Leveraging Debt to Fuel Growth: Strategies and Implications for Technology Growth Companies

Authored by Sarel E. , Co-founder and Managing Partner at Key1 Capital

In the dynamic world of tech, achieving efficient and sustainable growth is paramount. While equity financing remains the predominant path to fueling expansion, developing innovative products, and scaling operations, debt can also play a pivotal role in empowering the growth trajectory of tech businesses.   

In the U.S. alone, 2023 witnessed $30.9 billion of venture debt financing, a significant leap from $10.6 billion in 2014. This increase of nearly 3x underscores the consistent uptick in the deployment of debt as a financing mechanism for growth technology companies. The surge stands out even more when compared to VC equity activity, which only grew 2.2x in the same period, reaching $166 billion by 2023.  

Below, we delve into the strategic application of debt, exploring its evolution, diverse functionalities, and associated benefits and drawbacks within the venture capital-backed landscape.   

Understanding Debt: Borrowing with Benefits (and Responsibilities) 

In the context of tech growth companies, debt signifies borrowed capital requiring repayment with interest over a defined period (or facing potential consequences). This is unlike equity financing, where investors acquire ownership stakes in the hope of maximizing returns 

With debt, the capped returns and requirement for downside protection translate to an overall lower cost of capital compared to that of equity investors, who focus on multiplying their investments with no contractual obligation for repayment.   

Evolution of Debt Instruments in the VC Ecosystem 

Venture capital financing traditionally relied on equity investments in early and later-stage tech companies. However, as the startup ecosystem matured, so did the financing options available to entrepreneurs. Convertible notes, a short-term debt instrument that can be converted into equity, emerged as a significant milestone in this evolution. 

Offered in the early 2000s, convertible notes provided a flexible and efficient financing option for early-stage startups. These instruments enabled quick capital acquisition without valuation determination, streamlining the fundraising process and offering investors the potential upside of converting their debt into equity later. This form of debt has remained the primary debt instrument in seed and round-A companies. 

Over time, venture debt emerged as another prominent financing instrument tailored specifically for venture-backed companies. Venture debt providers (banks, specialized lenders, and dedicated funds) offer debt funding alongside equity injections, leveraging the "cushion" of the company's equity value determined in concurrent equity rounds, while minimizing shareholder dilution. Venture debt is primarily used in Series B and C and in many cases, includes a form of some upside sharing, typically in the form of warrants 

But as the industry evolved, new forms of debt financing beyond classic venture debt, have emerged to cater to diverse business needs and asset values. Examples include: 

Revenue Based Financing (RBF) 

With RBF, the debt providers finance client acquisition costs without equity dilution and are repaid a percentage of monthly revenues until a predetermined cap is reached. This form of debt, which is one form of working capital financing, is primarily used in SaaS, subscription-based models, and gaming companies that can present backward-looking financials and KPIs, thus it is better geared to later-stage companies with good visibility and comfort on pay-back periods. This should be the cheapest form of debt, given the duration of financing and seniority in the liability stack. 

Asset-Based Lending 

Asset-based lending relies on using intellectual property (IP) or other assets as collateral to secure loans. This debt is typically utilized at later-stage companies where substantial capital has been invested to build an asset that credit providers could value based on its monetization potential and value.  

Unitranche Financing  

Unitranche financing (aka “Term Loan” or “Credit Facility”) is a more traditional financing option for later-stage companies based on ARR or EBITDA (>$50mm ARR). This form of financing relies on a company’s ability to generate substantial revenue to allow it to pay interest and principal over time and is sought-after to fuel organic growth and acquisitions. In addition, the lender will introduce financial measurements (e.g. covenants) that will be tested periodically thus predictability of revenue and cash flow is essential.  

Unlocking Strategic Growth: Diverse Applications of Debt 

Debt can be strategically utilized in multiple ways to propel tech company growth.  

One example is client/user acquisition loans, which provide financing for businesses to cover the costs associated with attracting new customers or users in B2C or B2B businesses. The magnitude and terms of these loans depend on the perceived quality of the acquired users/clients. 

