Alex McCracken is a managing director in Silicon Valley Bank UK. In this article, he explains why debt is potentially a good growth financing strategy for tech businesses.
As venture capital continues to flow into the UK, with Beauhurst reporting £3.2bn equity funding into UK companies in H1 2018, there is a corresponding increase in the range of debt financing solutions available to tech and life science companies.
Larger tech businesses are raising levels of debt previously unheard of, such as Spotify’s $1bn in convertible debt, and online retailer The Hut Group extended its debt facility to £500m to finance acquisitions.
Debt can be an effective way of preserving ownership for management as a company grows.
With a variety of debt financing solutions now available, these are the main debt structures and their key uses:
For early stage companies that have investment from VCs but are still proving their model, venture debt is the best option. Startups will typically have raised venture capital from VC Funds, are fast growing, cashflow negative and likely to require further equity investment.
Venture debt can be used to fund opex and capex and extend cash runway to the next round by a few months allowing the company to achieve more.
The typical debt/equity ratio offered by lenders is usually 20%-35% with no covenant. Total loan pricing includes an arrangement fee, fixed interest rate in the 10%-12% range and warrants (right to subscribe for shares, typically a 0.5%-1% stake).
Growth loans and accounts receivable credit lines
When companies have predictable, growing revenues, then growth loans and/or credit lines become viable options. Since the companies are later stage and therefore carry less risk, interest rates are in the 6%-9% range (depending on stage of the business).
Growth loans usually have covenants set at certain revenue, EBITDA or cash levels that the business must meet, otherwise the interest rate increases during the period of covenant breach. Growth loans can be used to expedite growth or hiring or for geographic expansion. They should not be considered for early-stage businesses lacking sustainable models, or if the company’s realistic plan won’t exceed the covenant levels.
Credit lines are usually available to companies with a growing debtor book. If they have £1m+ of Account Receivable, they may be able to use Invoice Financing to cover working capital. Pricing is similar to that for growth loans at around 6%-9% interest rate. However if a company takes a line of credit from a bank but does not use the line for a period, then the bank may charge a non-utilisation fee (typically 1% of the facility size).
SaaS Credit Lines
For growing SaaS businesses with £500k+ monthly recurring revenue (MRR) that need working capital, SaaS credit lines are worth exploring.
This revolving facility gives credit available based on a formula (typically 2x to 4x MRR), and the credit facility may have covenants and/or warrants depending on the cash burn of the company.
Interest is paid on drawn balances and the credit line availability increases as the MRR grows. However, SaaS credit lines are not suitable for companies with a high churn rate, or to finance cash runway.
Revolving credit lines
Revolving credit lines are an option for larger businesses. Credit can be drawn at will with no limitations on borrowing ability, so they can be used for a broad range of purposes, from financing working capital and increasing liquidity to recapitalisations or minor acquisitions.
Facilities tend to be 1-5 years tenure with covenants. Interest rates are typically in the 2% to 5% range. Usually lenders will ask the borrower to pay down the line quarterly or annually to zero i.e. a “clean down’ period, to ensure the facility is used periodically to finance working capital (rather than losses).
High growth, late stage VC-backed companies often use mezzanine loans for to finance acquisitions, share recapitalisations and/or to boost liquidity ahead of an exit (ideally an exit via IPO or M&A planned within 2-4 years). Mezzanine loans are usually interest-only repayments, with the loan principal repaid at exit as a “bullet” as well as a warrant and/or exit fee. Unlike most other loans mezzanine loans are junior/second-ranking debt.
Cashflow positive companies can seek a loan from banks who typically offer loan amounts up to 2.5 times EBITDA range over 4-5 year term (cash EBITDA assuming all R&D is expensed). Covenants are usually based on EBITDA-leverage ratio and cashflow-cover.
For smaller cashflowing businesses lenders may ask for the loan to be amortised fully via monthly repayments (i.e. 100% amortising), but for larger businesses 50% of the loan can be amortising, with a 50% “bullet” repayment on maturity.
Whichever debt financing option is most suitable for your company, timing is key. Earlier stage businesses will get the most attractive offers from lenders when they have just raised equity and therefore have cash and are less risky. As such, companies should explore debt finance when times are good and they have a lot of cash runway as they will get the best offers from lenders. Businesses should avoid waiting to approach lenders when cash is low or they are wanting a cash “bridge”, as lenders may then decline or charge a higher price due to the increased risk profile.
Companies should also check each term lender’s offer carefully, and avoid restrictive items such as covenants set at a level the company is unlikely to achieve, or very high “success fees” payable at exit. Rather than comparing just headline interest rates, companies should compare all terms between competing debt providers to calculate an overall cost of capital which includes arrangement fees, early repayment fees, exit fees, non-utilisation fees etc.
Whichever debt structure you opt for, it’s vital to take references on lenders from your Board or advisors, and choose a lender who will add value through useful connections (not just finance) and will be supportive over the long term through good times and bad.