The pricing model for venture debt today is based on a minimum of $2 million-$5 million ARR and an interest rate of SOFR + 3%-8%, but lenders are demanding that companies also provide warrants for security.
The underwriting process has changed since last year's market correction; thus, underwriting companies will now focus solely on the economics of each unit and the company's ability to retain users and manage cash burn before providing funding.
This guide provides an analysis of available tech startup loans, qualification requirements for each product, and the costs associated with borrowing money in the early stage and growth environment.
Lender Behavior and Core Underwriting Metrics for Tech Startup Loans
The lending environment has changed dramatically since the closure of major regional tech banks; therefore, lenders are much more selective when it comes to lending out money for early-stage software companies and are relying more heavily on private debt funds and specialty lenders to fill the void of lending money for these investments.
Re-pricing associated with the AI-related risk to software lenders has an immediate impact on their willingness to lend money for these companies. Lenders will now calculate debt capacity for each borrower based on the trailing revenue of the borrower; therefore, they will be looking very closely at the quality of the company's monthly recurring revenues (MRR) and customer concentration.
The high rate of churn represents a significant risk to the borrower's ability to repay the lender's debt. For example, if a company has a 5% monthly churn rate, the lender's risk to provide financing to the company will be elevated.
Lenders will also evaluate the burn multiple; therefore, if a company has a burn multiple of 3x to 1x, that will automatically lead to the rejection of the application for a loan in most conservative credit boxes.
Validation of Revenue and Unit Economics
As discussed above, to get attractive terms for a loan, a company must provide evidence of improvement in its customer acquisition cost (CAC) payback period. The LTV/CAC ratio will be used to calculate the size of a loan that a borrower is eligible to receive.
Debt providers want mathematical evidence that, based on cash flow, the borrower will have sufficient cash flow to make both interest and principal payments on the loan.
You cannot expect that you will have the ability to repay the loan just because you have had strong revenue growth; the timing of your profitability is very important to lenders' underwriting processes today.
Newly raised capital creates the largest safety net for a lender providing debt. To receive the best capital structure, lenders require startup founders to have received additional support from other qualified investors or debt providers via newly raised equity during periods leading up to the closing of the loan.
For all bootstrapped companies without institutional support, large underwriters impose a more stringent due diligence process and a higher probability of selecting a more costly, asset-backed or high-yield instrument versus an unsecured loan.
SBA General Delivery Mechanisms
The SBA 7(a) program is the most widely used program in the traditional finance space. It provides more than $25 billion in authorized loans each year and allows for a maximum of $5 million per applicant.
When the loan amount is less than $150,000, the SBA guarantees up to 85% of the principal amount of the loan. The Crestmont Capital case study is indicative of how effective this type of program can be in growing a company’s ARR by 40% in the first 12 months.
The SBA 504 program provides funding for capital needs for equipment and facilities that run $5 million or more and is often used by hardware start-ups to finance manufacturing equipment.
When founders require funds on an urgent basis, they can access the SBA Express program, which enables them to receive loan or credit decisions within a 36-hour period. The highest loan or credit limit for this product is a maximum of $500,000.
For example, a founder may use their loan amount to overcome the negative impact of a delay on an unexpected invoice, allowing them to avoid equity dilution and maintain operational activity.
In addition to banks, other options for capital sources are private debt and alternative capital sources. These sources take the form of specialized lenders and digital marketplaces, with companies like Lendio providing access to multiple institutional lenders through a single online application.
As the marketplace is fragmented, interest rates, loan terms and monthly payment obligations can differ widely based on the applicant's profile.
Venture Debt as the Only Institutional Debt Structure
Venture debt is the most popular form of institutional debt available today to replace costlier price equity rounds. Lenders generally size these transactions at 30-50% of the current annual recurring revenue (ARR) generated by a borrower.
While this type of financing is not inexpensive, it does not dilute the owner's equity. This makes it one of the most attractive tech startup loans on the market today.
Structure usually consists of an interest-only payment for a period of 6-24 months, followed by a strict 24-48 month maturity schedule. The only way to extend a company's existing runway is by properly applying for venture debt within those parameters.
Lenders will charge the Secured Overnight Financing Rate (SOFR) plus a spread of 3%-8% on overdraft interest. Lenders will also require the borrower to provide 0.3%-2% in warrant coverage. Warrants provide the lenders the option to purchase stock at a later date, thereby ensuring the lender participates in any future equity opportunity.
Revenue-Based Financing (RBF) and Digital Working Capital
RBF and digital working capital financing provide borrowers with fast access to working capital with limited operational limitations compared to traditional financing options.
