Is Debt Bad? Ushering in a New Capital Stack for Tech

Dhruv Mohnot & Rishub Nahar

Is Debt Bad?

“Debt is Bad” — this is a common mantra that pervades Silicon Valley, espoused by upstarts and legends alike. Certainly debt does not make sense for a super early stage software business. For these early stage companies, finding product-market fit is paramount and the high risk nature of these start-ups simply does not play nicely with debt financing. Indeed this leads us to the fact that because so many startups fail, equity investing is necessary.

However, against this supposed gospel, we take the contrarian view and believe as Alex Danco puts it “so many startups fail because of equity investing.”

Why? Well for a more mature company that does have product-market fit and solvent unit economics, growth is the first priority. But the risk profile of growth operations looks drastically different than that of initial product development. It is far less risky and the payout is relatively more capped. For example, hiring a salesperson is less risky than trying to build out a new product; it will also have a more limited returns. Further, a company that has strong recurring revenue (e.g. SaaS) is well-suited for making monthly payments anyway.

Hiring a sales team and building out a new product have drastically different risk profiles. Why then are they both being financed the same way?

Because of this limited upside, founders are reluctant to dilute their equity further to raise money for growth operations. This causes them to underinvest in distribution and growth and as Peter Thiel says “Poor distribution — not product — is the number one cause of failure.”

For these reasons we believe that debt is the missing piece for growth stage companies. But as we seek to defend this theory we come face-to-face with the old dogma “Debt is bad.”

Perhaps, however, our perception of debt being bad is not a demand issue but a supply issue. Traditional lenders may not be well-equipped to lend to a technology firm whose only asset is its code base. Of course, to start a business, any business, it is nearly impossible to get credit from a bank. Lenders are looking for companies that are somewhat well established, have been in business for multiple years, and can show revenue and positive cash flow. Every single one of these criteria is the opposite of the traditional tech start-up, which is why venture capital has been successful in this space. It fills a needed hole in the financing world, and its business model allows it to fail in 99 investments as long as it succeeds in one, because it has equity and therefore limited downside and nearly unlimited upside. Meanwhile, if 99 of a lender’s loans default, the lender is in deep trouble. Lenders have limited upside and unlimited downside. The asymmetry is flipped.

Clearly traditional lenders cannot afford to offer credit to early stage companies, but what about more mature businesses? Even then, many small businesses find it difficult to get loans, even if they show revenue and positive cash flow because they may have low sales volume and no (traditional) collateral, such as real estate or inventory. Additionally, getting approved and funded can take 2–6 months, which is a lifetime in the tech industry where the marketplace moves quickly and being late by a few weeks can be a death sentence. Many small business loans also require owner/founder personal guarantees, which can put the owner’s personal assets and credit score on the hook for the business loan. The other option is online lenders who give much smaller loans, at much higher APRs, a combination of factors that makes them quite unappealing for most start-ups.

Growth equity firms present yet another option for financing, but as their name suggests they take equity and at best take convertible debt which still can cause dilution.

Potential Debt Instruments

Growth stage tech companies would benefit from debt, but current debt instruments do not satisfy their unique needs. In the next section we hope to show what specific debt instruments would look like.

The debt product offering has to match the market need, be appealing, and be resistant to bigger players trying to enter the market. If any of these criteria are not met, the debt product will not be worth offering.

There are several products that could appeal to businesses.

1. Merchant Cash Advance: Clear Banc uses this right now, albeit with little flexibility in their product. Companies can ask for a cash advance on their future sales for a fixed percentage fee (5%), and then pay back the lender as their revenue rolls in. Meanwhile, they can use the cash advance to fuel growth now.
2. A Fixed Income Instrument: This is a bit more of a bet for the lender. Lenders can offer large loans in exchange for a fixed percentage of future revenues for a pre-established time period. For example, Stripe offers 1 million dollars in exchange for 3% of monthly revenues for the next 24 months. Of course, these are arbitrary numbers, but note that this is a product designed specifically for high margin SaaS companies that can afford 3%, and for Stripe/Square to offer, since it may be the one handling payments for the company in the first place! It has much more data to set the product terms than does any other lender.
3. Traditional Loan: this is self-explanatory. Lenders will likely offer a higher-than-normal APR, but will not ask for asset-backing (again, tech companies do not have any physical assets). The loan term will be shorter as well (12–24 months).
4. Cash flow securitization: this was suggested by Alex Danco in Debt is Coming. Businesses can sell their cash flows for debt, use the debt funding to acquire the next tier of customers, sell the cash flow for debt, ad infinitum. This is somewhat similar to #2 on this list, but Stripe could securitize across many companies and then sell the financial instrument to any interested buyer. Because the instrument is now diversified (in some sense), it may be less risky overall. It also allows Stripe to get the loan off its balance sheet, which may be in its interest depending on the particular details.

