This post will focus specifically on when the best time is to use business term loans to finance growth. There are other times and types of debt too but this article will focus specifically on using term debt to finance growth (1).
Venture Debt is not included in this post’s analysis because it is essentially leveraging a companies venture capital investment to extend the runway to the next raise so different rules apply. Not all startups will qualify for venture capital or have venture capital firms involved (2). This post will focus on term debt and I will look into venture debt in a future post.
There are many pros and cons when using debt as a financing option that you should also consider. First, let’s talk about the best timing to qualify for a loan.
Venture Stage not Revenue Numbers
When assessing whether or not a startup can, or should, access a loan for growth capital, a common question that I hear from founders is “what revenue amount do you need to see?”. It is my own fault that I get this question because revenue targets are usually the simplest way to set the timing for this conversation. Both equity investors and debt providers will often say things like: “Let’s revisit when you are at 75K Monthly Recurring Revenue (MRR)” to founders, but revenue numbers alone are not the full picture for qualifying.
The evaluation should not just be about the companies revenue amounts but also the stage of the company. Most lenders will still want a minimum revenue amount before they open a discussion for financing so this is another reason why we give revenue targets to start a discussion.
Lifecyle of a Venture Diagram
Let’s start by getting a strong understanding of the Lifecycle of a Venture.
Starting at the top we see the Development Phases of a technology venture. It’s important to note that this diagram can be stretched to adjust for time. For example, a biotech company that needs to go through FDA approval would have a much longer time in the R&D phase than say software as a service (SaaS) company which could launch at a much faster timeline and improve the product as it adds customers.
Next on the diagram is the Cumulative Cash Flow (the red line). This is where we see companies go into burn mode as they are developing their product or proving out their market. The risks in this area are highlighted with the blue arrows as two ominous Valleys of Death.
The Valleys of Death
- The Technological Valley of Death is the risk that the tech/innovation that is being developed is not able to be created. This could be due to running out of money or running into technological hurdles that can’t be overcome with the resources available. One of those resources could be capital.
- The Commercialization Valley of Death is the risk that the market rejects your product. This is commonly referred to as a “product-market fit”. Farther down the diagram you can see First Revenues followed by Product-Market Fit. These are two separate stages because unfortunately generating revenue does not necessarily mean you have reached product-market fit (I’ll write about this in another post). This is also why minimum revenue targets are often given to a client by a lender to set a timing for the next conversation. Hitting a minimum revenue target can generally mean that you are progressing well through this Commercialization Valley of Death.
A company will typically need to have made it through the Technological Valley of Death using equity financing. Loans will rarely be given to companies with unfinished tech risk (3). They should also be generating revenue and be progressing well through the Commercialization Valley of Death before debt can be considered.
The main reason why these valleys matter to founders considering taking small business loans is actually quite simple. It is a lot easier to pivot in these valleys on equity financing than it is on debt financing. A loan will be much less patient and forgiving. If you haven’t made it out of these valleys and the loans need to be repaid, then the company will be in a situation where not only is there going to be pressure to use cash flows to pivot, but also pressure on cash flows from loan repayments.
Lending does occur in the Commercialization Valley of Death but it should be at a point where there are stable revenues and proper sightlines to future cash flows.
Something to keep in mind with lenders is that they are not typically going to test out or validate your product. They usually won’t have the tools, resources or time to do this. They will depend on your paying clients and their commitments, to assess and prove that you have market validation. The general assumption of a lender is that if you have consistent and growing paying customers then they are validating your product and your progress through commercialization.
Equity Comes First
At the bottom of the diagram are the sources of funding and how they fit into the picture. For a discussion on debt, I would remove the pre-seed/seed/series A part of this diagram. Since the series typically refers to the amount of equity fundraising done, there isn’t really a perfect answer correlated to “series” for when debt should be accessed.
Something that should really stand out from this diagram is the bottom section where the options for financing are laid out. One of the key things to notice is that equity financing options always comes first (bottom left on the graph).
One of the most powerful ways I’ve heard this described is that debt needs equity to exist.
