The Lurking Debt Opportunity in Software - Part 1
The venture capital ecosystem has ingrained equity raises as the ideal way to raise capital for software founders at all stages. While this norm has proven successful, with the foreseeable low-interest rate environment, many growing software companies might start looking for more favorable alternatives.
Using debt to fund growth has started to become a common tool, and it is only a matter of time before it becomes more prevalent. A large factor contributing to this shift are the limitations with raising equity capital. Not only is raising equity dilutive, high valuations often destroy discipline and grit within a firm. Lofty valuations can create a confirmation bias in which companies believe they have a direct path to success and become complacent with their strategy rather than critically think on how to expand more, sell better, improve their product, and ultimately do more with less. Lastly, equity raises have many strings attached in regard to liquidity preferences.
There is more than just the ability to prevent dilution. Debt investors don’t negotiate a valuation of the business nor a seat on the board, leading to a quicker funding process. Raising debt can be a great alternative to a suboptimal valuation in an abrupt equity funding round, and the interest expenses are tax-deductible.
The world is becoming more attuned to the debt opportunity. The tipping point, in our view, comes from utilizing recurring revenue. For a long time banks and other debt investors focused on cash flow. However, what’s been proven over the last decade is that enterprise software spend might be even more stable. When a business struggles it still needs to operate, so, as it looks to cut costs, software spend is one of the last things to go. This might make software an even more durable asset to lend against than cashflow. Transparency into a very predictable recurring revenue stream is great for investors since it parallels a fixed income instrument. Rather than “collateralize” a building or a machine, debt investors can rely on the current revenue streams. Hence, the companies best suited for these debt raises are likely to have strong ARR and low churn.
The framework exists for debt. The best debt investors will capture the enormous value from software companies that can lever themselves productively as a supplement to equity raises. This growth credit can powerfully push SaaS firms to exceed their operational objectives in between funding rounds at a low cost. The focus is on ensuring that the company, rather than the investors backing it, has the ability to repay that loan.
Gradually we will reach a point of inflection where debt is no longer ostracized as a bad signal for future equity raises and can instead, in conjunction with equity raises, be optimized for growth. Dilute less and do more. In the next article, we’ll cover the different types of software debt products we are seeing and their implications.
This article is a collaboration between Archit Bhise and Sebastian Duluc.