Sand Hill Road in Menlo Park, California is the epicenter of VC. While many tech founders dream of scoring a deal with one of the prominent VC firms that make their home on Sand Hill Road, the reality is that less than 1% of U.S. based startups receive venture money every year. Another reality: many entrepreneurs never consider the less glamorous but more accessible (and cheaper) startup financing option: debt.
Here are some insider tips from Molly Otter, Lighter Capital’s Chief Investment Officer, and David Ehrenberg, CEO of Early Growth Financial Services, to help you understand the alternatives to Sand Hill Road.
1. Debt is relatively cheap and transparent.
Just like a mortgage or a car loan, your company’s loan payments are set ahead of time, which means you can account for them in your financial planning. Equity financing comes with murkier side effects. The value of the stake you give away fluctuates depending on the current and future valuations of your company. A 20% cut of your company may be worth $500,000 today but $5 million in two years.
When VCs invest in your company, they’re targeting a 5–10x return in 5–7 years. Lenders target much smaller returns. Lighter Capital, for instance, often looks for returns in the 1.65–1.8x range. It’s true that VCs can drop piles of money on your company—but they’ll be looking to extract a much, much bigger pile of money from you later on.
2. Get to know your local bankers.
Bankers have a hard time collateralizing the virtual assets of a tech company, so they will almost always require a personal guarantee. The threat of a lien on your personal assets doesn’t mean you should completely rule out getting a line of credit from a bank. A line of credit will be your cheapest type of cash. Realize, though, that the process can take many months, and it may take you some time to build your business to a point where it qualifies for a loan.
So start the process early by getting to know your local bankers. Banking is a relationship-driven business. Banks—especially local banks—want to loan to healthy local companies. They’ll help you if they can, and the friendlier you are with local bankers, the better.
3. Be careful with merchant cash advances
Quick cash comes with high cost. The only time you should consider online merchant cash advances is during an emergency. If you need to make payroll, or have unexpected cash crunch, it might be okay to take the cash. But if you’re looking for capital to run your day-to-day business or grow your company, this type of funding is extremely expensive—many have triple-digit APRs. Do the math before you take the money.
Part of the reason why they’re so treacherous is that they require repaying the loan on a daily or weekly schedule right after you take out the loan. This jacks the real interest rate way up, and chokes out your cash flow.
4. Very few can consider venture debt
For well-established startups with more than $5 million dollars in revenue, venture debt is worth a look during an equity round, but it’s a select club with high standards for membership. Your company will need to be partnered with one of the top 10 VC firms or you won’t stand much of a chance. This type of loan is only available if the VCs that are backing you have a good brand name.
Luckily, when you hit the magic $5M annual revenue marker, many other lenders will consider you, so venture debt won’t be your only option. With significant annual revenue, you’ll be able to tap into low-cost sources of working capital, including traditional commercial loans from tech banks (Silicon Valley Bank or Square One for example), AR factoring, and MRR lines, which are a newer instrument based on monthly recurring revenue.
5. Convertible debt combines the downsides of equity and debt
Convertible debt is a popular instrument for early stage startups. It acts more like equity than debt, but has the downside characteristics of both. It starts off as a debt instrument but converts into equity at your next round of financing, and the maturity date is typically 12–18 months.
If you secure the equity investment after the convertible debt is issued, then your convertible debt investor becomes an equity holder with an option to buy further shares at a discount. If you fail to get an equity investment at the time of maturity, you owe your investor the full amount plus interest as one big payment.
The risk? It is un-priced equity and you may be giving away your company at a very cheap price early on. And on the debt side, other lenders will see convertible debt as a liability that can negatively impact your cash position when it matures. This hinders your ability to getting a loan.
6. Ask yourself the right questions
Your funding options will depend on the stage of your company, how much funding you need, and what you’re willing to give up for that capital. So do your due diligence and really think about what kind of company you want to build. Ask yourself:
What are my long-term goals?
How much control do I want to maintain?
How much appetite do I have for risk?
Am I prepared for outside investors?