Startups should look at debt, not just venture capital funding

Three years ago, I met another venture capitalist in Jakarta to talk about startups in emerging markets. We talked about various sectors and business models. “But when these companies talk about monetization, they’re all lending companies,” he noted. He was right. Roadmap and monetization slips into many starter decks, even if they don’t lend strictly to fintechs, some form of lending has been talked about.

It seems that startups are coming to the same conclusion as GM and other American automakers in the 1930s: there’s more money to be made financing cars than selling them outright.

Do you have data on your customers’ inventory levels and flows? Let’s consolidate inventory financing. Carriers struggling with working capital to fund fuel costs? Try working capital financing.

Bundling loan products to facilitate consumer spending is common in most industries, and technology is no exception. After all, no company would turn down an opportunity to get more of the customer’s wallet and retain them.

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But tech companies are equity-backed, and raising equity is an expensive way to fund loans. This is because most venture capitalists expect explosive growth and returns, not those that can be obtained by lending at a reasonable rate. So, as startups evolve and grow in financing products, they will need to access debt to continue making loans themselves.

What types of debt exist for startups? These are the categories:

Asset based loans

A receivables loan is one of the easiest ways to fund a business with a financial product. The lender assesses the quality of the debt, ie the probability of timely repayment, and advances a facility on which the borrower draws if necessary. Commonly known as a revolver, these facilities offer flexibility to the borrower, but can be more expensive than a standard term loan on an annualized basis.

For fintechs or other startups offering loan products, the primary claim is the collection of loans they have made to customers that will be repaid. A “loan tape” shows all data on the loans they have made and tracks repayments. If the business goes bankrupt, the lenders have the right to recover the borrowed amount by staking their claims on the secured loans.

Corporate debt

More mature companies can often access a wider variety of debt instruments, including term loans, convertible notes, and traditional venture capital debt. These instruments are sometimes less expensive than asset-based revolvers, and lenders typically focus on the company’s ability to repay the loan with cash flow, rather than the valuation of balance sheet assets.

In debt parlance, this reflects a shift from underwriting a specific asset to underwriting the entire company. In some cases, subprime credit facilities also contain warrants – the lender’s right to convert their debt into equity – which can become very valuable if the value of the business appreciates significantly. Therefore, venture debt providers, unlike other debt providers, often focus on the total enterprise value and growth potential of the business.

In fact, many subprime debt providers count on warrants to generate fund returns, especially when lending to early-stage startups. Young startups sometimes fund themselves through convertible notes, which are effectively equity instruments disguised as debt. So while convertible notes and venture capital debt are available to early stage startups, investors know full well that they are trying to get a share of the future equity value of the business.

Revenue-Based Funding

A new class of digital lenders lends against the future revenues of businesses in the digital economy. Lenders in this category include Clear.co, Pipe, CapChase, and Uncapped, among others, as well as capital provided by Shopify, Square, and Stripe.

This product is not new – the merchant cash advance has been a staple for centuries. What has changed now is that the lender can connect directly to the borrower’s accounting and financial data, allowing for a quick credit assessment and quick loan execution. The disadvantage of such financing is the cost to the borrower. Annualized rates on merchant cash advances exceed 50% in certain circumstances.

Debt for emerging market startups

While venture capital activity in emerging markets has exploded, debt capital, particularly non-corporate debt, remains relatively scarce. Take Pakistan. Although venture capital has boomed over the past three years, startup debt barely exists. Since even non-fintech startups want to provide financial products, the demand for loan capital will explode over the next five years. For now, this is an unmet need.

Will debt disrupt venture capital?

To be fair, startup debt has only recently begun to gain mainstream attention, even in developed markets. Debt at risk increased to $33 billion last year in the USA. That’s still only a tenth of the $330 billion in equity that venture capitalists deployed in the US last year (keep that 10x ratio in mind for later).

Simultaneously, the meteoric rises of revenue-based funding startups (Pipe, Clear.co, etc.) have led many to predict an increase in debt funding for startups this century. Here is a great summary of debt options available created by a16z, and another one that makes an eloquent case for the incoming wave of debt. The summary: Startups with a good product-market fit, a repeatable sales process, and a growing cohort of users may benefit more from debt financing than traditional venture capital (equity). The cash flows of startups with predictable, recurring revenue are remarkably similar to the cash flows of mortgages: largely predictable and consistent. The analogy has its limits, but there’s no reason tech companies with recurring revenue can’t also access debt.

Who is building this in emerging markets?

Assuming the multiple of 10 from earlier, the $300m in equity funding for Pakistani startups should result in a demand for $30m in risky debt, which is a subset of the entire debt market for startups. It’s not a lot, but I expect the demand for debt to be higher given the lack of availability of debt products of any kind in the market. As the startup ecosystem grows, debt providers will need to step up their efforts.

But Pakistan is only a small part of the emerging markets venture capital ecosystem. the total debt demand for startups in emerging markets is easily a few billion dollars a year. And that will only accelerate in the next five years.

So who builds this?

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