U.S. Startups Taking on Debt
bloomberg.com
bloomberg.com
If all factors point into the right direction, why would you give VCs a free ride with a steaming train instead of just going all in yourself and personally taking on a bank loan? (especially in the way more conservative and less trigger happy VC environment in Europe)
No doubt it's hard (due to much heavier regulations around bank loans), but with the right KPIs it's really not much harder than raising a round.
Sociomantic did it. We did it too - and by now financed our own Series B with revenue.
Way too many people trying to build a startup instead of building a company...
Because most startups fail?
And startups that VCs aren't interested in, even more so?
What I think the ecosystem of startups in general (not just tech startups) needs is a continuum where it's more or less obvious how to "plug into" an ecosystem and succeed. And as long as your company is producing a satisfactory product / service (to the customer) you're more than likely going to succeed.
Will this transition happen within our lifetimes? Perhaps not, but I think it's an important thing that needs to be fixed for the future of civilization. Do I even know exactly what this other world will look like? Probably not, but I do believe it assumes there will be far fewer ultra wealthy and ultra poor, and a whole lot of middle class.
Do you have any reference or data to back this claim?
VCs often aren't interested in startups that don't aim to be a billion dollar business. And those might actually have a better chance of succeeding.
https://m.signalvnoise.com/reconsider-41adf356857f#.9npvz09a...
You mean "personally" as in the young company has no material revenue -- and therefore for any "business loan" the founder applies for, the conservative banks will always demand collateral of personal assets including house, car, retirement savings, etc? (The young startup has no business assets such as airplanes, factories, datacenters, etc for the bank to seize in case of non-payment.)
Well then, the "why" should be obvious: VCs can give orders-of-magnitude more money than personally-collateral-backed bank loans can provide. Also, the VCs (the good ones) can dive into their rolodex to help you hire hard-to-find executives. A bank loan officer doesn't have the same motivations.
E.g. In 2005, Mark Zuckerberg got $12.5 million from VC Accel Partners. There is no bank that will give a 20-year-old college dropout with no revenue a $12.5 million loan. Yes, his parents were upper-middle class but I doubt Mark had $12 million in personal assets to secure as collateral for a bank loan.
>, but with the right KPIs it's really not much harder than raising a round.
I think it's very hard to concoct a scenario where a startup founder has virtually equal opportunity to secure $1 million bank loan or $1 million in VC investment -- and the only reason he chose the VC was that the founder didn't have the financial wisdom to choose the debt. I can't think of a case study where that suboptimal decision actually happened.
In other words, the type of business (lifestyle/bootstrap/niche vs mainstream grow exponentially fast) or lifecycle stage (early no revenue vs mature with revenue) already predetermines a path of debt vs VC investment.
That being said, other sources of funding than VC (debt, mezzanine capital, government grants, incentivized programs, early temporary monetization options or getting experienced execs as cofounders for real shares (not the usual .5 options)) instead of paying them hard cash with borrowed money later on are often totally overlooked by startups IMHO for their own detriment.
(By the way congrats on financing your Series B with revenue, that is awesome!).
Just wanted to add one point in the equity vs debt debate is 'in theory' once a startup gets big enough doing the math on choosing equity or debt is very different. Once a startup is a real company and reasonably calculates how much money it needs and what it expects to earn on that money, an "optimal" capital structure calculation starts to emerge [1] and VCs and banks will compete for your business.
For a healthy, growing startup, if selling a certain % of your equity to a VC looks unattractive compared taking out a bank loan then your equity valuation is being mispriced here. Negotiate it. Conversely if a bank loan looks unattractive compared to VC equity offers (because the bank's convenants are too burdensome and your monthly interest/principal payments pull too much cash away from your growing business then the lender is mispricing your borrower risk). Negotiate it.