You may hear this from your lender too. They might ask you to raise additional equity as a condition to their financing or tell you that the MVP needs to be completed with equity. Sometimes this will be described as being over-leveraged, which means there is not enough equity to support adding debt.
Starting or building an early-stage company heavily levered on debt is not only likely impossible, because no debt providers will qualify you for a loan, but also it can trap you in one of the “valleys of death”.
Why does this timing matter?
The answer is actually quite simple. There is a type of risk that should be financed with Venture Capital funds and less risky spending that can be financed with debt.
Sales, marketing and revenue-generating expenses have much more predictable risks than the types of risk venture capital will take. VC money is also much more expensive. Yes, it really is. And it should be. (I’ll go into this in detail in another post). They are taking on more risk than debt does. In finance: higher risk = higher returns. Debt could never charge the rates to match the returns that equity could get on a successful investment (it would actually be illegal), but lenders could also not accept the failure rates. Many lenders would be fired for an 80% write off rate even if 20% of companies exited. (4)
Since the original diagram wasn’t initially meant for a discussion around debt financing, here is an edited version of the diagram for discussion around when to use debt for financing growth:
When does Debt come in?
A very simple rule of thumb that most earlier stage debt providers will use, is that you should have a path to profitability within 18 months. This will be assessed by a cash flow projection (I’ll cover how to make one in a future post). It doesn’t necessarily mean the company has to choose to head to profitability, but a clear path needs to exist. The reason for this is simple too. Lenders want to know that when repayments start, the company has the ability to repay without the need to do another equity raise.
So when should you consider term debt for growth? The best time is when this curve starts to invert and you have confidence in your future cash flows. This is marked in green. Based on the risk tolerance of your lender they may be willing to come further left of this curve to finance the company at an earlier stage.
Here is a quick checklist to simplify the thought process of being ready to seek out debt:
- Minimum Viable Product (MVP) developed and in market
- Generating revenue
- Gaining traction and adding clients
- Identified revenue-generating opportunities to finance (use of funds)
Growth Capital as Rocket Fuel
If a company has planned revenue-generating activities, growth capital can be extremely cheap (compared to equity) and very powerful rocket fuel to shoot up that slope. The non-dilutive capital can be a great tool to increase your valuation before your next raise and to get a company to a higher revenue amount.
What kind of company does this apply to?
The beauty of this model is that it can apply to any scaling tech company or startup. They don’t need to have raised venture capital, which is a good thing considering only a small percentage of companies qualify for it. Some estimates show that less than 1% of startups are funded by venture capital (5). If a company has raised venture capital then venture debt is another option (we’ll look into this in another post.)
You can even be fully bootstrapping off profits alone and then shift gears with some debt to launch up that slope. For the all too rare, currently profitable startup, the opportunity is to grow with leverage by using debt to take advantage of additional opportunities that the profits alone could not have made available.
- Term debt can be an extremely powerful non-dilutive tool to help cash flow and for increasing revenues when it is used at the right time.
- Consider which stage the company is at and how far the company has progressed through the technology and commercialization valleys of death.
- When considering term loans, keep in mind that you will want to have a path to profitability (even if it is not followed).
- Consider the pros and cons of debt, equity and bootstrapping to make sure this option is the right fit for the company.
(1) Term debt is a loan that will have set repayment amounts that usually come after an initial interest-only period.
(2) There is often confusion around the term “Venture Debt.” The term was originally meant to be for venture backed companies that used a debt instrument alongside their raise to extend their runway. Sometimes it has been used to refer to any loan to a tech startup. In this post I’m using its original meaning of debt for venture backed startups. I will write about this in detail in another post.
(3) The exception here is, again, Bio-tech where there are times where a substantial amount of IP can be used by specialized lenders for financing in this Valley.
(4) This 80/20 split is based on the Pareto Principle which is the idea that 20% of the fund returns 80% or more of the returns. 80/20 Rule applied to VC
(5) Where Startup Funding Really Comes From by Laura Entis for Entrepreneur.com:
Original Life Cycle of a Venture diagram created by BDC’s Industrial, Clean and Energy Technology (ICE) Venture Fund