With various options to weigh, raising your capital stack can become daunting. When raising equity, your attention is likely on dilution, valuation, preferences, rights, and who's on your board, among countless other things. Similarly, there are many details to evaluate when raising debt as well. With the rise of short-term lenders in the market, we'd like to point out a few overlooked aspects of short-term financing to bring greater transparency to founders.
Sticker Price: Too Good to be True?
Short-term lenders often advertise very low rates for growing start-ups. It isn't uncommon to see rates as low as 7% (typically reserved for the best companies and higher for the average business). The issue is that the sticker price doesn't accurately reflect the true cost of capital from a fundamental viewpoint. However, this rate fails to include the idea of money's time value.
Time value of money is a core principle of finance. As we've explained previously, understanding this concept is essential if you're thinking of taking a loan. In short, a dollar today is worth more than a dollar someday in the future. Therefore, the quicker money must be paid back, the costlier the loan is. Here's how it works out in practice:
Take, for example, a $250,000 loan that is paid back over 12 months with a 9% "fee." The total amount to be paid back would equal $272,500 ($250,000 * 1.09) in equal installments of $22,708 ($272,500 / 12). Using an internal rate of return calculation (this considers time value of money), the comparative interest rate is closer to 17.6%. Far more expensive than the sticker price might suggest!
The key here is to understand the cost of capital used by the lender and compare apples to apples. At Element Finance, we like interest rates as it is the most commonly used cost of finance in our everyday lives (car loans, mortgages, credit cards).
Working Capital Drain
Adding to my earlier point, the timing of repayments is an often-neglected aspect of the capital stack worth considering. Working capital is crucial for any business to have under control, especially a growing start-up. The nature of short-term loans requires a significant cash drain on the business. Relying too heavily on these funding sources can put your business in a working capital crisis.
We recently encountered a business with $9 million in ARR that owed $7 million to a short-term lender. Interest and principal payments were eating up over $1 million/monthly. You can't run a business when your cash flow is being decimated to that degree.
One of the short-term lenders' key characteristics (and appeals) is expediency. Most short-term lenders leverage machine learning and algorithms to perform the underwriting process and deliver funding options much quicker than a traditional lender. In an age of instant gratification, I can see the attractiveness of a solution like this. However, despite the benefits this might have, I would like to argue that it might not be in the business's best interest.
As highlighted in the over-indebted example above, algorithms seemingly struggle to look at the business holistically. The example business was growing quite well, hence the continued tranches of short-term debt. However, the algorithm failed to consider the burn from operations plus repayment. Because of this, the business was required to take out new funds simply to pay for the debt they'd already drawn.
We've found this to be the norm and not the exception at Element. We have had to refinance many short-term loans for a variety of reasons. The common denominator? Algorithms over-extend loans to businesses that cannot service the loans taken out. Just because you can borrow money doesn't mean you should.
In Praise of Relationships
We're a boutique lender, and we've long championed the benefits of strong relationships when loaning money to growing SaaS businesses. We think having an ongoing dialogue between the lender and borrower instills discipline on both our parts and gives the SaaS company the best chance at success.
Our experience at the start of the pandemic is illustrative of this fact. We had one borrower that entered a rough patch and couldn't meet the loan's original terms. So, we worked with them and restructured the agreement, extending the interest-only period in the process. The result? They emerged as a stronger business, and we even lent them more money! This sort of flexibility wouldn't have been possible with a short-term lender.
When Short-Term Financing is Good
Although we hold many reservations about short-term lending, they have their place and can prove helpful to various businesses. Our conventional wisdom is that your sources of capital should match your intended uses. For example, if the business needs working capital to sustain itself while the next equity round closes, the expediency and accessibility of short-term finance might do the trick. If, however, you are taking on an R&D-heavy project to improve your product over the next 12-24 months, short-term lending could cause serious headaches.
The Bottom Line
Short-term lenders can be tremendously valuable when used prudently. However, we caution founders from misusing these funds.
Looking for an easy-to-understand term loan for your SaaS business? We're Element Finance, and that's our wheelhouse. Give us a shout to see if what we offer is what you're looking for.