To follow on the Facebook example above, I believe they started mixing equity and debt almost immediately as early as 2004 [2]. Their seed investors backed their credit line (WTI invested $25k in equity and provided a $600k credit line). Later, FB took on $100M in debt from TriplePoint about the same take they sold .08% for $120M ($15B post). If you do the math here, then diluting ownership by .08% for $120M that you don't have to pay back vs. writing checks for $150M to pay back a loan over the next few years, the equity starts to look pretty attractive.
[1] Optimal Capital Ratio: One might disagree with how this is done or what it means but calculating an optimal capital structure is a thing: http://pages.stern.nyu.edu/~adamodar/pdfiles/acf2E/presentat...
[2] FB made some good choices early. I wonder how much equity and advise from Thiel played a factor: http://dealbook.nytimes.com/2012/02/01/tracking-facebooks-va...
Debt's a great strategy for companies looking to stave off venture capital so that they can improve their metrics in the short run and set themselves up for better term sheets. I know several founders who have saved millions in founder equity as a result of growing with debt financing first.
If you aren't young and have assets, ones that your family relies on, then you are risking the very foundation of your family--your home, car, savings, etc.
There's a very good reason loans are used more than they are.
Out of curiosity... how does one finance their own Series B with revenue? Did you actually issue new stock?
>Way too many people trying to build a startup instead of building a company...
Very wise words.
Do you mean "didn't need to raise a second round because we are profitable/growing?" Way to go!!
This was an awesome article to read as it balances the risks and possible advantages that taking on debt can bring a small company.
Do you mean relative to the startup scene / community in general? The general population? Other tech / startup online community? Or did you mean within HN itself where more people lean towards the sustainable business model?
I feel the exact opposite if we're talking relative to other segments of society. Most people I talk to don't know about the VC funding model.
The reality is that there is no single right way to build a company. You can find lots of survivors who used all sorts of capitalization strategies.
They do however sit at the very front of the line in a sale, (even before your investors) and that can make some investors a bit nervous.
The author seems a bit hyperbole happy; yes debt volume is up but it's nothing to foam at the mouth over...Phrases like "spiked in 2016", "surged 19%", "doubled last year's total" (Wellington did 5 loans last year, so "double" is only 5 more loans) this language makes "piling on debt" sound bigger than it really is...
If you look at the growth of startups over the past few years and compare that to debt volume: then up 19% or doing 5 more debt deals is in line with what would be expected and maybe even a bit low.
Second point: Without naming names, and without contradicting the article, a significant portion of debt taken on by startups is mezz debt or bridge loans. In the cases of bridge loans for example, more mature startups often use bridge loans prior to an expected IPO. So with the IPO market bottlednecked at the moment, the increase in debt deals this year is expected as it partly reflects startups waiting out an upcoming increase in IPOs (hopefully).
Connected to planning for IPOs is in some cases company boards and/or their VCs will encourage small debt deals to help train CEOs and CFOs for the "big leagues" after they IPO. New, relatively young, first-time CEOs and CFOs have no experience managing a complex capital structure of equity and debt. So boards and VCs encourage getting their feet wet with a bit of debt while still private. You see BS mini acquisitions by startups for similar reasons. If this sounds like boards and VCs treating some CEOs/CFOs like children who need training wheels, that is correct.
Lastly, the article makes it seem like a lot of startups are turning to debt because VC funding has dried up for them or they want to avoid printing a down round. This is not entirely accurate. While VC investors' approach might be generalized as thinking about 'reward before risk', debt lenders looks at 'risk before reward'. SO if a startup is too risky for VC capital, 9 times out of 10 they are too risky for debt as well. Any startups who think they have loans as a backup option if they can't raise their next round are in a for a tough wake up call. The startups that get debt are relatively healthy and will have both equity or debt as options. Or they just need a small amount of money and offer recourse assets. Debt is not as attractive as one might think if you actually do the math side by side and look at the convenants.