Advantages of rapidly paying off existing debt with aggressive early repayment terms: Providers with a 4+ star rating on Trustpilot for over 2,000 reviews which offer rapid payment discounts for rapidly expanding small business customers include National Funding with a 4.7. Customers receive a discount of 7% for paying off their debt early.
The platforms that deliver capital quickly are: Companies with a 4.9 star rating on Trustpilot which deliver funding in as little as 24 hours including Clarify Capital by analysing cash flow history.
Flexible lines of credit include: Companies that provide revolving credit lines to small businesses up to $250,000 with starting rates (3 years) upper 7.8% and have money transferred immediately electronically.
All of these options eliminate the necessity of raising equity to fund the company. Companies can create immediate cash flow issues when paying back debt too quickly, particularly with daily or weekly withdrawal limits or with any seasonal trends.
How to Choose Funding for Your Growth Stage
To have an effective strategy for capital deployment, the company must know what level of growth they are at. When debt is placed ultimately is misplaced in the wrong stage of growth, the cash flow problems will happen immediately. The early seed company needs a different type of product than a Series A company.
Funding Options for a Pre-Revenue Stage Company
A pre-revenue stage company has no real conventional options available to it because the bank wants to review the cash flow history of the business before they can determine the amount of money that a business could repay.
For pre-revenue stage companies, owners have very few options available to them. Founders have to rely on alternative funding sources, such as a microloan from the SBA, personal credit cards or very early stage equity.
Placing debt at this early stage introduces an obligation on a business that it cannot support using its current business model.
Seed Stage Funding and Monthly Recurring Revenue
This section allows founders to employ early-stage engineering or sales talent before having to raise equity capital through a priced round. The concept is basic; raise quick cash to improve your operational metrics prior to going to VCs.
You only repay a percentage of your monthly sales. If your sales decrease, your repayment obligation decreases proportionately. Securing the right tech startup loans at this phase is critical to avoid premature dilution.
Series A and Growth
Institutional debt becomes the primary tool of companies at this stage. During Series A, companies typically will use debt to smooth out their cash cycle, as well as to fund customer acquisition.
The biggest risk to company operations at this stage is covenant risk. If a company breaches a revenue covenant or has too low cash levels, the lender may declare an event of default and recall the loan. It is imperative that founders negotiate covenants to retain operational flexibility.
Business Model Impact on Financing Options
Financing options are extremely different for a hardware company than they are for a pure software company. Because of the existence of tangible assets and physical supply chains, lenders must perform completely different underwriting analyses for hardware companies.
Software and SaaS
Predictable revenue is the best form of collateral. SaaS lenders generally prefer SaaS companies because the recurring nature of their revenue establishes a base level of future cash flow.
Therefore, revenue-based financing and venture debt are natural forms of capital for these types of companies. The absence of tangible assets makes it very difficult to secure traditional commercial loans without providing the lender with very robust personal guarantees from founders.
Hardware and Physical Products
Hardware companies typically maintain physical inventories of their products and require factories and assembly facilities to produce them. Therefore, lenders can lend to hardware companies using equipment financing and invoice factoring.
A lender has the legal right to repossess the physical equipment in the event of a default, therefore lowering the lender's perception of the loan's risk. Through invoice factoring, hardware companies are able to transform their unpaid commercial invoices into immediate cash.
Invoice factoring helps hardware companies to close the gap between their production of a physical product and their ultimate receipt of cash from the purchaser. Comparing these options against other tech startup loans is vital for hardware founders.
Service and Marketplace Companies
Service companies have very high overall costs due to labor expense and revenue vulnerabilities due to client project fees. Service companies often use business lines of credit to manage payroll until they receive payment from major clients.
Similarly, marketplace companies experience timing gaps similar to service companies; therefore, many marketplace companies use merchant cash advances as an interim bridge to funding their operations.
An alternative to financing that uses these interim solutions is Rollover as Business Startup (ROBS). With ROBS, founders can utilize their retirement funds without incurring early withdrawal penalties therefore utilizing a traditional route of financing.
Capital Structuring and Loan Costs
Allocating debt requires a mathematical analysis that analyzes the cash repayments from the company relative to the amount of time the company requires to extend its runway.
If a company takes SOFR plus 8% in combination with warrants and has the expectation that its utilization of this capital will support a growth plan that produces returns that exceed the total cost of the debt, it is worth acquiring.
If a company uses high-cost, short-term credit to cover burning cash as a result of systemic issues with their burn rate, the company will eventually fail.
Founders must align their long-term capital maturity rate to their next anticipated equity round and profitability milestones to maximize the value of their tech startup loans.