Qonversations on Debt with Equity - Qapita

Written By:
July 7, 2023

Amar A Ummat, one of the Founding Partners at Recur Club, aims to explore the factors that make debt financing a catalyst for sustained growth in venture capital-backed companies. Recur Club offers a unique approach by providing fast, flexible, transparent, and non-dilutive capital. Unlike traditional lending, which often comes with restrictions and covenants, Recur Club aims to decode the financial landscape and embrace a paradigm shift where the power lies with the borrowers rather than the lenders.

Check out the full conversation here:

When Should Company Consider Taking Debt:

During the Fundraising Phase: Debt is not an ideal instrument when a company is in the process of raising capital. At this stage, the focus is on deploying the capital to generate revenue. Debt, being a liability, does not directly contribute to revenue generation. Therefore, it is usually not recommended during the initial stages of a company's journey.

Early Stage with Limited Cash Flow: In the early stages of a company, when cash flow is limited and the product-market fit (PMF) is still being evaluated, debt becomes a less attractive option. The company is often in the process of pivoting and refining its offerings to find the right customers. At this point, debt may add unnecessary financial burden and hinder the company's flexibility.

Identifying the Right Customer and Receiving Feedback: As a company progresses and identifies the right customer segment, debt can start becoming a more attractive instrument. Once the company has a clear understanding of the problem they are solving and has identified potential customers, receiving feedback becomes crucial. This phase marks the transition towards customer retention and building a sustainable business model.

Customer Retention and Predictable Cash Flow: When a company reaches a stage where it has started receiving feedback and customer retention becomes crucial, debt financing can be considered. At this point, the company should have a cash flow stream that is predictable or at least offers a certain level of assurance. Such businesses are more likely to benefit from debt financing, which can be utilized not only for capital requirements but also to establish creditworthiness.

Factors to Consider when Opting for Debt Financing:

1. Speed of Deployment and Return on Investment: One key reason for a company to consider debt financing is the ability to deploy funds quickly and generate a higher return on investment. Before taking on debt, it is crucial to evaluate if the potential return on investment exceeds the cost of borrowing. For instance, if a company can generate a 21% return on capital while paying a 20% interest rate on the debt, it may be favorable to utilize debt for identified opportunities such as hiring or inventory purchase that can drive revenue growth.

2. Cash Flow and Revenue Generation: Companies should assess their cash runway position and revenue-generating potential. If a company has a typical vintage of one year and an annual recurring revenue of approximately one crore, it becomes an attractive candidate for some form of debt financing. A sustainable cash flow position and the ability to generate revenue are essential factors when determining the feasibility of utilizing debt.

3. Identified Areas for Growth: Debt financing should be used strategically in areas where it can fuel growth and provide a competitive advantage. It is important to identify specific opportunities where the infusion of debt capital can enhance business operations, such as investing in new technology, expanding production capabilities, or entering new markets. Properly utilizing debt in these identified areas can contribute to overall business growth.

4. Expert Guidance on Debt Usage: Companies can benefit from seeking advice on how to effectively use debt. Partnering with professionals who specialize in debt financing can provide valuable insights on the best practices and areas where debt can be deployed to achieve maximum impact. Their guidance can help companies make informed decisions and optimize the utilization of debt capital.

The Impact of Debt on Financial Burden:  

1. The Role of Proper Planning: Debt can potentially add a financial burden, but this typically occurs when it is not well planned. Proper planning is crucial to ensure that debt is used strategically and managed effectively. By carefully considering the company's stage and financial situation, debt can be utilized to drive growth without becoming a burden.

2. The 1 to 10 Journey and Revenue Generation: When a company is in the 1 to 10 stage, generating approximately 1 crore of Annual Recurring Revenue (ARR) and serving a significant number of paying customers, the focus shifts towards customer retention. With a retention rate of 90-95%, the revenue generated from these loyal customers can support the repayment of debt. Debt can be effectively utilized to maximize revenue generation in this scenario.

3. Managing Cost and Revenue Dynamics: In business, costs are often front-loaded, meaning they are incurred upfront, while revenue recognition tends to occur over time. This creates a working capital gap, where additional funds are needed to bridge the cash flow mismatch. Debt can play a role in covering this gap and maintaining sufficient working capital for smooth operations.

4. Listening to Customers and Passionate Customers: In the 1 to 10 journey, it is crucial to listen to customer feedback and adapt accordingly. However, as the company progresses, it gains passionate customers who provide invaluable insights. Debt should be considered when the company has the ability to build a strong and sustainable cash flow, supported by these passionate customers.

Choosing Between Debt and Equity:  

1. Debt and Equity as a Combination: When considering financing options, it's not a choice between debt or equity alone. The ideal approach is often a combination of both debt and equity. The decision depends on factors such as the company's go-to-market strategy and its stage in the business lifecycle.

2. Early Stage and Bootstrapped Companies: In the early stages, especially for bootstrapped companies that are cash profitable, utilizing debt becomes feasible. These companies can leverage their profits to reinvest in the business and take on additional debt to experiment and drive growth. Having the ability to generate consistent cash flow positions them to take on more debt.

