it suits some founders and business strategies, but not all. Debt-based funding includes loans, which can be offered in many ways. Previously, debt funding was available from banks, but loans were short-term, and banks would typically want proof of two years of profit before lending, which many early-stage startups simply don't have. Now, with new providers, loans can last up to seven years and repayments don't start for two or three years.
Some are offered purely on the basis of revenue – so-called revenue-based financing (RBF), which is rising fast in Europe. These can be useful options but are typically short-term in nature, with the duration of loans lasting no more than 24 months, and so they're not suitable for all businesses.
Others harness artificial intelligence (AI) and machine-learning to tap into a company's raw data and combine this with relevant external market data to provide tailored financing options, based on potential. The latter can be particularly useful for early-stage startups predicted to grow super-fast, but which might not yet be profitable.
This is why, rather than settling on one option versus another, it's better for entrepreneurs to understand the broad range of funding options available to them, so they can ensure any capital taken suits their specific needs. Clearly, there are complementary methods to grow startups that exist as a viable and sometimes superior alternative to VC funding.
Most ambitious startup journeys start with equity. At seed stage, it's common for founders to part with 20 percent to 25 percent of their company when taking equity-based funding. That's a lot to give up so early on, particularly considering that equity can prove a competitive advantage for startups looking to hire top talent when they can't match big tech salaries. Data supports this: small businesses offering equity schemes are 26 percent more likely to have higher quality hires and 42 percent more likely to gain better Glassdoor ratings.
Unlocking new forms of growth.
Still, it doesn't make sense for businesses with predictable revenues to rely solely on equity as a source of funding. It can prove very expensive in the long run and doesn't always scale well. By unleashing loans and other alternatives to VC funding, new forms of growth can be unlocked. Founders should retain more ownership of their companies.
To achieve this, more transparency is needed throughout the fundraising process – something that VC funding doesn't always facilitate. After all, no matter how small, any investor equates to a long-term relationship. Many founders looking to grow and scale their businesses are prevented from doing so because of VC funding that prioritises profit and excludes large portions of the startup ecosystem. Founders taking VC funding usually must commit to certain growth targets and aggressive scaling ambitions.
Those who can't meet these expectations risk failing to grow and scale their business at any significant pace if they've already parted with a certain amount of equity and started long-term relationships with VC investors. As a result, it's common for entrepreneurs to find themselves stuck in certain phases of the startup journey, such as in between traditional milestone VC rounds like Series A and Series B (which partly explains the rise of round extensions).
As well as reducing equity dilution for founders, debt-based funding doesn't come with the same aggressive growth expectations that are usually attached to VC funding. This can be particularly important for founders who, for example, have small children or want children soon. This can help founders ultimately gain full control of their companies, especially if they operate in smaller markets, allowing them to grow, scale, and ultimately reach their full potential.
'Time is money.'
However, this doesn't mean that there is no place for VC funding; I believe the best place for it is in conjunction with alternative and complementary funding sources like debt financing.
With the right approach, fast and non-dilutive debt funding can help entrepreneurs reach their next growth milestone and make key hires at exactly the right time, resulting in a better valuation that appeals to VCs – useful for later in a company's life cycle when it's time to accelerate momentum.
Simply put, a one-size-fits-all approach doesn't work. Any founder knows how difficult fundraising can be. Retelling the company's story and hoping to convince the other side to part with their cash takes a lot of time and resources, which instead could be spent on the business a founder is trying to build – time is money, after all. At last, the capital structure model has been innovated to suit those who innovate.