OPINION
Ozair Ali
Startups should be looking at debt, not just VC funding
But tech companies are financed through equity, and raising equity is an expensive way to finance lending. That’s because most venture capital investors expect explosive growth and returns – not the sort that can be achieved by lending at any reasonable rate. So, as startups scale and expand into financing products, they’ll need to access debt to keep making loans themselves. What kinds of debt for startups exist? These are the categories:
But what are the options?
Asset-based lending
T
hree years ago, I met another venture investor in Jakarta to talk about startups in emerging markets. We spoke about various sectors and business models. “But when these companies talk about monetization, they’re all lending companies,” he remarked. He was right. The roadmap and monetization slides in a lot of startup decks, even if they aren’t strictly lending fintechs, talked about some form of lending. It seems that startups are arriving at the same conclusion that GM and other American car manufacturers famously did in the 1930s: there’s more money to be made in financing cars than in selling them outright. Got data on inventory levels and flows for your customers? Let’s bundle inventory financing. Transporters with working capital challenges to finance fuel costs? Try working capital financing. Bundling lending products to facilitate consumer spend is common in most industries, and tech is no exception. After all, no business would turn down an opportunity to get a larger portion of the customer’s wallet and create loyalty.
The writer is Former: Emerging markets VC with Alter Global. Now: Entrepreneur PS: I also write short speculative fiction
COMMENT
L
ending against receivables is one of the most straightforward ways to finance a company with a financial product. The lender assesses the quality of the receivable, i.e., the likelihood of timely repayment, and advances a facility that the borrower draws on as needed. Typically known as a revolver, these facilities provide the borrower with flexibility but may be more expensive than a standard term loan on an annualized basis. For fintechs or other startups with lending products, the core receivable is the collection of loans they’ve made to customers that will be paid back. A “loan tape” shows all the data on loans they’ve made and tracks repayments. If the company goes bankrupt, the lenders are entitled to recover the borrowed amount by staking their claims to the collateralized loans.
Corporate debt
M
ore mature companies can often access a broader variety of debt instruments, including term loans, convertible notes and classic venture debt. These instruments are sometimes cheaper than asset-based revolvers, and lenders typically focus on the company’s capacity to repay the loan with cash flow, as opposed to assessing balance sheet assets. In debt-speak, this reflects a shift from underwriting a specific asset to underwriting the entire business. In some instances, venture debt facilities also contain warrants – the right of the lender to convert their debt into equity – which can become very valuable if the value of the company appreciates significantly. Therefore, venture debt providers, unlike other debt providers, often focus on the company’s total enterprise value and growth potential. In fact, plenty of venture debt providers count on warrants to deliver fund returns, particularly when lending to very early-stage startups. Young startups sometimes raise financing through convertible notes, which are really equity instruments masquerading as debt. So while convertible notes and venture debt are available to early-stage startups, investors know fully well that they’re trying to get a piece of the company’s future equity value.
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