1. What is Growth Debt?
Growth debt is a financing solution tailored to early-stage companies that can be a supplement to equity financing. Growth debt extends a company’s runway to the next value creation point while minimizing dilution.
Growth debt has been present in the US market since the 1970s and is widely used by startups. The value of growth debt transactions in 2020 amounted to over US$ 27bn, accounting for almost 18% of all investments into VC-backed companies in the USA. For US startups, growth debt has been an essential part of building the best tech companies in the world.
Despite Europe being a significantly younger and more fragmented startup ecosystem, growth debt has been thriving in the region for the last twenty years. In 2020, the amount of growth debt transactions in Europe reached €1.5bn, ca. 5% of the total funding provided to VC-backed companies in the region. As the ecosystem matures, more and more startups decide to fuel their growth with growth debt financing as a complement to equity.
2. Why is Growth Debt attractive now?
At times of market uncertainty, growth debt can be used to extend a company’s cash runway and give it more flexibility when it comes to the timing of its next equity round. Typically, in this situation growth debt is raised alongside a convertible round.
During favourable markets, growth debt is an ideal complement to an equity round as a non-dilutive source of capital.
3. What are the differences between Growth Debt and bank financing?
Growth debt is a financial product positioning itself between equity and traditional bank financing.
Equity financing is the most popular and readily available capital source for early-stage companies, but it is also the most expensive capital source – founders and early investors are diluted and face a deterioration in their liquidation preference.
Bank financing is on the opposite side of the spectrum, being the cheapest financing available to companies. However, banks are usually unable to finance smaller companies that are undergoing rapid growth and are unprofitable as a result. Banks also generally need physical assets as collateral and the loans are usually subject to financial covenants.
Growth debt fills the gap between these two financing options, being able to finance fast-growing, but still loss-making and asset-light businesses. It is more expensive than bank financing, with interest rates being at low to mid-teen percentage points, but it does not dilute the company’s founders or equity investors and it generally comes without financial covenants, facilitating the company’s growth path.
4. Who opts for Growth Debt?
VC-backed companies around the world use growth debt. The product has the longest history in the US, where approximately 15% of all funding for VC-backed companies. In Europe, the use of growth debt is becoming more common, however, it contributes a significantly lower percentage of total funding for VC-backed companies at approximately 5%.
Traditionally, European growth debt providers have mostly been focused on the UK and Western Europe. The extended Central and Eastern Europe market is estimated to account for just 3% of all growth debt deals, according to Deloitte. Instead, European founders have historically used traditional equity or rarely, where available, bank financing — and are often unfamiliar with the specifics of growth debt funding, although this is rapidly changing due to the appealing nature of growth debt as a complement to other forms of financing.
5. When should my company take Growth Debt?
1) To extend the cash runway of your startup to get it to the next “value creation” milestone resulting in a higher valuation at the next equity round.
2) If you’re concerned that it might take longer than expected to hit your next milestone and you don’t want to raise equity under unfavorable conditions, growth debt can also be used as an “insurance policy”, allowing you to extend your runway. This is particularly true when capital markets are less favourable to tech investments.
3) To improve the efficiency of an existing round, by raising part of it in debt and reducing dilution for the founders and existing investors.
4) To fund an acquisition to accelerate growth.
5) To act as a bridge to profitability.
Additionally, as a growth debt round is “signal neutral”, it may be helpful in a situation where the company wants to postpone a larger priced round without showing any alarming signs.
6. Who should I take Growth Debt funding from?
1) Look for a growth debt investor with a “light touch” approach to financing. Restrictive covenants (which sometimes include financial metrics such as liquidity thresholds or limitations on a burn) put excessive bounds on the startup’s freedom to execute its strategy and vision. For instance, covenants on burn levels can ultimately restrict the company from investing more in sales and marketing and growing at a faster pace.
2) A good sign is if a growth debt provider looks closely at who your VC backers are and, even better, has a long-term working relationship with them. Include current investors in the process of selecting your growth debt lenders and negotiating fees. Ask for early repayment opportunities and flexible drawdowns — these would make the facility more flexible for you and tailored to your company’s financing needs.
3) Make sure your growth debt investor is someone who listens and understands your funding requirements and is creative and flexible enough in finding the most suitable loan structure for you.
