Non-dilutive financing (also known as debt) has lots of benefits when it comes to funding a growing company. But it also has drawbacks. In this article, Hum Capital’s Ryan Ridgway explains what it’s like for growth-stage companies to raise debt and to live with it, now and in the future.
In our earlier post, we described the different kinds of debt available. Here, we take a broader perspective, examining the process of getting this type of financing, the associated risks, the impact of conforming to lender monitoring requirements, and the way debt affects your future balance sheet flexibility. We’ll dive into specific, common expectations founders bring to this process that often prove different in reality. Preparing yourself is half the battle.
Process of Raising Debt (Non-Dilutive Financing)
How many lenders should I approach?
Expectation: Some number more than one. But how many?
Reality: 3-5. In our earlier post about the top five mistakes founders make when fundraising, we emphasized the importance of approaching multiple lenders to give yourself a choice of terms and packages. When you’re buying a car, you want to visit a couple of dealerships to compare pricing and availability. But after you’ve visited the third one, the price differences are unlikely to outweigh the time you’re spending on this process. Unless you find a huge variation in the terms for your deal, approaching more than five lenders is unlikely to be helpful.
Hum Note: Hum Capital’s Intelligent Capital Market (ICM) platform lists more than 250 qualified lenders and facilitates the process of matching you with the most appropriate product and provider.
How much time will it take?
Expectation: Surprisingly variable. Many founders think raising debt takes no time at all; others fear raising debt will take months.
Reality: It depends. While lenders can provide term sheets faster than ever, the due diligence process still requires research and time. The lender and debt structure you choose dictates the process and time required to close the deal. If you’re securing the loan with collateral, it will need to be evaluated. Even this process can take varying amounts of time! Real estate, whether you’re purchasing it or pledging it as collateral, must be assessed. Likewise with machinery, which can require calls to manufacturers, excavating old spec sheets, and understanding the details of the new or used machinery markets. The process will go more quickly if the debt provider has done a similar transaction before, more slowly if it’s an unfamiliar asset type or a specialized product.
You can also ask about what your timing expectations should be, not just for the entire process but pre- and post-term sheet as well. Some lenders provide term sheets in a matter of days and spend a month on diligence; others take two weeks for a term sheet but close a week later. Understanding the lender’s typical timeframe provides you comfort with the process.
Even fairly common types of debt, such as products based on accounts receivable like factoring or revenue-based financing (RBF), face these uncertainties. Part of the reliability of accounts receivable payment depends not on you, the company founder, but on the customer. The lender will therefore need to assess the customer’s payment records. The process is straightforward with well-known firms like Walgreens or Procter & Gamble, but lenders will need to do more research on lesser-known customers before they feel comfortable with their payment prospects. And sometimes, as we saw during the pandemic, the whole process bogs down for reasons that feel inexplicable. Be aware that the lender isn’t trying to mess with your head; it’s to everyone’s advantage to understand your business so they can provide the most informed underwriting. The upcoming section on due diligence recommends the materials you should have on hand to streamline your part of the process.
Hum Note: The best timing for a typical debt transaction will be one or three weeks, but it might take as long as 14 weeks.
What about timing the negotiations? When do you disclose you’ve received another term sheet?
Expectation: Open the discussion with the fact you have another term sheet and expect this provider to beat it.
Reality: Proceed very carefully here. While you want to let the other lender know if you’ve received another term sheet, there’s a better way to go about it.
Let’s say you and the financing partner have had an initial call and you’ve discussed your business and how the financing fits into your growth plans. You’re both excited about working together. That’s the time that you, the CEO, mention that you’ve received an offer and describe its general shape. The lender and we at Hum, who act as an intermediary, appreciate knowing who else you’re talking to and how they view the deal. And you’ll look as if you’re dealing in good faith. You can introduce it as “Hey, I’ve been working with another bank, and the process has gone pretty well so far. Here are the rates and terms that we’re loosely discussing. I just wanted to be transparent and share them with you. That way, we’re all on the same page. I just wanted to give you and your team the opportunity to put forth a similar, if not better, offer.” If there’s a date by which you need to respond to the other provider, mention it, but in a nice way. Remember, people talk and the financing world is small. Presenting yourself like a jerk can come back to bite you.
Is the due diligence process as difficult as I’ve heard it is?
Expectation: It’ll be worse than an IRS audit.
Reality: It depends. If you’ve kept good records and have a reliable finance person, it’s not bad. Every founder should keep a zip file or Google folder containing your basic financials—actuals vs. projections; pro formas; cap table—and your most recent pitch deck, business plan, data on your top clients, and information about your technology. In short, it’s the sort of information you’d want to see if you were financing the deal yourself. It’s the stuff you present every time you talk to someone about financing. This should not be too difficult to compile and keep up to date.
Of course it’s possible that the lender may ask for additional information or for different analyses. These can be very helpful ways of looking at your business that you haven’t thought of yet. Typically, lenders ask for this material for a reason; if you don’t understand why they’re asking, simply discuss it with them.
Hum Note: Here at Hum, we can help you understand exactly the type of information you need to present for the funding you’re trying to raise. You can then prepare what you need to share, which will streamline the process for everyone.
Debt as a Concept
What does it mean to take on a debt obligation?
Expectation: Debt will be risky and scary.
Reality: Debt is an important arrow in the quiver of financial options. It’s called leverage for a reason—it allows you to leverage your current assets and grow beyond your immediate resources. Debt, with terms that are ethical and reasonable, is a very powerful tool for growing your business. Debt injects your business with additional capital, allowing you to grow your salesforce or buy more equipment or achieve a development milestone. Many of the use cases we see support growth, usually for really novel ideas, whether climate initiatives or social issues, disrupting education or finance or power delivery. Debt doesn’t have to be a four-letter word. It’s often fuel to make the fire burn hotter.
