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Summer is coming to a close, and whenever something ends, it helps to look back. This week I looked back at almost five years of arranging debt financing for tech companies. We’ve seen and analyzed a great many companies in that time and learned how capital providers look at a business, which differs quite a bit from the usual operator’s view.
In pretty much every one of those conversations we discuss if someone should raise at all, long before we discuss terms.
So for once, this edition of the Capital Stack is about the cases where, in our experience, the answer to ‘should I raise debt’ is no. You often learn more from when something doesn’t fit than from another reason to embrace it.
That same read is now available for your own company. You can run a capital readiness assessment at re:cap. It tells you which financing instrument fits you best, not only debt but equity, grants and your own cash as well, and what you need to do to become fundable in the first place. If you try it, I’d be curious to hear what you think.
Almost every conversation we have starts the same way. A founder wants to know whether the company can get debt, how much and on what terms. re:cap has been built to answer that question.
What is always implicitly part of these conversations is the question: should you take on debt? Our team has answered it in hundreds of calls, usually somewhere between the intro and the term sheet.
Of ten companies that come to us with a concrete request, on average three to five could get a debt facility arranged. Debt fits more often than founders expect, especially once revenue is recurring and the growth story has a base underneath it. But it does not fit every company and it does not fit at every point in a company's life.
Usually this newsletter, like most of our conversations, is about when debt is a good fit. I thought it could be interesting for a change to discuss when debt isn’t the right instrument for you. Here are three cases we see often.
Roughly a quarter of the companies we’ve analyzed or talked to fit into this cluster.
Let’s say a company reaches 300k in revenue. It has won real customers, sees strong early signals and wants to move fast. For a business like that, a seed round of 1 to 3 million is possible. And in many cases that’s the expectation a founder brings to us, because in our industry equity is still the default, and it frames what founders expect.
Bring the same numbers to a lender and you’ll be offered 100k. That won’t get you where you want to go.
The reason for this is simple. Debt is priced off what you already earn, equity off what someone believes you will earn. In the first years, belief buys more than history.
Some come back a year later at 600k ARR and still won’t get the amount they’re looking for. If that sounds familiar, the honest move is to raise equity now and return to debt once the revenue base can carry it.
Ask yourself one question before you borrow: can you describe, with numbers, where this business will be in eighteen months?
Not precisely. Nobody can. But in a way that you can still manage the repayment schedule if things go moderately worse than planned. In our experience a business plan of a growing and fairly young company gets rewritten every six or seven months. What might be normal for you, isn’t a good fit from a lending POV.
If you are launching a new product or expanding into several markets at once, then you’re looking at equity-type risk. Debt can’t and shouldn’t price that. Once you’re in repayment, it wants the same amount on the same date. A slight deviation of your plan can quickly turn into a covenant breach, or in venture debt structures, into an equity kicker. Many founders don’t have that on their radar. But they should.
The one thing we always ask: does repayment still work in the conservative case? If you’re a VC-backed founder that is actually a mental challenge. You’re trained to build aggressive growth cases with - let’s say - a solid amount of optimism. That is not the plan a lender wants to see.
The last case might sound counterintuitive. You grow fast. For debt, you grow too fast. Of course, this isn’t bad for the business. But it sets an expectation that the ticket should be far higher than what today’s revenue can support.
I’ve said this above already but you can’t repeat this often enough: Debt is arranged against what you earn today. A company tripling from a small base can be an excellent business and still not borrow its way to the amount it wants. As in the first case, other sources will get you a larger ticket. Debt could be great for your company. But just not now.
In this situation, as in the other two, the honest recommendation is usually equity. Sometimes it is a grant, or another debt provider whose model fits the profile better, or simply growing on your own cash flow for two more quarters before taking on any external financing at all.
If you've read this far, you might be wondering how to find out which instrument fits you and your situation best. Usually it comes down to two things.
The first is the business itself. Your numbers, your model, and the stage you are at. Recurring revenue that renews on its own borrows well, project revenue does not. A company with two years of predictable cash behind it can carry a repayment schedule. A company launching its second product cannot. And whether someone stands behind you changes the impact of debt on your business. If you are bootstrapped, there is no investor who tops up the account when a quarter goes sideways. Your repayment capacity is your operating discipline, month after month. Debt rewards that discipline, and it punishes the lack of it faster than equity ever would.
The second is what you already believe when you walk in. Most founders arrive with the instrument chosen and want us to confirm it. We hear it from both sides. Investors who don't quite believe their portfolio companies when those say they aren't debt-ready. VC-trained founders who have never priced a credit line against the dilution of their next round. And, increasingly, founders who have read enough about non-dilutive capital to decide that debt is the only sensible route, before they have checked what their revenue can actually carry.
Fixating on debt is the same mistake as fixating on equity.
The companies that get this right let the numbers pick the instrument, and they are willing to hear an answer they didn't walk in with. If you want to see how a capital provider reads yours across debt, equity, grants and your own cash, our capital readiness assessment does exactly that.
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