Be mindful of the story you're telling with your debt; it can impact the values you get on your future capital raises, debt specialists said in a Teampay webcast last week.
The kind of debt you take out — and when you take it out — should make sense for your growth stage, Ben Brachot, managing director at Dwight Funding, said.
For companies wanting to boost revenue before seeking its next capital raise, an asset-based loan can make a lot of sense, Brachot said. It can smooth out your accounts receivables, enabling you to fund a targeted ad campaign or make some other short-term investment to boost revenue.
"They're a great way to take some of the lumpiness out of a company's intra-month cash flows," Brachot said. "As companies grow, they buy bigger lots of inventory, place large purchase orders with their factories, and then, as they sell — they could be selling a large order into a Target or a Costco — they're waiting on very lumpy payments from some of these retailers. So, an asset-based loan is a great way to draw down against these assets as needed and smooth out these cash flows throughout the month."
They're typically underwritten against accounts receivable or inventories, so they're good options for companies that provide software, business services, or products, he said.
And if managed the right way, they not only boost your revenue; they pay for themselves to the extent you pay them back using the revenue you generate from the proceeds.
Using the loans to generate a short-term revenue boost makes more sense than dipping into equity or cash on your balance sheet. In the case of a products company, you want to save your equity and cash for fixed costs — G&A, R&D, and sales and marketing — and use the loan proceeds to, say, ramp up your inventory for a campaign.
"Your inventory is ... sitting in a warehouse, and then after you've sold it, it's turning into an accounts receivable," rather than generating revenue, he said.
You especially want to save your equity and cash if you expert a slowdown in receivables, like many companies are experiencing because of the pandemic, when retailers are stretching payments, he said.
Match loan to stage
What you don't want to do, Brachot said, is take out loans that don't make sense for your stage of growth; you'll have to explain that to potential investors at your next capital raise.
"There are founders we come across that cobble together six types of debt early on," he said. "I commend them for being scrappy. But you're telling future investors a story you probably don't want to tell."
Capital term loans
If you're at an earlier stage in your growth cycle, a growth capital term loan can be a good fit, Lindsey Guinn, a Silicon Valley Bank director, said.
These loans are usually sized at between 20% and 35% of your equity and drawn down as needed, ideally to fund a growth campaign or otherwise give yourself more time between capital raises, she said.
"You would want to use them when you want to extend your runway out maybe a quarter or two before you go out and raise an additional round of equity," she said. "That's the perfect time to draw down on that facility and hopefully that allows you to get a little bit further, have a little bit more power in your negotiations on that next round of equity."
Growth capital term loans provide flexible money, but, as a trade-off, they're underwritten more as an equity risk than an asset-based loan and come with a warrant component.
Revolving credit line
Later, as you move further up the growth curve, it can make sense to take out a revolving line of credit, which can be asset-based or tied to monthly recurring revenue, depending on your type of business, the specialists said.
"The trade-off for these types of facility is, as they start to grow with you and become a meaningful size, they might be associated with a performance covenant, whereas that growth capital term loan is going to be as flexible as possible and won't be tied to that covenant," Guinn said.
Another loan type is a term loan from a more traditional venture fund. This type of credit fund operates like a venture capital firm to the extent it uses equity invested either by shareholders or limited partners to fund the lending activity.
"That type of capital is going to be subject to fewer regulations than a bank facility, so they can offer flexibility that a traditional bank can't," she said.
That means more forgiving covenant structures and more attractive interest-only periods, but you'll pay more.
"I would always tell my companies you really want to wait until there's meaningful traction on the business and you're really weighing the cost of a last round of equity versus a little more funding from a venture debt partner," she said.
Separate from the warrant component, with the revolving line, you're going to pay 5-6% internal rate of return (IRR) like a bank facility, said Guinn. Compared to a venture fund-type facility, you're going to pay in the lower teens.
And the warrant component is also going to vary. A bank facility is going to be closer to 25-50 basis points of fully diluted ownership, a fraction of the dilution from an equity dollar perspective, she said.