Of course, non-dilutive financing also brings risks. While debt is a powerful growth engine, you should always go into a debt deal understanding the absolutely worst outcome if you couldn’t repay. Be very aware of whether you, as the founder, are personally guaranteeing the loan. Different lenders have different opinions on the need for a personal guarantee. Be sure you understand the impact on you personally, and on the business. Look at the covenants, even if they’re light, and be sure you understand them.
Companies face adverse conditions all the time, and often unexpectedly. If things are going sideways, you, the founder, need to over-communicate with your lenders. Even if it’s not stipulated in the agreement, they’ll help you as much as possible because they want to protect their loan or investment. A lender who doesn’t hear from a client when things are uncertain will always assume the worst. You should handle it by contacting them and saying, “We may be facing a cash crunch in the next few months, even though we’re doing our best to avoid it. But I wanted to let you know and see if you had any ideas about how we could work past it.” Sometimes they can provide a small grace period or a little bridge loan. Despite their reputations, bankers can be creative as long as you give them time. Don’t just sign the papers and leave the room; keep in touch with your lenders.
How much leverage makes sense?
Expectation: As much as possible!
Reality: Not always. Just because you qualify for some amount doesn’t mean you should take it. The amount of leverage that a bank will offer depends on your company’s circumstances and prospects, the anticipated use(s), and possible future financings. The market will help you understand how much leverage you can take, which is yet another reason to talk to more than one capital provider!
From the founder’s perspective, how much money you borrow should depend on what you’re planning to do with the loan. The size and structure of the credit instrument should correspond to the use of the loan. That is, if you have a cash crunch due to outstanding accounts receivable and you could use that money to grow the business, you should get an accounts receivable loan, whether factoring or revenue based financing, that will bring in the money you need. You shouldn’t get a three-year term loan. But if you want to hire more salespeople and you know the economics around your sales approach and need a lump sum to recruit this talent, then get a three-year term loan. You can expect that the salespeople will sell enough to earn back their cost basis long before the loan is due.
What covenants should I think about with leverage?
Expectation: Who cares? I’m on a rocketship and going to the MOON!
Reality: Jokes aside, in many cases loans for small and medium-sized businesses are fairly covenant-light. But you do need to be aware of several of them. For instance, will the lender have lien priority over the business? Whether your lenders have liens on the business and what they cover plays an important role in future financing options. If you have a factoring facility on your accounts receivable, that lender will likely have a security interest on those invoices, but they won’t have a blanket lien on the entire business. A lender financing a piece of equipment will have that equipment as collateral. With a venture debt deal or a line of credit, though, the provider most likely has a blanket lien on the business and a first lien on everything. In that case, you have to be aware of how your existing lender may respond to future efforts to raise capital—and, of course, how new lenders may respond to your situation. Maybe the two lenders will agree to go pari passu (that is, sharing equally) and accept equal risk. Maybe they won’t and you’ll have to navigate a complex intercreditor agreement. In either case, you should think through your strategies.
Another situation is warrants, which may be granted to lenders who provide more senior credit instruments. Some lenders use warrants as a part of their capital allocation strategy — they want to be on the cap table so they can participate in future upside. The lender may be willing to work with you to trade off the interest rate for warrant coverage. But be aware of the complexities this may add later. Some equity investors can get nervous if you have a bunch of warrants outstanding to the bank. For others, it’s no big deal.
Living with Debt
Expectation: It’s horrible and time consuming.
Reality: It’s often less of a bother than you’d expect. Depending on the lending relationship, you may have to do some reporting. In the case of a fintech company that takes a loan, you’re likely to have to reconcile the monthly performance of your deals and report to your creditor. If you take revenue-based financing, you need to report on the performance of your borrowing base against projections. With other credit products, like factoring, you’ve handed over the invoice-tracking task to the factoring firm. Alternatively, with some unique products, the monitoring may require a fair bit of work. In such a case, your CFO may spend 10 hours a month on the task, or you may need to engage a fractional CFO. This should be spelled out with the deal.
What will your current and future investors think about it?
Expectation: The current investors might hate you for taking debt and future investors won’t touch you.
Reality: Different investors will view debt differently. It all depends on the reasons you’ve taken it on. If you can demonstrate that every dollar you spend in sales will generate five dollars in revenue, or that you need more inventory to fill demand, it only makes sense for you to have a credit instrument.
Equity capital and debt capital should be used differently. Equity investors, and you as the founder, should understand the reasons for debt. The difference can be described as “working on the business” versus “working in the business.” Equity should be used to fund the company in a holistic sense, such as for R&D for a new product. Debt should fund inventory or headcount for sales or things like computers.
You need to be aware of how different term lengths and structures can interact. If you have early termination penalties on a loan with a long term and your equity investors want to get debt off the balance sheet, it can be complicated. You need to be aware of this possibility and describe the situation upfront with investors and lenders alike.
It’s possible that equity investors in an earlier round may not play well with new equity investors or debt providers for any number of reasons. You can’t guarantee that investors will always act like grown-ups and keep the interests of the company top of mind. As a CEO or CFO, all you can do is try to make them see reason.
The more clearly you can articulate the uses of debt and non-dilutive financing, the more likely you are to raise the right amount in the right structure at the right terms. Debt is not a monolithic asset. It comes in different forms that should be used in different situations. Having a good financing partner can help the company’s suite of financial structures evolve over time.
At Hum Capital, we pride ourselves on working with growing companies to identify and obtain the best products for your current and future needs. Sign up for a free Intelligent Capital Market account today or contact us to see how we can help you on your growth path.