Startups and debt (II): Advantages of debt, opportunities in the current environment and a look at a few routes

In the previous article in this series, we explained, in relation to the necessary and very positive contribution that venture capital funds make to the ecosystem, a few setbacks associated with startups’ exclusive dependence on equity rounds, especially for their founders, and how increasing their debt levels could counter those setbacks. In this new article, we look at the advantages of debt, the opportunity afforded by the current environment and study a few first and hypothetical routes to get debt financing.

‘Debt is beautiful’; it helps with market orientation

Invariably not going down the equity route to cover the cash that a startup burns along the way, and getting debt financing can see the start of very positive trends in the company’s very management and prospects. One is that it contributes to preventing the company from getting caught up in a model based perhaps on success in technology terms and less on achieving more business focused milestones and from losing its ability to adapt its course to a more "holistic" viewpoint.

Entering this dynamic would aid the survival of more companies of this type, if they set their sights on raising funds from other sources in the form of debt, and become more market-oriented as a factor for their viability.

Debt means better governance

Alongside this greater market orientation, the fact of startups having to live with lenders and debt providers usually makes them keep a tighter rein on their management, because their financing agreements usually include clauses binding the borrower to meeting financial ratios or covenants and to delivering quality financial information on the company. This should compel a startup to adopt better control and monitoring procedures resulting in better overall governance of it.

Acquiring an executive with expertise in finance preferably with experience is always recommendable for any startup although, in the context of searching for and managing debt, and of the relationship with lenders, having a professional of this type makes even more sense.

These companies therefore have much to gain by identifying and opening up routes to finance that involve borrowing; using debt providers in other words.

A lasting low interest rate environment

We should not forget either that scenarios of very low interest rates (and negative rates in some cases for the best debtors) are here to stay. This is shown in the interest rate statistics published on September 2, 2020 by the ECB as of July 2020 placing the interest rate on new loans to businesses at 1.51% per annum, in the chart depicting interest rates since 2003, and the downward curve over recent years which has now brought us to the current levels for a while.

This is bound to have given the market an appetite for a new alternative type of asset like startup debt financing, offering much higher returns than the existing corporate debt.

Public money for digitalization and sustainability

On another note, most startups are engaged in businesses related to digitalization and perfectly compatible with, if not conducive to, the circular economy. And so are very much in step with the concerns of many finance providers to do business with sustainable industries.

Governments and the markets are known to be concerned about the sustainable economy, and within it, about sustainable finance. As seen, for example, in the plan on sustainable finance adopted by the European Union (view here).

More recently, the Next Generation Europe plan, based on the agreement in principle reached by the EU Council in 2020 targeted at revitalizing the economies of countries hit hard by the effects of the COVID-19 pandemic, with a huge program to inject funds out of the EU budget, has announced that large sums of public money will be spent on projects in the digitalization, green transition, and health fields (more information here). Although details of this plan are in short supply for now and fail to show how far they may translate into loans and other financing for companies, it is predictable that this option will be adopted, and even include low-cost financing. In Spain, however, this remains to be seen.

Routes to explore: hard to generalize

The environment, as we have seen, is a promising one, although it remains to be asked what routes startups should explore in their search for debt.

To which there is no single answer because every company, every business model, every type of product or service and every stage of development is a world in itself.

Take as a first example the difference between startups engaged in health and life sciences and those seeking technology solutions resulting in new digital products or services to be supplied on a massive scale. These are very different activities and circumstances and that difference could be key to whether they will be able to get debt finance and which types. We will return to these issues later on in our series of articles. It simply needs to be mentioned that our comments perhaps apply more to the second category of companies described above.

For now, however, here are a few general remarks that may be useful.

We should not rely too heavily on commercial banking and its ordinary channels

The first is that the solution probably does not lie in the well-trodden paths of conventional microeconomics.

Commercial banks and their ordinary distribution networks are not going to offer their traditional products: working capital loan agreements, discounting facilities, reverse factoring, conventional loans and credit facilities. These products are designed for stable small and medium-sized companies that have short-term financing needs, tangible or readily realizable assets and recurring revenues from their businesses. Many of these mechanisms are simply not conceivable or, if they are, involve amounts that will hardly make a difference.

Think also that incentives in the banking business depend heavily on the capital requirement rules for credit institutions (as set out in Regulation EU No 575/2013). Loans to startups that really are just starting out will attract a high risk weighting which eats into equity and therefore means a penalty. Moreover, credit risk is often measured using statistical models built on past experience which does not fit with an innovative segment without precedents in startup debt finance. Until the regulations change, and for many other reasons besides, commercial banks are unlikely to move massively towards offering conventional financing products to startups on their ordinary distribution networks for small and medium-sized companies.

Another factor is the role that banks could play through other financing methods which we describe in this series of articles, perhaps not in massive proportions although enough to attract clients with growth potential to whom, when the time comes, the institution, as a relationship bank, could offer classic commercial banking products (or private banking products for founders and their teams).

And probably not conventional bonds either

We cannot rely either on fixed income issues on the existing markets. The best markets for the bonds of small and medium-sized companies (such as MARF, the Spanish alternative fixed income securities market) are not really suitable for startups in the purest sense due to having disruptive models yet to be implemented.

MARF is an active and efficient market although it is used for issues by medium-sized companies which have relatively stable business models and stages of development. This is determined not so much by regulatory requirements, which are flexible, instead by the likelihood of the securities being successfully subscribed. To achieve this it needs to be known that the placement banks are the usual institutions and the targeted investors are institutional investors not specializing in startups. Quite a radical change would therefore be needed to be able to conceive of startups in the purest sense regularly using MARF.

For now at least we will leave these methods aside, in their most common and standard expression, for the earliest stages in the life cycle of startups.

In the next article in this series we tackle the routes that do seem to be promising for giving startups access to lending.