Other such loans include working capital Loans, which cover day-to-day operations like payroll and rent, expansion capital which cover expansion initiatives such as opening new offices or hiring additional staff, equipment financing which includes loans for acquiring special equipment or infrastructure 

In addition, debt-funded M&A is a highly efficient way of funding non-organic growth, expediting the time of closing, minimizing equity dilution upfront, and bridging to a potential equity raise once the integration has been completed and synergies have been realized. In addition, in the case of a merger between two companies, debt can fund immediate cash needs for the transaction without having to immediately strike a valuation once the exchange ratio between the two companies has been set. 

Weighing Advantages and Disadvantages: A Balanced Approach 

Debt offers several benefits for tech growth companies: 

• Efficient Capital: Raising debt is often cheaper than equity due to capped returns and better downside protection for debt investors. 
• Minimized Dilution: Unlike equity, debt preserves ownership and control, leaving founders and existing shareholders with full decision-making authority. 
• Tax Advantages: Interest payments on debt are often tax-deductible in many jurisdictions, reducing the overall tax burden and increasing cash flow. 
• Predictable Repayment Schedules: Fixed repayment schedules enhance cash flow forecasting and facilitate financial obligation management. 

However, debt financing also comes with drawbacks:  

• Risk of Default: Failure to meet covenants or repay debts can impact operations, potentially leading to bankruptcy or asset foreclosure. 
• Cash Flow Constraints / Refinancing Risk: Principal and interest payments must be made regardless of financial performance or market conditions, potentially straining cash flow and forcing equity raises at unfavorable times. 
• Limited Flexibility: Debt agreements often impose covenants and restrictions, limiting the ability to take on additional debt, distribute dividends, or pursue certain business activities. 
• Reporting Requirements: Heightened transparency, reporting, and covenant certifications require appropriate financial systems and internal processes that many companies do not have prior to taking on debt. Failure to meet the reporting requirements can result in default.

Actionable Next Steps 

Not all debt solutions fit the current life cycle of a company. Before considering debt, it’s essential to clearly define your growth goals and carefully evaluate your ability to handle the appropriate quantum of debt, tenure, covenants, and payments. In addition to evaluating whether taking debt is a good idea, a company should look into what kind of debt best suits them to ensure a fit for their specific needs. 

Some key points entrepreneurs should consider before deciding to take on debt include: 

1. Intended Use of Proceeds: What is the primary purpose of the funding? Is it for funding operations such as sales or working capital, investment purposes like capital expenditures or acquiring another company, or as a bridge to an equity round?
2. Equity Capital Base: How robust is my equity capital? Is it sufficient to support my near and medium-term growth plans, financial obligations, and liabilities?
3. Business Maturity: How confident am I in my ability to forecast my business's performance? Is my business predictable and mature enough?
4. Financial Controls: Are there robust financial controls in place?

Once a company has decided to take on debt, it should size and structure such debt appropriately. This includes raising and structuring the amount of debt that the company needs (not the amount it can raise or be offered) and the amount it can serve comfortably based on a stress-tested business plan. 

With debt taken on, it is on the company to then maintain strong financial discipline. Implementing robust financial forecasting and cash flow management can ensure timely debt repayments and avoid defaults. 

Throughout this journey, it is essential to partner with experienced advisors specializing in debt financing for tech companies, such as venture capitalists who have experience in raising debt for their portfolio companies. For companies dealing with debt for the first time, understanding the complex world of debt and how it can impact the future of your company is crucial.  

To be clear, debt cannot and should not replace equity financing in its entirety, it needs to work hand in hand with equity financing, as it is the basis for the capital stack of the company. It is a powerful tool for accelerating growth, but it's crucial to use it strategically and responsibly.  

By following these steps and remaining mindful of the risks and rewards, tech entrepreneurs can leverage debt to achieve their full growth potential in an optimal manner while minimizing overall cost and dilution.