Despite — or in some cases, thanks to — the COVID-19 pandemic, the innovation sector continues to benefit from the entrepreneurial spirit that’s woven into the fabric of America’s business culture.
Startups have been attracting disruptive entrepreneurs since the 1980s when Silicon Valley was the only place to succeed unless one came from substantial family wealth.
Just as technology innovation has evolved, making it much easier to bring startups to market, so has the financing landscape. There are now more venture capital funds than at any other time, with almost $80 billion in 2020, a new high, according to VentureMonitor. While the majority of that capital was raised by established funds, investment in new venture funds remained robust, with a record $32.7 billion raised across 141 funds in the first quarter, setting up 2021 to surpass last year’s milestone.
Several new and established private equity (PE), growth equity and venture debt funds have emerged to target investments in Software as a Service (SaaS) businesses. Some estimate that undeployed PE capital (i.e., dry powder) has now reached almost $2 trillion globally. The commercial banking landscape has also changed with a dedicated handful of financial institutions offering loans to cash flow negative companies without asking for personal guarantees from founders or investors.
Here are the financing options available and insight into each.
Venture capital: The best-known source of financing for early-stage software companies, these funds also reserve capital for additional cash injections and are often willing to continue to invest in a company when certain milestones are achieved, such as revenue growth and gross margin improvements. These investors typically seek minority stakes with a preferred class of equity accompanied by a liquidity preference upon sale. This option has the highest “cost-of-capital” and involves different constraints than you might see from other financing tools. VCs have a long investment horizon at 7 to 10 years, and tend to be focused on revenue growth.
Private or growth equity funds: Usually follow an early-stage venture fund, coming in at a later stage and invariably need to reserve proportionally less capital for follow-on investments than their VC colleagues, unless capital is required for acquisitions, at which point their generally larger-sized funds show their flexibility. Some firms tend to have lower tolerance for delays in reaching value-creation milestones, and may seek the right to liquidate their position upon sale of the business. The targeted return is usually lower than a VC round, but they will seek to exit sooner, in say 5 to 7 years.
Venture debt: This type of capital is rarely available to “bootstrapped” businesses that lack an institutional equity investor. Given the higher implied risk than a later stage deal, venture debt investors seek warrants to purchase equity in future capital raises at profitable strike prices, or a success fee upon the completion of the round or sale. They require a secured lien on company assets, including any intellectual property, rather than imposing strict covenants. This has proven to be a an attractive option to extend a company’s liquidity runway and delay equity dilution while using growth capital to achieve targets and attract investors to another capital raise at a higher valuation. While much cheaper than the cost of equity, this is typically the most expensive form of debt capital but it with a more flexible structure if needed. Tip: This area of the market has attracted new entrants, so look for an investor with experience with lending to cash-burning companies.
Revenue participation debt: This is a different form of royalty financing and remains unproven as a sustainable financing technique for privately held e-commerce firms. The lender requires direct access to the borrower’s accounting system and bank accounts. Each day or week, the lender deducts a percentage of sales to cover principal and interest payments. The effective interest rate is usually between 11 to 25% per annum, and the lender also makes money by managing the company’s Google or Facebook ad buy program. There are no operating covenants, which may be because the lender has direct access to cash on hand. These firms also offer to purchase accounts receivable, which effectively prevents refinancing the business at a lower interest rate via senior bank debt. Tip: If you don’t understand it, that’s probably for good reason.
Junior or mezzanine debt: Often requires the borrower to comply with certain covenants such as minimum revenue growth, minimum liquidity, maximum leverage and minimum EBITDA or cash-burn. Lenders require a junior or second lien on assets. Interest-rate terms could make this option as expensive or more so than venture debt, so use caution here. Tip: Good for company owners with healthy credit profiles who want to avoid dilution that would come with equity/venture debt offerings.
Non-bank senior debt: These lenders offer credit lines and (generally) charge cash interest. Some non-bank lenders require scheduled payments during the life of the loan, a balloon payment at maturity or a percentage of monthly gross revenue receipts. Financial covenants such as minimum revenue growth, minimum liquidity, maximum leverage, and minimum EBITDA or cash-burn typically are required. Non-bank financing tends to be less costly than junior or mezzanine debt, and is likely to have a higher tolerance for leverage than a bank financing. Tip: Be “on guard” for a huge asset manager with multiple investment strategies that might be just as happy to own your business if you trip a covenant and get into financial difficulty.
Bank senior debt: This is the cheapest form of capital and comes with the most structure (i.e., covenants). Banks have historically sought already established businesses with revenue traction, and they require regular financial reporting in addition to a first lien on assets. But as we’ve seen with the growth in this space, a number of commercial banks have over the last decade established specialized lending practices catering to software startups.
A good adviser will help you navigate the forms of financing available and select the right one for your startup growth stage.
