Why Your VC Doesn’t Like Debt
Welcome to our first issue of INTRO to Finance! The goal of this newsletter is to break down complicated financial topics and financing questions into easily digestible and actionable answers that we’ll be sourcing directly from you, our (hopefully) loyal readers.
But first, a big thank you to everyone who joined us for our “Funding Options Hiding in Plain Sight” session last week. We were blown away by the response and questions that we received during and after the conversation. Today we’re going to dive into a question that came up in the session and a few times since.
Why are so many VC investors averse to companies using debt to grow?
The VC and startup ecosystem doesn’t utilize debt to fund growth nearly as much as other industries. There is one exception — Venture Debt.
The most widely accepted use of debt within VC portfolios are Venture Debt Term Loans. These loans are usually taken shortly after a new round of funding is closed to extend runway until the next round of equity financing is raised, at which point the loan is generally repaid.
Yet, for all the time and energy VCs spend helping their portfolio companies strategically prepare for an equity raise, it’s uncommon to see investors spend any time helping their portfolio companies raise debt. On an individual level, that might be explained by the VC not having a network of lenders, or they might not be experienced in corporate finance. But, on an industry level, there are two large disincentives for VCs helping their portfolio companies leverage debt to fund growth:
Reason One — Debt Service
Unlike equity, which has fairly undefined and uncapped payback, companies who take on debt to grow must make the required loan payments or “Debt Service”. No matter the type of company, it’s always important to manage any debts taken on strategically and appropriately. Taking on too much debt and being unable to service it can be dangerous for both investors and their portfolio company. There are a few standard ratios to monitor how much debt is appropriate for a business, and we’ll explore those in future posts, but most calculations require cash flow to justify debt service. As our good friend Bill Janeway is fond of saying: corporate happiness is positive cash flow!
For a traditional VC backed company with little to no cash flow, debt payments mean a higher burn. If the company is running the Blitzscaling “burn to grow” playbook, it’s important to keep debt service to less than ⅓ of total burn. Having more than that puts the business in a position where investor capital is mostly being used to pay debts and not grow the business. When a business is dependent on investor capital, it creates a bit of a robbing Peter to pay Paul scenario, with the VCs being Peter. Investors want to see their money going into growth of revenue and market share – not providing a market return to lenders.
That said, if a business takes on a manageable amount of debt, the company, its founders, and its investors could see that, in some cases, debt would be a more cost effective source of capital (read: less dilution) than raising the same amount in equity. The use of debt can also preserve optionality that a new round of repriced equity removes (along with resetting the 10x+ multiple expectations of equity investors).
As a reminder, you ALWAYS have to service the capital provided to the business – whether it’s debt, with set loan repayments, or equity, which removes some founder controls and takes a percentage of proceeds at exit. Analyzing the amount of debt service a company can manage is certainly important, but servicing debt out of proceeds from equity financing will always put VCs and potential lenders at odds.
Reason Two — The Capital Stack
The “Capital Stack” of a company are the legal rights that others have to your business assets in a downside scenario. It sets the priority for who gets paid first and who gets paid last (if at all). Debt always sits in front of equity (VCs) in terms of repayment. While a company may not have every element, we put together a simple visual representation of the different layers to the Capital Stack.
As the visual shows, the company must pay taxes and employee wages before anything else. The next layer, well, it can be a bit more complicated. Debt terms, rights, and covenants can become fairly complex fairly quickly – depending on the company and the debt instruments they have in place.
Anything, ANYTHING, that sits between preferred shareholders and their return can cause real heartburn for VCs. Depending on the outcome at liquidation (read: bankruptcy, acquisition, or IPO), minus the amount of taxes, employee wages, and debt that the company must pay, this could mean the difference between seeing any return at all or a total loss for the investors. But, before we shed too many tears for our friendly neighborhood VCs, this is part of the risk they get paid to take on being an equity financier vs a debt provider. Just because that’s their business model doesn’t mean it has to be yours, dear reader!
VCs might not love it but you should
Both debt and equity have their place in the pantheon of options for funding and scaling a business. So please keep in mind: the business, NOT the financiers, should be driving the funding strategy. The company's incentives are never going to be perfectly aligned with either debt or equity providers. BUT if the company is utilizing debt to fund profitable initiatives, and has the strength to support the debt service, they can build a balanced Capital Stack that preserves optionality and rewards ALL shareholders.
Oh, that last bit? Don’t forget that common shareholders sit at the very bottom of the Capital Stack and only get paid if there’s something left over once the mouths above them have been fed. As operators and owners, understanding and optimizing your Capital Stack can mean the difference between a life changing outcome for the whole team or being locked into the binary business model of the Capital Stack you’ve built.
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