Why has debt become so taboo in the startup world? Yes there are venture debt firms and as certain businesses reach a certain scale, financial institutions like Silicon Valley Bank will step in and offer debt, but typically that doesn’t happen until $5–10M in ARR which often does happen for 2–3–4+ years for most startups. So why has debt not become a more prevalent tool? How can we issue and leverage it using your existing revenue streams? And how it can actually help drive better returns for your investors.
First, let’s take a look at how we can leverage debt, even in early-stage startups. Let’s take a startup with $25k MRR ($300k ARR). If we segment out your revenue by different customer types, we find that 1/3 of your revenue is from strong-fit customers with annual net revenue retention of 88%, or representing $88,000 in income that is relatively stable for the upcoming 12 months. Any reasonable bank would be willing to finance 80% of your accounts receivables into a line of credit at prime interest rates. If you are the financial backers of this company, say you already invested $750k in a seed round, you could then offer this startup a $70k line of credit against those projected receivables. Assuming a $600 CAC, the founder could leverage that line to acquire 116 additional customers over the next 12 months. If this company sold a $99/month subscription, that is an additional $11k in MRR, $130K ARR and it will generate liquid returns against the line for your investors.
Want to know the best part? Let’s say you use that $70k to target, acquire and retain those same ideal fit customers, that revenue stream over 12 months grows to $250k in ARR at an improved 92% net revenue retention. So assuming we keep the same terms on the line, it can be increased to $180k. You can do the math on how many customers the founder can put that money to work acquiring, oh and you can still raise an equity round, probably at better valuations, and continue to produce liquid returns for your investors against the line of credit. Not bad!
Not only can introducing debt help increase how much capital you have access to, it actually can help increase the rate of return on the equity your investor's buy-in against. How? Check out this image from a recent Bond Capital whitepaper about Mezzanine Debt:
As you can see in the above graphic, debt not only reduces your cost of capital, but it increased your return % on your equity since you can shrink the principle (the denominator effect, the bigger the denominator (equity investment) the bigger the returns you will need to generate in order to create outsized returns). Also not only does the cost of capital decrease with debt, the due diligence, and analytics needed to enable debt style investments also have strong operational insights baked into them, so the founder can use those insights to grow the business, improve unit economics, and then the cost of capital becomes even cheaper.
Debt also can lead to more aligned investor-founder relationships, especially if it is coming from the same source of capital. Equity is a powerful lever, you can sell it to investors who buy in anticipating growth in the business and that equity to multiply, its a long-term, we are in this together kinda thing. The problem is it’s illiquid, meaning the investors can’t touch it unless there is a liquidity event. Debt on the other hand is a short-term, liquid payout. If a startup has healthy, growing revenue, that repayment becomes fairly stable and predictable and will grow over time meaning cash flow for the investors. It gives investors all of the short-term upside, while also being in it for the long haul with their equity position meaning that if debt needs to be refinanced or repayment needs to be paused for a month, you can have a more holistic dynamic with your capital providers. Having a long-term upside mixed with a short-term return can create powerful and healthy investor-founder relationships that lead to success.