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When founders think about raising debt, they often imagine going to a bank. In my three years of advising companies on debt financing options, I often remind founders that banks are certainly an option — but not the only one. Founders exploring debt should familiarize themselves with all the options in the market, from traditional asset-based loans to more innovative business debt and revenue-based financing solutions.
These various lenders not only have distinctive capital structures and terms, but each has a specific set of criteria to qualify for a loan. By familiarizing yourself with the entire market in advance, you can focus on the lenders that best suit your business, maximize the number of term sheets you receive, and spend less time chasing dead ends.
Related: Why Founders Should Embrace Debt Along with Equity
Banks
Banks themselves come in all shapes and sizes. When it comes to business loans, you have the local community banks, the large multinational banks, and the specialist business debt banks. Sometimes a large bank can bring all of these departments under one roof, providing a range of options from revolving lines of credit, term loans, warehouse lines and more.
Many times these banks have access to the cheapest capital available and can therefore offer you the lowest interest rate. But bear in mind that while this is usually the cheapest option, banks also have a high threshold to qualify for their capital. They may include covenants or other performance requirements to ensure that the business continues to meet benchmarks throughout the life of the loan.
For many small businesses, getting a loan from a local community bank can be a simple, low-cost option. But be aware that they may have minimum asset or cash flow requirements to qualify or even require a personal guarantee.
Corporate debt banks, on the other hand, specialize in VC-backed cash-burning ventures that show huge growth potential. Often, getting a loan from one of these banks requires multiple rounds of equity from name-brand venture capital funds, providing up to 25-35% of the most recent equity raise amount.
Eventually, when your business generates several million dollars in cash flow, it opens up an even wider range of banking options, including some of the largest multinational banks.
Business loan funds
More traditional business debt offers are very similar to what you would find at a bank. A three- to four-term loan structure is typical, although generally, interest rates are more expensive than banks with the downside of a larger amount of capital.
Similarly, venture debt funds look for companies that are VC-backed or at least some form of institutional backing, rapid growth and high LTV/CAC. There are also more tailored options, often referred to as growth debt rather than business debt, as they can provide capital to angel-backed businesses or even full-fledged startups.
Both of these options typically have teenage capital costs with interest-only periods and can be quite creative in structure. Founders should be aware that for both banks and venture debt funds, loan packages often come with warrants—essentially an option to buy shares in the company in the future at a fixed price. This means that a small amount of dilution should be expected, although some lenders in this space pride themselves on being fully non-solvent.
Related: When’s the Best Time to Raise Venture Debt – Here’s the Key
Revenue Based Financing (RBF)
An increasingly popular non-dilutive financing solution for early-stage companies is not technically debt. Revenue-based financing is more like a cash advance. Capital contributions are repaid as a percentage of monthly income, as opposed to a fixed capital repayment schedule.
If you’re looking for the fastest way to get capital, revenue-based financing is the solution. Many companies that use API integrations into your accounting and trading data are able to aggregate this data through their underwriting systems and offer terms in 24-48 hours.
While this chapter tends to be on the more expensive side, the speed and flexibility make up for it. Unlike other lenders, RBF facilities typically do not require collateral or impose restrictive covenants that may limit your ability to grow.
Regarding the requirements for an RBF, the minimum monthly income can be up to $10k with at least six months of operating history. The critical requirement is to demonstrate recurring revenue. This usually means low-variance SaaS revenue, but it can also apply to most subscription-type businesses or even transactional e-commerce businesses that have a strong track record of loyal customers.
Non-bank cash flow lending
Traditional private equity funds lend to established companies that have many years of traction under their belt. They are generally EBITDA or cash flow positive, some start at just $3 million in annual EBITDA while others require $10 million+. Businesses can be founder or sponsor-owned and range from fast-growing late-stage technology companies to more traditional businesses and even turnaround funding for distressed situations.
The use of capital covers a huge spectrum from financing leveraged buyouts or asset purchases to growth capital. Financing structures run the gamut from senior secured debt to mezzanine debt (below senior lenders but above equity holders) or even preferred equity in the capital stack. Interest rates are typically higher than banks in the single digits to mid-teens, with terms of three to five years. Closing fees and exit fees are common, as are deals, and loan sizes are derived either holistically from business fundamentals or as a function of cash flow.
Non-bank asset-based lending (ABL)
An ABL facility allows borrowers to use an asset as collateral for a line of credit or term loan. The asset can be as liquid as accounts receivable and inventory or as illiquid as real estate or a particular piece of equipment. Some of these loans can be secured by a single asset. For example, a company needs a new warehouse and gets ABL financing for it, or it could be a combination like A/R and inventory.
Asset-based lenders often focus on a specific industry and require a minimum amount of whatever asset they specialize in (customers, inventory, capital equipment, real estate, or even intellectual property). These assets can be held on the books as collateral or in some cases bought outright at a discount (for example, claims agencies).
Unlike other secured debt facilities, ABLs typically capture a specific asset rather than taking a security interest in the entire company. This reduces risk for borrowers and provides some flexibility in piling on additional debt, provided they can cover it. The advance rate (the amount of cash you receive up front) is usually between 50% and 90% of the value of the pledged assets.
Related: The Old-School Solution to Your Receivables Hidden Cash Flow Problems
Questions to ask yourself
As you consider which debt provider to approach, you need to think about the features of the financing vehicle that will unlock the long-term potential of your business — while meeting your short-term cash flow needs. Don’t forget that each lender has their own unique criteria. Fundraising without a clear plan of action can become a huge waste of time for founders, taking them away from running the business. By strategizing ahead of time and learning the market, you can ensure that you only spend valuable time with lenders who can offer a real deal.
Once the term sheets are available, you can now take advantage of them and choose the terms that are best for you. I will discuss this in my next article.