Let’s face it. Debt doesn’t exactly have the greatest reputation. Every day, it’s possible to pick up a newspaper and read about a company that over-leveraged itself and faced financial ruin. Equity, meanwhile, clearly has better PR. The odds are you’ve never seen a story about a Venture Capital firm putting a start-up out of business.
In certain situations, or amounts, debt can be toxic. For example, suppose too much money is borrowed, or the money borrowed is wasted. In that case, a company can face a cash crunch that will ultimately affect shareholders, employees and possibly lead to the firm shutting down altogether.
That said, we would suggest that debt’s bad reputation isn’t always deserved. In some cases, it makes far more sense for a company to borrow money than it does for them to issue equity.
Why Your Growing SaaS Company May Need Venture Debt
In our (admittedly biased) opinion, fast-growing SaaS companies are a great example of when debt can be preferable to issuing equity. Lenders won’t usually lend to businesses with little or no sales, but you may be a candidate for a loan as long as your company has monthly recurring revenue.
Typically, a SaaS company will turn to revenue-based finance or venture debt when trying to expand faster than its cash on hand allows. It will have a product in-market and a solid customer base but require financing to accelerate growth. The company almost always will have to invest in sales and marketing to grow.
Of course, one way to obtain financing is to issue new equity. But there’s a downside to this. Every new issuance of equity dilutes the founders’ stakes in the company they built from scratch. What’s more, founders may end up ceding control of the business to the new investors they bring onboard.
Founders may turn to venture debt instead of equity because they have a good sense of how the next 12-18 months will play out. They may believe that one of two things is likely to happen:
• Either they will achieve profitability, or
• Burn a lot of cash while growing rapidly
If they are on track to achieve profitability, borrowing debt is a rational choice and non-dilutive. On the other hand, even if the company burns a lot of cash while growing rapidly, it can probably do an equity raise at a much higher valuation. A higher valuation means less dilution for the founders.
Avoiding dilution isn’t the only reason SaaS companies turn to venture debt, though. Here are some of the others:
• Buying out an existing investor: If a current investor is looking to offload their shares, a founder may leverage the company to buy them out. This can be preferable to the investor selling to a party the company isn’t familiar with. Plus, it means the founder retains control.
• Bolt-on Acquisition: A startup may spot a great opportunity to buy a competitor or a company with an adjacent product. Borrowing money may be required to close the deal.
• Refinance Existing Debt: If your SaaS company already has debt taken on at a prohibitively high-interest rate or covenants that don’t now fit the business, refinancing with another lender will lessen the cost of carrying that liability.
It’s easy to think of debt as something to be avoided at all costs, yet it is often a much better option for a growing company. Sometimes, it can play a meaningful role in accelerating a company’s growth while protecting the interests of the firm’s founders.
Looking for founder-friendly term loans for your growing SaaS business? We’re Element Finance, and that’s our specialty. Plus, we never ask for board seats, warrants, or personal guarantees. Give us a shout anytime—we’d love to chat to see if we can help you take your company from good to great.