You're right it would take a surprise total catastrophe for principle to be wiped out. But the principle isn't always the main worry for startup lenders. Well it is, but the loan terms are written in such a way lenders are confident they will get some or all of the principle back. The big worry and risk for lenders is usually time. Being paid back too soon or being paid very late are both risks (the latter happens in bankruptcy cases where court system can take a long time to get lenders their money back).
Reminds me of the one startup we once partnered with that were entirely bank funded through a major R&D effort. I'm still in awe at the financial discipline it took them, given that the bank released money in tranches equivalent to what he needed for 1-2 months at a time, entirely contingent on meeting extremely narrow performance targets to convince the bank they were on track and still met the risk profile. Mess up the slightest little bit even one month, and they'd be totally at the mercy of their bank manager. The bank saw it as borderline in terms of their risk.
Meanwhile, if they'd gone to a VC with the business in the state it was in, the VCs would be metaphorically throwing stacks of money at the company.
But if you use debt, all the upside is yours.
I still think debt is better, especially because a lot of equity comes with with debt-like terms like liquidation preferences. So it's basically the worst part of debt and equity combined.
Many of these companies that take on huge VC rounds or take a lot of debt seem to often employ unnecessary many people, hire big unnecessary offices money that would never have been spent if it was their own money.
Sure I understand if you really need to grow fast, but even then I think many spend their money on unnecessary crap even when they have zero revenue.
The goal for every company should always be to maximize revenue and minimize the cost of doing business. People in the startup scene seems to forget that too often.
Startups don't forget that--they just focus on the former whereas established companies focus so hard on the latter that anything different looks unusual today.
Often doing both at the same time is difficult, and near impossible. To increase revenue you need a sales staff, and engineering time on building new features for new markets. Reducing costs requires your engineering staff, and maybe a business staff to negotiate with suppliers (or whatever your other inputs are). The engineers are often different kind of people. The type of engineer who is great at maximizing a process is probably not the same type of engineer who is good at rapid prototyping, and building something that "just works".
There's a transition in every startup that reaches a point of maturity where they start to build processeses, and start to rebuild existing systems. It's usually at the same time that the founding staff starts to leave.
Startups concentrate on Revenue, and hope they reach the level of worrying about costs.... and VC money makes that SO MUCH EASIER. Bootstrapping usually means you limit your input costs, which limits the rate of growth you can achieve.
"With fewer companies getting funded these days, many startups are opting to borrow money instead. "
Leaves some serious financial issues.
Generally speaking - if you could raise debt, you wouldn't ever want to raise equity.
The whole point of raising equity surrounds the fact that there's too much risk for debt.
If you can get good terms on a deal, and are not too leveraged, then every VC should be wanting the company to have debt in lieu of equity. Why would anyone want to dilute if they don't have to?
What on earth are these startups using as collateral? Equipment? Receivables?
And given the likelihood of a startup going bust, why are banks even offering debt, at any price?
I can definitely understand a 'bridge loan' for some financial operation - or even holding off for better valuations ... or again, some kind of low-leverage on solid receivables for an SaaS or something ...
If someone has some experience with this, maybe they can chime in?
Another possibility could be they are no where near to producing the revenue needed to make payments or pay off a loan and equity has no hard deadline or immediate revenue requirements. Unfortunately, that's kind of a terrible cycle as a company with cheap debt and revenue is likely to be built on better fundamentals than one that has no idea when it will have revenue.
---> Then there is no way they could feasibly get any debt.
That's the odd part of all of this.
- nobody is ultimately responsible for the debt. if the company runs out of cash, money gone. you cannot go after the people who squandered your cash. 90% of startups fails early. it's like a slot machine but when you win, you get 14%.
- a recent strategy for companies is bankruptcy followed by a 'restart'. get rid of any debt and a lot of employees, keep the rest.
- take the money and run. the current system would enable unscrupulous ceo's to direct the money to themselves and let the company crash. a lender would lose his money.
lending to companies is broken. if you have ever seen a loan fail to repay itself, you will not make that mistake again. to enable lenders to have a reasonable guarantee they will see their money back, the system should be adjusted so that shareholders can be easily held (personally) responsible for the companies debt.
conclusion: debt is an amazing way to finance a startup, if you can get it. the last thing seems very doubtful. a lot of these startup lenders are likely to lose money.
