Startup Loans: When and how to raise debt funding as a tech company

In this article we will dive deeper into loans as a funding option for tech companies, and establish what considerations entrepreneurs should have when finding a funding partner. Many companies that we come across are almost exclusively concerned with the size of their potential loan, and the interest rate paid. It is of course key that the loan amount supports the company’s investment needs. While interest ultimately determines how expensive the loan is, one also needs to take a number of other things into account when weighing different loan options against each other.

Below we have listed three areas that we believe companies really need to think through before engaging with lenders.

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Dilution

The first thing to consider is to what extent you are willing to sell shares in your company. Many tech companies start with a series of equity investments from business angels and funds. This can be a great kickstart, both through injecting cash into the business with few restraints, and through adding valuable experience to the company’s management. It does, however, of course, mean that the founders will have less ownership of the company, and ultimately receive less of the earnings. In this sense we would recommend thinking about what parts of a business need to be funded by equity, and what parts are more predictable, and can be funded by debt.

Dilution is, though, not as simple as the choice between debt and equity. Many debt providers, especially in the venture debt space, require some type of warrants or options. E.g. instruments that will convert to equity. This is not necessarily a bad thing, but must be weighed against the cost, both in monetary value to the owners, but also to how the potential conversion and associated dilution impacts others willingness to invest in the company in question.

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Duration

Loans of course differ against equity injections in that they need to be repaid. Many borrowers do, however, fail to consider the implications of the repayment period. It is our belief that companies should, to the extent possible, only start repaying loans when this can be supported through positive cash flow, e.g. when they have reached profitability. The period before a loan starts being repaid is often referred to as a grace period. A longer grace period gives the borrower more freedom to time their road to profitability, and also means that valuable cash can be reinvested in the business. At Gilion we typically offer a two year grace period.

Once the grace period has been established, it is also important for the company to think about the repayment period. Gilion’s loans typically repay over four years, meaning that companies can use the majority of their income to grow their business. We are seeing many players in the market offering loans that repay over one year or less. Although there can be benefits to this setup it can also pose a huge risk to companies, as they get a very short time frame to react if things don’t go according to plan.

A third thing to consider when borrowing is how, and when you will be allowed to repay the loan earlier than agreed. This is a common scenario for borrowers who e.g. raise additional equity earlier than expected, or have stronger cash flows than anticipated. Many companies who have not negotiated their borrowing agreements sufficiently end up being trapped in very expensive structures, or paying exorbitant fees to be allowed to repay their loans in these scenarios. At Gilion we do charge a fee for repayment very early in the loan cycle, but customers can refinance loans without cost for the majority of the loan period.

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Covenants

Loans typically come with a set of rules that a borrower needs to follow, to keep the risk at a manageable level for the lender. Covenants can regulate things like maximum allowed dividend or permitted acquisitions and divestments. These things are often buried quite deep in a loan agreement, and can typically be negotiated to manageable levels, but are very important to understanding. While banks are typically very friendly lenders, if you manage to secure a loan from them they can be quite restricted in this regard, with a lot of very restrictive provisions buried in their general terms and conditions.

Apart from figuring out how feasible the proposed covenants are for you to follow, you also want to gain an understanding of how the lender that you are engaging with would behave if you did break a covenant. Potential consequences can range from entering into a constructive discussion, to the loan being cancelled to the lender automatically gaining access to parts of your business.

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In conclusion

Assessing a potential borrower along the proposed lines sums up to a pretty daunting task. There are not only a lot of different parameters to consider, but the underlying facts can also be hard to find. So how does one go about to pick the right lender? Below are five suggested steps.

1: Get help. Borrowing money as a tech company is a skill. Try to find places in your network to look for advice. Do you have a board member or investor with other portfolio companies that have taken up debt? Does your accountant have any input? What about your peers?

2: Make a plan of what you need and can live with. How much money do you need, what interest can you afford, and how quickly can you repay a loan. Knowing these parameters will help you negotiate better.

3: Seek multiple offers and compare them where it makes sense. Tech lending is still a young and fragmented business, so loan terms will differ wildly in different parameters. However comparing things like covenants, interest rate and dilution will help inform a decision.

4: Find your key pain point. Is cash flow and runway your main concern? Then optimize for that by finding a loan with a long repayment time. Do you need to maximize burn before a big round? Then expensive and short loans with quick repayment like revenue based finance might get you there? Do you need full flexibility, opt for a smaller loan with loser terms

5: Know what you’ve signed up for. Make sure that the loan offer a) is easily understandable for you and the company’s financial management. Obfuscated terms and covenants are a big warning sign b) make sure that you are certain that you can live with the loan and associated terms, or have a feasible route for early repayment. Debt is a fantastic way of growing a company, but can be very risky if you don’t understand what you’ve signed up for.