For start-ups and scale-ups looking to expand their businesses, equity finance can prove to be a double-edged sword. Whilst founders may welcome the extra cash, they may also have to dilute their holdings in their companies and this won’t suit everyone.
‘If you’re reluctant to relinquish control, or dilute your holding in the business, then you might prefer to take on debt,’ says Jason Hill, Head of Challenger Banking at PA Consulting. BDO’s David Bevan makes a similar point: ‘The decision comes down to whether the shareholders are willing to sacrifice equity in their business in exchange for cash, or take on debt to get the money upfront.’
What is debt finance?
The term ‘debt finance’ generally refers to business loans: money lent to companies, usually by banks, with an interest rate and maturity date attached. These are typically secured against the company’s assets – for example, its premises, trade debtors, intellectual property and/or cash flows.
Debt finance provides a ‘cash runway’, which a firm can use to grow its revenues – and therefore the valuation of the business.
The company may then use it to hire the necessary talent; develop and expand its products; run customer acquisition campaigns; enter new markets; and so on.
What are debt providers looking for?
Start-ups, however, may not yet have any such assets, and may not yet be generating cash. Fortunately, alternative debt financing options are tailored to the needs of fast-growth innovation businesses.
Kevin Smith of KPMG explains: ‘Traditionally, debt has been difficult for early-stage businesses to secure. But more providers are now creating offerings for companies with less of a track record.’
One such provider is Silicon Valley Bank, which works closely with the Mayor’s International Business Programme, an initiative set up to help London-based scale-ups expand overseas via a 12-month programme of mentoring, corporate engagement, trade missions and workshops and events.
Andrew Parker, Vice-President at Silicon Valley Bank, explains the its approach: ‘When lending to a pre-profit business, we typically look at its growth, and therefore its ability to attract equity investors, or transition to profit, in the future.’
For start-ups looking to raise debt finance, borrowers must be innovative, high-growth and disruptive.
‘We fund technology and innovation businesses that are disrupting a market, or creating an entirely new one,’ says Parker. ‘That means having a unique and defensible proposition that can’t easily be replicated.’
Working alongside equity
Debt is also there to work alongside equity finance. Edtech firm, Firefly Learning, is on the Mayor’s International Business Programme. Their co-founder Simon Hay believes equity and debt finance should ‘work hand in hand. They’re there to solve different problems.’
Parker agrees. ‘Venture debt isn’t an alternative to equity – it’s really there to complement an equity raise,’ he explains. ‘It’s an additional source of capital to allow a company to build value.’
Lenders will work collaboratively with shareholders. And like VCs, they should have networks of potential customers and suppliers, potential hires and future investors to bring to the table.
Things to consider before going down the debt route
The main terms a business needs to consider when taking on debt are:
- The loan amount and period – how much you’re borrowing, and for how long
- The total cost of the debt – the interest rate, plus any arrangement and/or early redemption fees
- The security – the assets against which the lender can claim should you default
- The warrant – the option for the lender to buy a small amount of equity in the company
- The covenants – the financial parameters the business borrowing the money must perform within (such parameters are a condition of some credit facilities)
Companies should also be mindful that the debt has to be repaid, however – and by a set date, Parker cautions.
‘Think carefully about how much you can borrow, and how much you can afford to repay. It’s important to be prudent with debt financing. Don’t be tempted to overburden the business – or yourself – just because it’s available.
‘Your lender should work with you to agree the right amount for the business, and the ideal balance between debt and equity.’
And choose your lender carefully, says Parker, by doing as much due diligence on them as they’ll do on you.
‘You’ll want a provider with a track record of being patient, and of supporting businesses through thick and thin. After all, you’re looking for a long-term partnership.’
For more information on the Mayor’s International Business Programme please see gotogrow.london.