As venture debt lenders, we talk a lot about the benefits of debt, but sometimes a company should look for equity instead. We pride ourselves on giving straightforward advice to companies. If it is not a fit for us, we let them know why and what they may be better off doing.
Not every situation is a good fit for debt. Here are several where equity may be more attractive:
1. You’re burning huge amounts of cash to grow
If your company has to burn a lot of cash to grow, it can be difficult to lend to you. Most lenders are capped on how much capital they can provide you. If that number is too small to get you far enough down the line, then equity is really what you need.
The way to look at this is the ratio of recurring revenue to net cash burn. This can be calculated as monthly net cash burn divided by MRR. The lower the ratio the safer it is to lend you money, but the money lent will also last you longer on your growth path.
We see companies with a relatively low ratio of revenue-to-burn when they have a vast target market, there is a land grab between competitors, or they’re still in an early stage of growth. Capturing these big, broad markets against competition requires large marketing spends and a high net cash burn rate. Debt just won’t be able to provide enough fuel to get you to where you want to be.
2. You have a long customer acquisition payback period
Companies have to invest cash to grow. Waiting to recoup the acquisition costs doesn’t allow you to effectively reinvest profits for growth. Debt is optimal when you see relatively quick returns on money spent, because it allows the debt to become self financing.
I.e. the new sales quickly pays for the cost of the debt.
If a longer payback period occurs, the cost of debt may be prohibitive and a form of longer term capital may be a better option. Sometimes companies use a mix of equity and debt in this scenario.
3. You’re pre-revenue or expect low revenue for a while
Pre-revenue businesses have no choice but to raise equity from angels, friends, family, or the founders. Debt providers won’t lend to you with no revenue on which to secure their investment or with which you can fund repayments.
Most SaaS lenders will provide you with a multiple of your recurring revenue. If your growth plan involves you being zero or low on revenue for a while, you’ll need to look for equity.
4. Only predatory loans are available to you
In addition to higher interest rates, predatory lenders may require board seats, large equity warrants, extortionary prepayment penalties, or outrageous covenants. If this is all that is available to you, you might be better looking for equity instead.
This type of financing may put your company at risk, and you don’t want to lose control of your company by trying to save equity. Watch out!
It would be better to find an equity partner who can see your vision and support your growth until more reputable lenders are willing to work with you.
5. You want to make a large bolt-on acquisition
If you are in the market for a SaaS bolt-on acquisition, you are probably going to pay between 1x and 10x that company’s annual revenue (ARR). Depending on its growth, business sector, etc., that number might change.
Some lenders (like us), will include the bolt-on company’s MRR in the calculation to determine your credit worthiness. You’ll still be limited to around 6x the combined MRR of both companies.
Therefore, venture debt providers will be able to help you fund a bolt-on if the math works out to cover the purchase price. If a larger acquisition is on the table, debt can get you part of the way, but you’ll need an equity partner or cash in the bank to fund the rest.
When to look for debt:
If you have reliable recurring revenues and 6x your MRR can fund your business growth, you should look for debt. It’s likely much cheaper in the long run than equity.
To get started, talk to others who have used venture debt before and get recommendations. Then work towards getting a few term sheets. Some won’t be a fit, and you will want to compare all the offers to find the best deal for your company. Keep an eye out for prepayment penalties, equity warrants, and restrictive business covenants that you may want to avoid.
Ready to get your first term sheet? Apply here.