Too often startups focus their fundraising solely on equity funding. While in the past banks were reluctant to grant loans to startups things have now changed – the banks want their share of the startup market and have developed their product offering accordingly. Smart startups seize this opportunity and leverage their equity rounds with debt.
But why? Don’t the interest payments of a loan divert funds away from the company and away from the growth? Yes, they do; but considering the growth rate of a typical startup, the interest payments are immaterial. Even while interest rates between 6% to 12% might seem high, you should always compare these to your growth rate (and not your 0.5% mortgage!) and the cost of equity. If the growth rate is higher than the interest rate, you can create value with the loan. And cost of debt is usually less than the cost of equity (remember, every time you have an equity round you are effectively selling your equity).
One should always compare interest expense to the growth rate and the cost of equity (and not to the interest rate on ones mortgage)
Case example of debt, growth and development of value
Let’s compare three alternatives. We have a company in a SaaS-business. The product is ready to be scaled up and the future growth depends mainly on sales efforts.
In case one the company obtains 250k equity funding;
In case two 500k equity funding; and
In case three 250k equity funding leveraged with 250k debt.
Now let's take a look at the development of monthly recurring revenue:
As the growth is driven by the resources allocated to sales, cases two and three with more sales resources beat case one with lesser resources clearly. Also, the companies with more resources hit the break-even point faster and can use operating cash flow to support sales.
Let's move from revenues to cash:
As we can see, not only is the company growing slowly under case one, it hits the valley of death and needs to find way to bridge its way through.
Between cases two and three we can now see that as some of the cash flows are needed for interest payments, case three has less funds available for reinvestments in growth than case two. So, we still have equity leading over debt.
But let’s add value of founders’ equity in the picture as well. Assuming pre-money valuation of 1.5m an equity investment of 250k would dilute the ownership by 14% and an equity investment of 500k would dilute the ownership by 25%. Now let’s see how the value of founders’ equity develops.
Now we can see that while the profitability has been slightly higher in case two, the value of the founders’ equity is significantly higher in case three. So smart founders should opt for case three.
But maybe you are not driven by the value of your stake, maybe you prefer growth over big bucks instead. Well, even in this case the case three is probably a better option for you because as the founders have a larger stake in the company, the more money you can now raise from the investors without giving out the control of the company. And the valuation is significantly higher now than what is was in the previous funding round, giving out equity at a later stage brings more funds for the company in consideration.
Using debt funding boost your growth but also leaves you with more equity for future
One should always consider leveraging equity rounds with debt as well if debt is available. For a company growing double or triple digits per year, an interest of single digits is less expensive than the dilution of equity.