4) Feel comfortable that your business is at the stage where it can sustainably service its debt. Most growth debt providers are happy to support cash flow-negative companies; however, they look for signs that the company has either a sufficient cash cushion to make debt repayments until it hits profitability or is well placed to attract the next round of equity financing. A sound growth debt investor will advise on whether the company is mature and stable enough to take on debt financing or suggest the steps it needs to take to become growth debt ready.
7. What makes Growth Debt appealing?
The main advantage of growth debt over traditional equity financing is that it is virtually non-dilutive. Since growth debt is essentially a term loan (with a usual term of three to four years) that works much like a mortgage, the borrower’s cap table remains practically intact. It allows to raise additional capital without giving up a significant share of the business.
The only thing to keep in mind is that growth debt providers most often take warrants — these give them the option to subscribe to a predefined amount of a company’s new equity (usually equal to a fraction of the overall facility) at an exit event — i.e. when the company is sold, merged or listed on an exchange. The price at which options are exercised is agreed at the time of underwriting the facility and is usually linked to the most recent equity round — and if the company grows, growth debt providers partially participate in potential equity upside. However, the dilution from warrants is limited to 1-2%. Furthermore, unlike equity rounds, growth debt providers do not “price” the company — i.e. they do not establish a new valuation — eliminating one of the more painful discussions companies face when dealing with equity investors. This also makes the process of raising venture debt more streamlined as compared to other forms of financing.
8. Lower dilution is probably the number one benefit anyone would call out when speaking of Growth Debt. But that reduced dilution comes at a cost — you have to pay interest on debt, while equity comes as free money. Does this benefit offset the cost of the borrowed money?
It is a common misconception that growth debt is more expensive than equity. While debt does require cash interest payments, the dilution which comes with raising equity is a much greater cost, especially as your business grows and becomes more successful. One should look at it not only from a short-term cash-flow standpoint but from a value perspective. Giving away a stake in a growing company is much more expensive than the interest on a loan.
9. What is the cost of Growth Debt?
The interest rate on a venture loan is the single most discussed term of the facility and varies from low to mid-teen percentage points. It is typically a fixed rate, which allows borrowers to better manage their cash and depends on the credit risk score of the debt provider. At Flashpoint, the borrower’s unit economics, the quality of its VC support, and its cash runway are among the key elements that impact this assessment.
Apart from the interest rate, additional fees typically apply, such as:
- A closing fee, payable in cash when the facility is signed or funded, which usually varies between 1% and 2% of the total loan amount; and
- An early repayment fee is payable if the borrower decides to pay down the facility in advance.
10. What are warrants?
Warrants are included in most growth debt deals and provide an additional reward for the lender for taking the risk associated with supporting early-stage companies. Warrants are essentially a call option allowing the lender to purchase shares in the company at a liquidity event in the future for a specified price. This liquidity event might be an IPO or a sale of the company to a strategic investor.
Usually, the warrants are cash-settled and the lenders prefer not to hold shares once the warrant is exercised.
When it comes to warrants, there are several key terms to keep in mind when negotiating a deal. Those are:
- Warrant coverage. This represents the number of shares that the warrant holder is entitled to buy.
- Strike price. The price at which the warrant holder can buy shares. This is typically aligned with the valuation of the concurrent or most recent equity around, which means the company does not need to undergo a separate valuation process when attracting growth debt.
- Class of shares. The term sheet should also specify the class of shares which the warrant holder will acquire. Typically, this is the most recent or senior class of shares at the time the warrant is exercised.
Now, let’s take a look at some examples. Let’s assume that the borrower received a growth debt offer for a €1m facility, with 12% warrant coverage and a €20m strike price. This means that the lender will have a right (but not the obligation) to buy shares worth €120k (calculated as 12% * €1m), at a price per share implied by the company’s €20m valuation. In such a case, the dilution to the company would amount to ca. 0.6% (assuming no further capital increases) or lower (if additional capital increases occur between granting the warrants and exercising them).
It’s important to remember that dilution with growth debt is not only substantially lower compared to equity financing but it is also delayed until the liquidity event and happens only if founders and other investors of the borrower are making money too. Therefore growth debt allows not only preserves additional value for the company’s shareholders but also it aligns the interests of the borrower and all other parties involved.