Debt is a powerful, but often fairly complex, financial instrument. Much like venture capital. The difference is that most folks in the financial industry are intimately familiar with debt but relatively unfamiliar with venture capital; or worse, to those coming from a PE background VC can often appear completely insane.
The growth of fintech has indirectly added a whole cohort of founders and entrepreneurs who are much more likely to know how to work with debt and be able to use it in tandem (or in place of) venture capital.
Obviously not written by a lender. There are countless schemes for lending money. These are custom contracts, not credit cards. At the simplest, a lender can delay repayment for a period of years in full knowledge that the business may fail between now and then. The startup accepts an otherwise ridiculous interest rate. Or a hybrid approach can be made whereby the later debt can be settled with stock, stock valuated when the debt is due. Maybe the stock takes off and repayment is easy, or maybe the stock tanks and the lender takes substantial ownership of the company. The deal still begins life as a loan.
Lending money to a business and buying a shares in that business are not mutually exclusive concepts. There is an entire range of schemes available between those two options.
Junk bonds are nothing new.
VC money is mostly issued with the expectation that most recipients will fail and it's priced accordingly.
A strongly performing 'real' company (i.e. one with a strong profit stream) will nearly always prefer debt to VC money in the same way a strongly performing public company will issue bonds over selling more shares--the later tending to be for companies in trouble.
Of course Bezos left Wall Street to found Amazon so he already had wider connections that gave him more flexibility in financing.
Look it up. It was a very ballsy move. Even by failing, it still went down in history as a pretty masterful move. It also caused Germany to change their accounting laws around things such as that. In the US an equivalent move would be illegal. The US learned from Short Squeezes when the NY City Council tried to punish Cornelius Vanderbilt and he exacted revenge on them.
Eh. I'm not too into the whole startup scene these days, and I haven't been exactly fishing for VC deals in today's market, but I believe that if your startup is only getting term sheets that provide you with a deal that forces you down or flat, you should seriously be considering looking at your business fundamentals before you are trying to raise funding by other means.
VC is speculative and looks for returns with dilution; if your company starts to go belly up, you can look at some acquihire or insta-acquisition through the VC's network so the VC firm can save face and see some ROI.
However, if you can't make your debt payments, banks don't care. They have no LPs to answer to, just their balance sheets. They will gladly step in with their attorneys and carve out any asset they can from your precious company. Caveat emptor. I have always been told by trusted GPs that debt is useful in very, very limited situations, and it seemed to me that the dreams of the entrepreneurs getting stuck with debt deals are already grasping at straws. I think there's a point at which you need to know when to quit.
+ They may not have a choice. A lot of things require working capital in one way or another.
"They will gladly step in with their attorneys and carve out any asset they can from your precious company." - thing is most startups have zero in the way of assets. So ... there's not a lot to collect upon. It's not like writing off a mortgage, wherein they can recoup 75% of the loan on foreclosure.
The whole premise of this article is upside-down ... why are startups with limited ability to collateralize even getting debt at any price?
I'll bet that this 'phenom' is happening for a variety of very specific reasons, and that 'debt' happens to be the common instrument, hence the basis for the article. If they broke it down into the various categories, we might get a better picture.
EDIT: The author is totally talking about venture debt and buried the lede. So yes, convertible notes as far as I can tell. Very misleading.
We had a $X million dollar venture note from SVB at a previous company that needed to raise cash, it was helpful to keep the company afloat but definitely came with some pretty onerous terms (as to be expected). It was much different to the convertible notes that started the company.
https://www.svb.com/Blogs/Derek_Ridgley/Extend_your_startup_...
[1] https://www.bloomberg.com/gadfly/articles/2016-06-15/uber-s-...