3. Equity for Early-Stage Companies: For companies in the early stages of their journey, where stability and cash flow may not be fully established, equity becomes an attractive asset class. Seeking equity investment can provide the necessary funding to fuel growth and establish a stronger financial foundation.

4. Debt for Stable Cash Flow: If a company has stable cash flow, debt financing becomes a viable option. With predictable revenue streams and a demonstrated ability to meet debt obligations, companies can leverage debt to fund their operations and expansion plans.

5. Mix of Debt and Equity for Market Expansion: When a company has a good product-market fit and is looking to acquire new customers or expand into new markets, a combination of debt and equity is often utilized. This allows the company to balance the need for capital with the desire to avoid excessive dilution of equity. Debt can provide additional financial resources while retaining ownership control.

Decoding Venture Debt and Revenue-Based Financing  

Venture debt serves as a crucial financing option for early to mid-stage founders who have not raised significant equity. It fills the accessibility gap for these founders and complements venture equity financing. While it may not offer the same level of flexibility and speed as other forms of financing, venture debt provides the advantage of longer repayment periods. Venture debt closely follows the trajectory of venture equity and behaves in a similar manner. It is often structured to align with equity rounds and may even include equity-like features such as warrants. This integration with equity financing allows for a more comprehensive capital structure.

Revenue-based financing is an alternative funding option where repayment is tied to a company's revenue. While it has its merits, certain limitations lead to a decision to pivot away from it. One such limitation is the potential penalty imposed on companies that grow rapidly, as they are obligated to repay the debt faster. When working with companies or founders taking on debt, the aim is to avoid penalizing them for rapid growth. Revenue-based financing, although categorized as debt, relies on the company's revenue to service the debt. This means that if a company experiences significant growth in a given period, the repayment amount also increases, resulting in a higher effective cost of capital. Other financing options mentioned by Amar include sales invoice discounting, which allows companies to access funds by using their sales invoices as collateral. Additionally, venture debt may involve equity linkage, where equity-like warrants are attached to the debt. These features further enhance the financing structure and align it with the company's growth prospects.

Also Read: Top 8 Equity Management Software for Startups in 2023

Internal Governance for Companies Considering Debt:  

1. Establishing Formal Finance Functions: Before considering debt, companies should focus on setting up formal finance functions within their organization. This typically occurs during the startup phase when companies realize the need for dedicated financial expertise. While initially, one of the founders may handle financial responsibilities, as the company grows, it becomes essential to establish specialized teams and systems.

2. Importance of CFOs and Fractional CFOs: Having a Chief Financial Officer (CFO) in place is highly recommended, although it may be more suitable for later stages of the company's lifecycle. However, for early-stage founders, fractional CFOs, ecosystem partners, chartered accountants, or company secretaries can provide valuable financial guidance. Being well-prepared and having access to financial expertise ensures that the company is equipped to handle debt financing effectively.

3. Implementing Management Information Systems (MIS): Implementing a robust Management Information System (MIS) is crucial for companies seeking debt financing. An MIS provides a comprehensive overview of the business, enabling founders and management to track and analyze key metrics. Being data-driven and metrics-obsessed is essential for making informed decisions regarding debt utilization and maximizing its potential.

4. Data Hygiene and Metrics Obsession: Founders and management must prioritize data hygiene and become obsessed with relevant metrics. Having accurate and up-to-date financial data allows for better financial planning, forecasting, and risk assessment. This data-driven approach ensures that debt is utilized strategically and optimally.

Typical Timeline to Close Financing:  

When considering financing options, the speed and efficiency of the process are important factors for companies. A streamlined and efficient approach to closing financing deals can significantly benefit businesses in need of capital. The process begins by leveraging technology and integrations with financial tools, invoicing systems, and CRM platforms. These integrations enable the gathering and organization of data in a quick and consumable manner for credit underwriters. This ensures a thorough evaluation of creditworthiness and facilitates the debt financing process.

The timeline to close financing is designed to be as efficient as possible. Depending on the complexity of the financing request and the data provided, the process can be completed in as little as 48 hours. In more intricate cases, it may take between 10 to 14 days (about 2 weeks). The aim is to expedite the process and provide a timely turnaround for businesses in need of funds. This commitment to a fast and efficient timeline sets the foundation for businesses to access capital swiftly and effectively. By minimizing the waiting time and streamlining the necessary steps, companies can address immediate needs, invest in growth initiatives, and stay competitive in their respective industries. The goal is to provide entrepreneurs with the financial resources they need to succeed on their terms and propel their businesses forward.

In conclusion, debt financing can be a catalyst for sustained growth in venture capital-backed companies, provided it is strategically utilized and managed effectively. Startups should carefully assess their stage of growth, cash flow position, and identified areas for expansion before considering debt. While equity remains a viable option for early-stage companies, venture debt can be a valuable complement to equity financing, offering longer repayment periods and aligning with equity rounds. Revenue-based financing, on the other hand, may have limitations and should be carefully evaluated. To make the most of debt financing, companies should establish formal finance functions, leverage financial expertise, implement management information systems, and adopt a data-driven approach. By following these principles and closing financing deals efficiently, businesses can unlock the power of debt and accelerate their journey of growth.

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