Startups and debt (I): Overdependence on equity rounds. Reasons and setbacks

Spain - 

This is the first in a series of articles on the subject of startups and their, for now, zero or extremely low level of debt and we share a few thoughts and suggestions aimed at the business community, investors and their legal and financial advisors.

Rafael González-Gallarza and Alex Pujol, partners at Garrigues Corporate Department

Searching for additional financing routes, in the form of debt rather than equity, could benefit startup founders by curtailing their dilution in equity rounds and also have other advantages for the companies themselves. This would contribute to encouraging more young entrepreneurs to start and carry on with their projects and would also benefit venture capital funds, key and irreplaceable players, in that they would have more and stronger investment opportunities.

Starting point: dependence on equity rounds

Tech startups usually fund themselves with equity only, contributed by their founders and by specialist investors. In their creation and early startup stages companies consume cash at a faster pace to develop the tool or invention that will define and take forward their business models, build their team, and lay the other foundations they will need to attack their market. These are months or maybe years in which the company cannot yet bring its services or products to market on a mass scale and therefore has no funds coming in (or, if it does, they are symbolic amounts). Coming through this stage successfully is a matter of life or death.

Funds and other specialist investors in startups play and will continue playing a necessary role in the development of these companies, of the digital economy, and of science and knowledge generally. We recognize their formidable contribution and everything we say in our series of articles on the advantages of debt financing for startups also will be conducive to multiplying and strengthening investment opportunities in equity.

Abundant equity and practically non-existent debt

There is no shortage of investors ready and willing to invest in these projects and accept the high risk associated with them. According to an article published in Spanish journal Expansión on September 14, 2020, as of June 30 this year, there were over €1,150 million in Spain ready to be invested in startups and at least 37 venture capital funds were active here.

There are also incubators, accelerators and active networks of investors, individuals and professional funds willing to accompany founders at this stage by injecting the necessary funds in successive rounds, as the company meets its milestones at its seed and launch stage.

This equity, however, is practically the only source of financing that startups use; for them debt in the usual sense of the term does not exist. We are not aware of any record or statistics showing the debt levels of startups. It is telling that the figures distributed by Preqin, an agency providing data and insight on private equity and venture capital, do report on and quantify growth in what are called private debt funds. In this segment, however, Preqin identifies various types of investments and specialist funds in them (distressed, mezzanine and direct lending) and does not report on any segment or category for startups’ loans or debt. There are now a few venture debt funds on the scene, as we will see in later articles, although they do not as yet have sufficient importance in Europe and do not appear to be active in any debt products apart from venture debt.

We do not enter into the subject of the types of public aid (either nonrefundable subsidies or loans with favorable terms) which may be obtained and relieve financing needs to some extent, because we assumed that startups use any that become available and they are not the target of our thoughts.

Cultural reasons for this exclusive dependence on equity

There are many reasons for this extreme dependence on equity financing. Including cultural explanations and others related to the experience and tastes of the human teams; as a general rule founders do not have a great deal of knowledge about or experience in corporate finance. Investors do not require parallel sources of financing to their contributions, perhaps because their own managers specialize in and confine themselves to their role as shareholders, by taking up their position in the development stages in which they invest, namely the A, B, C and even D series in which they participate.

Influence of valuation models

Another reason why those investors tend not to be keen on debt financing for the companies they own might be that, when the company is sold, if the usual valuation method is taken based on the assumption that the company is cash free and debt free, the existence of debt will almost always lower the purchase price. The fact is its debt balance is unlikely to be offset by its cash balance because, as we know, the revenues of companies of this type are not usually very high whereas their cash consumption is. Even so, by turning to debt, they can reduce their invested equity and boost their income by divesting, which could offset the lower purchase price.

Apparently incompatible ecosystems

We believe there is a certain general feeling that models that have not been tried and tested cannot be framed in the ecosystem of debt financing. The contents of the balance sheets and the nature of the assets of these very young companies are almost invariably intangible, and their bottom lines would hinder entry to the lending market.

Let’s innovate and adopt the … old paradigm

This exclusive dependence on equity, though characteristic, is not necessarily the best position. We must stress that it is not so much the shortage of equity (there is probably enough equity to cope with all eligible projects) as the setbacks that it creates for the companies themselves, their early investors, and the digital and scientific economy generally.