11. How can Growth Debt lower the dilution of a company’s shareholders?
Dilution is a key concern for both founders and investors as companies attract growth capital to fund their expansion. However, growth debt is an ideal financing tool to limit dilution, as it is the least dilutive form of funding available to a startup.
For example, growth debt can directly replace part of an equity round. Let’s assume a company that has an opportunity to raise €2m, via equity, convertible loan, or growth debt facility. The pre-money valuation for an equity round was set at the level of €20m, for a convertible loan the cap was set at €40m and for a growth debt facility, the warrant coverage was set at 12%. In this case, a pure equity round would dilute all existing shareholders by 9.1% (€2m divided by the post-money valuation of €22m). The dilution when using a convertible loan, assuming the best possible scenario of converting at cap, would be 4.7% (€2m divided by the post-money valuation of €42m). If the company used only growth debt, the dilution would be only 1.2% (€240k divided by the post-money valuation of €20.24m).
Another scenario is a company postponing its next equity round instead of partially replacing it with debt. Let’s assume a company is growing its revenue by 50% every 6 months and is burning €200k each month. The company is looking to raise €7m of capital to continue its growth trajectory and cover its burn for the next 2 to 3 years. The company is able to raise this equity round at a valuation of €20m with approximately 25% dilution. The alternative scenario is to raise a €1.5m debt facility to fund the company’s burn for the next 6 months, and then raise the €7m equity round at a higher valuation of €30m, which would entail a lower dilution of approximately 19%.
By postponing the equity round, current shareholders of the company are able to increase both the valuation of the company and their future stakes in it.
12. What are the covenants?
Covenants are commitments and restrictions which the borrower undertakes when receiving a loan. There are many different types of covenants, with financial covenants being the most popular and limiting for companies.
Covenants are mostly associated with bank loans. Often banks will offer a cheaper loan but with quite extensive and restrictive financial covenants. In these situations, these limitations could actually destroy significantly more value for the borrower than the benefit gained through a lower interest rate. Such covenants could include a requirement to keep a minimum cash balance in the bank’s account, a restriction on burn rate (which could undermine the company’s marketing strategy), or revenue targets which, if not met, trigger repayments.
Growth debt facilities generally do not include financial covenants, making it a more flexible tool than bank financing. However, some non-financial covenants are standard for all debt deals, such as limitations on permitted indebtedness or the sale of the company’s assets.
13. What is the advance payment?
It is common for a lender to ask for a capital deposit equal to the last installment of the loan at the time of funding. This is a risk management tool for the lender, and from the borrower’s perspective, it means that the actual amount of the money the company receives will be slightly lower than the amount of the loan (however it won’t need to make the last payment on the loan, as it will be offset by the advance payment).
14. What is the security of a Growth Debt provider?
Growth debt is usually the only senior secured lender in the company. Seniority describes the order in which different stakeholders receive proceeds in the event of an exit or liquidation of the company.
Senior secured lenders are one of the first to be repaid in the event of a sale or a liquidation. The simplified structure of the seniority looks as follows:
- Government and employees;
- Trade creditors;
- Senior secured lenders;
- Junior secured lenders;
- Unsecured lenders;
- Preferred shareholders; and
- Common shareholders.
Security is a set of assets that the company pledges to a lender, and which the lender can take control of in the event that the company fails to comply with its obligations towards the lender. The type and perimeter of security taken by a growth debt provider varies by company and jurisdiction. Given that the companies which use growth debt tend to be young asset-light tech companies, a floating charge over all of the company’s assets is the most common approach toward security.
15. What are the legal documents needed for closing a Growth Debt transaction?
In general, there are three documents that need to be signed when closing a growth debt transaction:
- Facility agreement, which is a document containing all the key information on the loan’s terms and conditions; and
- Warrant Agreement, containing all the key terms of the warrant; and
- Security documentation, which can widely differ depending on the jurisdiction.
When working on a venture debt facility, it is important to remember that the documentation does tend to be more complex than an equity transaction and varies from jurisdiction to jurisdiction. Therefore, using external counsel who has experience with venture debt in the specific jurisdiction is key, and allows both the lender and the borrower to save money and time during the documentation process.