Some venture investors compare the usage of debt financing in their portfolio companies to placing dynamite in one’s living room. However later stage and buyout equity investors know that debt financing is requisite to generate healthy equity returns for their target strategies. Somewhere in the middle of this spectrum lies the growth stage technology company. It may be growing fast but is not yet consistently profitable. With revenue between $15 million and $100 million, it may not yet be a unicorn (and perhaps never will be). It has an established collateral base and substantive enterprise value, but it may have a historical operating history of only a few years.
At this point, debt financing must be evaluated carefully. When utilized appropriately, debt will reduce dilution, extend runway (in many cases to profitability), and accelerate growth with limited cost to the business; most often this capital is far less costly than an equivalent equity raise (see analysis below).
However, if utilized poorly, in the wrong situation, or with unfavorable terms, debt can reduce a company’s agility and become an obstacle to future equity raises.
Cost of Debt vs Cost of Equity – A (very) Simple Analysis
The following demonstrates the “cost” impact of a $15 million financing for a growth stage company that is transitioning to profitability under three financing scenarios: 100% debt, 50/50 debt/equity, and 100% equity. Note that “cost” of equity is simply equity ownership percentage give-up multiplied by equity value at year 4, less the original amount of the equity investment.
Financing size: $15m
Enterprise value at financing (year 0): $50m
Enterprise value end of year 4: $150m
Debt fees: 2%
Debt interest: 9%
Debt term: 4 years
Debt interest-only Period: 2 years
Debt warrant coverage (as % of loan principal): 8%
In the all debt scenario, existing equity holders retain >97% of the equity ownership and achieve 2.9x cash-on-cash returns (31% 4-year IRR).
In the all equity scenario, existing equity holders retain 77% of the equity ownership and achieve 2.5x cash-on-cash returns (26% 4-year IRR).
Of course this simple analysis ignores a multitude of factors that can dramatically impact “cost” such as accruing or paid-in-kind dividends, participating preferred structures and liquidation preferences of an equity investment, and amortization dynamics, covenants, and other possible constraints of a debt investment. Varying the company’s equity value expansion assumptions will also dramatically alter the results.
Some will argue that the added risk of adding debt to the capital stack could offset its benefit (though good luck winning that argument with late stage growth equity or buyout firms). In the end, the key is to keep debt sized at suitable levels and structured with appropriate flexibility.
In the next installment of Spinta Bytes, we will highlight when emerging growth companies should and shouldn’t consider a debt financing.