Why debt raises might make sense in a down economy

Debt gets a bad rap. That’s partly because it’s associated with higher risk. For startups, a few missed payments could force them to shutter, depending on the terms of their loan agreements.

But despite its reputation, debt isn’t an act of desperation during down times. As my colleague Alex Wilhelm notes, for companies that have high recurring revenue and visibility into future performance, debt historically has been a huge asset. Loans can provide money to grow while preventing dilution, which is perhaps why global venture debt funding hit an all-time high of $58 billion in 2021, according to PitchBook.

With economic uncertainty causing VCs to close their pocketbooks, debt could prove to be a viable alternative. The question, though, is whether it makes sense for all startups, given rising interest rates and the market’s general instability.

Don Muir, the CEO and co-founder of finance platform Arc, said that not all forms of debt are appropriate for all companies. Profitable, cash-flow positive, late-stage startups are prime candidates for traditional bank debt because defaulting on the loan risks pulling the company under. On the other hand, early-stage startups might seek revenue-based financing because the capital allocations are faster, based on future recurring revenue and have fewer requirements and restrictions.

Even seed-stage startups have debt options, Muir said, like annual recurring revenue (ARR) financing, which converts future revenue into upfront capital to fund growth.

“Debt will continue to play an important role in the capital stack. While debt financing is typically less expensive and more predictable than equity, in a rising rate environment, both forms of capital have higher costs simply because each dollar borrowed is more expensive and dilution is higher,” Muir told TechCrunch via email. “The demand for debt has grown significantly since the initial rise of Fed rates in February of this year and we expect that trend to continue, particularly for startups with high recurring revenue and strong use cases for funds. In general, as the cost of capital rises, startups will shift to debt because the requirements to qualify are significantly lower than equity.”

Re:cap co-founder Paul Becker pointed out that companies at the Series C stage have historically been good fits for debt, assuming they had stable growth, unit economics and product-market fit. (Think startups with subscription-based pricing, whose customers agree to make payments on a regular, reliable basis.)

Pipe CFO Lukas Wagner said debt starts to make sense once a company can “reliably predict the ability to service debt from month to month.” As for Vitt CEO Saket Kumar, he’s of the belief that firms with at least 12 months of revenue history and models “showing themselves relatively robust to the macro-cycle” (e.g., business-to-business) should “definitely” be investigating non-dilutive options.

Given how equity is becoming relatively more expensive, I’d argue for many startups, debt is a far more compelling financing tool in this current market environment,” Kumar told TechCrunch via email. 

Capchase CEO Miguel Fernandez agreed that debt should be on the table when it comes to strategizing funding. Different types of debt can be used for different purposes. Longer-term debt is ideal for bets and initiatives with “uncertain” returns, Fernandez said, like product development and new markets and geographies. At the same time, non-dilutive debt can be used for anything that’s predictable, like customer acquisition, user activation (i.e., converting users to paying customers) and working capital.

“With an optimal mix of capital sources, a company can grow faster and have more runway, as opposed to the old status quo, where the faster you grow, the more equity you sink into things like ads, sales commissions and working capital,” Fernandez said in an email interview. “A recent rise in interest rates has led to a more conservative institutional investment appetite, as already evident by VC investors retrenching from the market. Even for companies with strong unit economics, market conditions may only present highly dilutive equity investment opportunities or lower valuations.”

Headwinds and opportunities

John Gallagher is less rosy about the future. The CEO of Element Finance predicts the cost of debt will steadily increase in the next 12 to 24 months, causing some lenders to either pull out of specific industries or tighten their credit policies to mitigate risk.

“In the software-as-a-service business lending market, the cost of debt, such as revenue-based finance, was at rates well above high street bank rates, so there was an ability to absorb some of the increase in the cost of capital,” Gallagher told TechCrunch. “The debt market is very much still open for startups of a certain size. However … the way people price debt will also become more attuned to what is happening in the market (i.e., directly linked to rate rises). There will also be an effect on the amount a company may be able to borrow as lenders look to manage risk profiles more tightly.”

Another blocker for startups — albeit not a new one — is the inaccessibility of debt, according to Becker. Legacy lenders don’t usually allow companies to leverage “intangibles” (e.g., software and subscription contracts) as collateral for lending, leaving “asset-light” tech firms out in the cold. Often, startups are forced to go the route of alternative lenders, including venture debt and private providers with onerous terms.

“In my view, accessibility of debt is the biggest challenge for startups — irrespective of the changing interest environment, increased uncertainty and shift from a buyer’s to a seller’s market. The new wave of alternative debt providers already brings positive change but most of the innovation is still to come,” Becker said in an email. “[M]any startups are only now beginning to realize how important alternatives to venture capital are. Still, a lot of education needs to be done.”

As startups explore debt now, they’ll find that qualifying for loans has become harder than it used to be, according to Muir. Businesses with little to no revenue, negative unit economics and weak fundamentals — which lenders were less inclined to reject when interest rates were low — will unsurprisingly have a tough time securing loans. But so might startups on more solid ground, depending on when they pursue debt.

“Given that [the Fed] has stated that it will continue to raise rates, startups who qualify for debt and other forms of alternative financing should consider taking it sooner rather than later, and locking in fixed rates if available,” Muir said.

Muir said that over the past six months, he’s seen an increase in the number and complexity of stipulations in debt deals “across the seniority spectrum.” For example, there’s been a rise in increased minimum cash balances that necessitate that founders restrict a portion of their cash. Lenders are also seeking to add performance requirements such as minimum growth rates and gross margins, even operating leverage. (In accounting, “operating leverage” is a formula that measures the degree to which a company can boost its operating income by increasing revenue.)

“Companies who are unable to meet these requirements may be subject to ‘streamline triggers’ (if included in the provisions), which enable lenders to sweep cash collections from customers into a separate account to repay the loans even before companies have defaulted,” Muir said. “For founders in a cash crunch, these quasi-predatory warrants may seem like the only option, but they can be detrimental to shareholders and should be avoided if possible.”

Fernandez said that startups today can generally expect to pay a combination of cash coupons and a small warrants package. (Warrants are contractual agreements that give an investor the right to buy a certain number of shares of stock at a set price.) Beyond this, they should expect to pledge a “security package” consisting of a subset of their assets — although this may not always be the case, he said.

“In navigating the debt market during this economic environment, it is critical to maintain a strong relationship with debt capital providers who will support you across debt raises,” Fernandez added. “Given the challenging macro environment, raising a round in the coming months will be difficult as your revenue and growth will have to be much higher in order to achieve the desired valuation. So startups should be looking at ways to extend their runway to buy time for that growth to materialize.”

The upside to all this is that the comparatively short-term nature of debt offerings can insulate them more from long-term risk, Wagner said — despite the hurdles involved.

“While in equity markets, times are very tough right now, valuations are dropping and availability of capital is constrained,” he said, “but alternative financing markets are still looking comparatively strong.”