A classic paradigm of corporate finance is that it is best to cover financing needs efficiently, by using equity and debt in the proportions and for the purposes that are the most efficient and suitable in every case. There are purposes or levels that require or make equity financing preferable and others that call for debt. For the second category a very diverse range of mechanisms exists that can be adapted to the most varied circumstances and needs: commercial and financial debt, which may be short, medium or long term, senior or subordinated, on or off the balance sheet, and secured or otherwise, among others.

The time is right for that paradigm to enter the world of startups also. It is indeed questionable that the only place for startups is equity financing. The inefficiencies that this involves are notable.

The dilution experienced by founders

The first type is dilution for the investors themselves. The early investors, namely the founders and business angels, are the first to take a risk, by putting their limited funds into a stage in which the company could go either way: be born and survive its first steps, or not. If the following rounds are exclusively for equity (new shares and additional paid-in capital), the high returns that new investors expect, in line on another level with the nature and price/risk ratio of the instrument they subscribe, erode the ownership interests of those who first put money into the company to a greater extent than would occur if the existence of other sources of financing allowed a lower level of new equity to be raised.

No matter how high the valuations and interests that the founders and early investors have kept, their dilution will always be lower if any amount of funding could be raised by incurring debt. This is particularly true where the business plan is delayed or has run into difficulty and the company faces a down round. Dilution them multiplies further, due to the anti-dilution mechanisms that are usually agreed to protect financial investors in the event of a down round. In practical terms, these mean that protected investors do not see their interests lowered in the down round and therefore the founders and other early investors experience greater dilution than would otherwise have occurred.

Amplified effect caused by anti-dilution clauses

There is actually more than one type of anti-dilution protection. They are generally required by investors taking up a stake in a first equity round for a company in which previously only the founders and its supporters when it started out invested. Investors seek to ensure that, if the following equity round is based on a lower valuation than that taken for their own first investment, their ownership interest will automatically increase, at the expense of the founders, so as to offset or reduce their dilution.

There are various types of mechanisms to provide these types of protection which translate into a greater or lesser impact in quantitative terms for the founders; the most common and least harsh on the founders is the broad based weighted average. The full ratchet mechanism is the most costly for founders and initial investors and, perhaps for this reason, the one least used in practice. See here for an example of anti-dilution provisions, in the term sheet published by the U.S. National Venture Capital Association, on page 5.

And by liquidation preferences

And this is before any mention of the liquidation preferences that funds set apart for themselves over the founders, which may reduce the founders’ expectations even further. For a better understanding of liquidation preference, see page 2 of the model term sheet published by the U.S. National Venture Capital Association (view here) which includes this item. It essentially consists of a preferred right for financial investors, in the sale or liquidation of a company, to recover their investment out of the proceeds (either the purchase price or liquidation dividend), and in a few exceptional cases up to two or three times that amount before the founders or investors can recover theirs.

It is not such a good party for the founders

So, it is not unusual at startups, including successful ones, after multiple funding rounds, for several “layers” of preference to coexist in liquidation (each one generally equal to the amount invested in each funding round). These cases may have an adverse effect for motivating founders because to implement these preferences a high purchase price for the company is needed for the proceeds to reach the founders.

The founders’ motivation is usually strengthened in these cases through pay increases or more commonly by providing stock options, phantom shares, bonuses or other similar instruments that will correct, at least in part, the adverse effect caused by applying successive liquidation preferences at mature startups.

Though all of this, which is explainable and even fair from the standpoint of the interests at stake, tends to penalize to some extent those who make it all possible: young entrepreneurs and their close associates. To the point where who knows how many projects are abandoned or are never undertaken because they do not give the founders enough economic incentive.

Debt may be a solution

It is therefore a matter of finding alternative financing routes, presumably with a slightly lower risk profile for the lender, added to a lower cost for the company and indirectly for its owners. If the company manages to cover a portion of its needs in this way, it could take a little more time before organizing the following equity round and perhaps be able to reduce its amount and enhance a few of its terms and conditions.

Founders may as a result come out much better off in equity rounds which will continue to be inevitable, even if they involve lower amounts. This would encourage more young entrepreneurs to start and carry on with their projects. The investors in the first rounds and therefore the investor community at large also stand to gain from this.

In the next article of this series, instead of the setbacks of exclusive dependence on equity, we will explain the advantages of debt and the favorable environment that could prompt borrowing.