In many growth-stage technology companies, the question about when to raise equity or seek debt financing can raise many questions and considerations. It’s important to make the distinction that, generally, debt is not a substitute for equity, but rather they can be very complimentary.
Debt also comes in many forms and for different purposes. Typically, when a company is in a growth phase – scaling at an accelerated rate or branching into a new geography, for instance – that calls for growth capital, which is used to expand the business and fast-track its expansion.
While equity financing requires no repayment, debt does not require giving up a percentage of ownership. Most companies use a combination of both to meet their capital needs. There are many reasons a company might pursue debt financing. Below are the four we most commonly see among technology companies seeking growth capital.
1. Mitigate Dilution
For venture-backed companies or those currently raising capital, debt can be a good solution alongside equity to limit dilution. For example, if a company aims to raise $100 million in financing, the founders may not want to take on that much equity funding, so they may raise $70 million in equity funding and $30 million in debt. This reduces their dilution significantly essentially enabling them to maintain that much more control over the business’ future.
2. Boost Valuation
Often, a company will look to bring on debt shortly before an equity funding round. Because debt is non-dilutive, the company will get to its equity raise with more cash on its books. This accomplishes two important things. First, it gives the company traction to boost its valuation. And second, it provides leverage and negotiating power, because that debt financing provides the company with options, or “walk away money.” With additional liquidity, the founders don’t have to accept a deal that is less than desirable.
3. Bridge to Profitability
For a startup or growth-stage company, getting past the break-even point and reaching profitability is the promised land. At a certain point, a company may need some level of capital to become cash flow positive and cross that threshold. Particularly when it’s so close to the milestone, debt can be a better capital source than equity because debt is non-dilutive and thus less expensive at this critical stage. Debt can enable a company to clear that final hurdle to become profitable.
4. Backstop SPACs
In the spirit of the current times, more companies are using debt to backstop SPACs, particularly in the last six months. A special purpose acquisition company (SPAC), sometimes called a “blank check company,” is a shell corporation, created explicitly to raise capital through an initial public offering (IPO) or for acquiring or merging with an existing company. In essence, the SPAC combines its public shell company with a startup to take it public and raise capital. SPACs are volatile by nature and there are definite risks involved. Investors in SPACs have the option to redeem their shares prior to resigning. With the current economic climate, SPAC redemption rates have been incredibly high over the past several months – sometimes as high as 99%. This can greatly impact the startup in question because the equity expected is not available. However, in many cases, there is a minimum cash condition to proceed with the deal. Securing debt to ensure the company has cash on the books can be beneficial in backstopping the SPAC, making the company more secure, especially when redemptions are high, as is the current trend.
While both equity and debt capital have their place with growing technology companies, debt can prove to be exceedingly beneficial and complementary in various stages of equity raises and growth. By being strategic about when, why, and how to seek debt, a company can maximize its potential and mitigate risk.