We can imagine that each of these options will appeal to different customers, and they can choose what is best for them. The question now becomes how to implement the underwriting process, and what to consider during it. SaaS operates on a unique business model and using things simply like daily revenue and credit history are not appropriate to gauge company health. A more nuanced approach should be taken.

As such, we now turn to some metrics that we believe will be useful for these lending products. Of course, the PhD data scientists at Stripe may be able to find other more useful metrics and design their own risk scores, but this is our first approximation for what may be useful.

Metrics

A SaaS company may be worthy of debt if it can show strength across these three fronts

1. Retention
2. Margin
3. Growth

Let’s explore each of these.

Retention

1. Revenue Churn: Revenue churn rather than customer churn is often more telling for later stage company health. Regular customer churn does not illustrate whether it is your so-so customers or your strongest customers that are churning. For mature startups small monthly churns compound to massive numbers. 3% monthly churn => 31% yearly churn. Recovering this in the form of acquiring new customers is very expensive. This is a vital metric that must stay low in order for a company to be debt grade.
2. Net Churn = Revenue lost due to churn and contraction less revenue gained from current customers . If this number is negative it shows that the company is able to grow revenues without adding new customers. This is a very positive sign for any debt issuer.

Margin

1. Lifetime Value (LTV) >= 3 * Customer Acquisition Cost (CAC): This is a pretty simple rule of thumb but foundational to ensure good unit economics.
2. Time to recover CAC: CAC / Average MRR (monthly recurring revenue) of customer. This number is paramount to formulate the terms of the loan. If it takes 2 years to recover CAC, then creating a debt instrument whose lifetime is one year will just cause liquidity problems for the company.

Growth

1. Monthly Recurring Revenue
2. Expansion Revenue: additional revenue from current customers. Upselling and cross selling your current customers is a quicker way to generate returns than going after newer customers. Thus, expansion revenue is more appropriate to service debt, which lies on a shorter time frame than equity.

These metrics are constantly evolving and as such capital could be deployed incrementally. As long as the KPI thresholds are met, the next wave is deployed. This is mutually beneficial for two reasons:

1. It protects the lender from overcommitting capital. They only are obliged to invest if the metrics continuously look good
2. It prevents SaaS companies from having to front-load on debt and having to pay interest for it throughout. In growth stage, capital needs six months from now could look very different than today, and a company should not have to pay interest for money it intends to use in six months.

Who Will Fill the Void?

We believe Brex, Square, and Stripe are all in unique positions to offer debt to growth stage tech companies.

In the last part of this exploration we ask ourselves the question “who would be the best vendors of these debt instruments?”As shown above, to underwrite well, lenders will need data. We believe Brex, Stripe, and Square all have certain qualities that make them ideal candidates for providing debt in the target space. For one, all these companies have instant access to their customers’ daily revenue and account balances. They already use this to supply SMB loans. We believe they can expand their offerings to help more growth stage SaaS companies. And why should they bother? It is the same lesson that GE learned so many decades ago, helping to finance the growth of your customers is a great way to catalyze sales.

Stripe (Vertical Integration)

Stripe’s ecosystem of fintech and legal products give them vertical integration for anyone trying to start and grow a digital business. A SaaS company that uses Atlas to launch, Payments for credit card processing, and Billing and Payouts to handle subscription revenue and costs would be more inclined to turn to Stripe Capital if they had a debt offering unique for SaaS companies.

Square (Securitization)

While it is true that Square’s current customer base is mostly not SaaS companies, Square Capital is already seasoned with the business model of securitizing SMB loans. We believe this can be extended by securitizing the recurring revenue generated by SaaS companies.

Brex (Industry Specialization)

Brex’s goal is to become the “bank” for startups. To do this they must do two things:

1. Offer transactions and account services: This is already accomplished through Brex Cash
2. Offer lending services: This is what Brex could fulfill by offering debt instruments

Brex is uniquely positioned to offer debt for SaaS companies because they have a deep understanding of the types of things on which SaaS companies spend money, based on their current customers.

Conclusion

“Debt is bad.” Maybe so. But perhaps a part of the negative image of debt comes from its potential to challenge the reigning VC financiers. We should not pretend that a capital stack solely based on equity is always the ideal way to grow a company. Tech companies are staying private longer, and it is important that we give them the options to finance growth for the future.