The growing importance of debt funding for technology companies
There are more debt funding options than ever for high growth tech sector businesses, as lenders get progressively more comfortable with leveraging intangible assets, such as IP and revenue. This article outlines various types of debt funding and the pros and cons of each.
Venture debt
Venture debt is targeted at high-growth businesses (those growing c.20% year on year) at the scale-up stage and backed by institutional venture capital investors and debt funds (including banks). It can be used to help bridge the gap to the next funding round, to smooth fluctuations in working capital or seize out-of-cycle opportunities.
Pros |
Cons |
|
Equity dilution is avoided or minimised so founders can retain control. Some but not all funding providers do ask for warrants (an agreement to buy future shares in the business at a fixed price). |
Interest costs and repayments: Monthly interest payments can impact cash flow. It is a loan, which will require repayment over a certain period or on the occurrence of certain liquidity events (eg. a sale or IPO). Interest rates tend to be higher than those seen in more mature markets. |
|
Faster time to raise (than capital): Quicker access to funds compared to equity financing. |
Covenants and reporting requirements: There will be a suite of covenants that restrict and monitor the operations of the business and which, if breached, can lead to immediate repayment obligations. The lender will also require regular financial reporting and access to Board and shareholder documents. |
|
Lower cost of capital: Generally it’s cheaper than equity financing, so can be taken alongside equity to reduce the overall capital cost of funding. |
Fees: Certain funders will apply fees that are triggered on early repayments. |
Recurring revenue
Recurring revenue finance provides loans for tech-based growth-stage companies with a recurring revenue business model (often suited to software-as-a-service (SaaS) and enterprise software businesses, as well as others). These revenues typically come from subscriptions, licence fees and maintenance charges, which are often paid annually in advance, and thus provide a steady income stream. It is prevalent in the US and becoming increasingly common in the UK.
Pros |
Cons |
|
It is based on contracted and predicable revenues, so provides a predictable and stable income for businesses. |
The documentation for recurring revenue deals can be complex. |
|
Allows companies to reinvest revenue into growth without immediate pressure to generate profit. Targeted for those businesses in the early stages of growth, pre-profit or yet to generate sufficient profits to comply with typical leverage ratios. |
Costs of the financing are higher than financing that is established at the post-profit stage. |
|
Retain control and avoid equity dilution at the early stages. |
Debt available will depend on the quality and predictability of revenue. |
|
Often secured over the IP of the business. |
IP secured funding
Lenders are increasingly more comfortable with valuing intangible assets and allowing businesses to leverage that IP as collateral in a similar way to tangible assets such as real estate. Funds available would be on a loan to value basis with some lenders able to offer hybrid products, whereby businesses with tangible assets could "top up" the value of the collateral by including the value of their intangible IP.
Pros |
Cons |
|
Unlocks opportunities for businesses with significant IP assets but limited tangible property. |
The business would pay an annual fee for the valuation which can add to the overall cost of funding. |
|
Often a standardised assessment process identifying, valuing, and assessing the separability, saleability, and strength of IP assets. |
The valuation of IP can be complex and requires specialist knowledge to avoid overvaluation. Targeted towards growing businesses with existing, separable and saleable IP so it won’t apply to many start-ups. |
|
IP funding depends on the strength and marketability of the valued IP, so if the business fails to generate the expected revenue, then the company might face difficulties in servicing the loan. |
|
|
The IP is at risk in a default scenario. |
Comment
The type of debt funding that is appropriate for the business will depend on many factors, including those set out above, the size and growth of the business, existing funding that's in place and the industry that the business is operating in. There is no one size fits all but there should be options for most businesses to consider.
Our content explained
Every piece of content we create is correct on the date it’s published but please don’t rely on it as legal advice. If you’d like to speak to us about your own legal requirements, please contact one of our expert lawyers.