Start-Up Financing: the different views around the table

Different start-up financing tools give rise to different opinions around the (cap) table. In this article we will take the view of the bank, the debt provider, the new investor, the existing investor and - most importantly - the Founder.

While the merits of equity financing are widely discussed there is comparatively little information available on other financing tools such as convertible loan notes (CLN), venture debt and credit lines. These lesser known financial products are becoming more mainstream. Yet, founders may lack the knowledge to trade-off the different products in a calculated and rational manner.

In our recent workshop on this topic, founders were exposed to a framework that takes into account the impact on cash and the cap table of financing through these different structures. This framework also holds for any more tailored product beyond the 4 plain-vanilla ones described here.

In essence, any financial product for start-ups is can be bucketed into one of the main 4 categories:

• Credit line – short term debt financing
• Venture Debt – long term debt financing
• Equity – long term equity financing
• Convertible Loan Note – long term debt converting into long term equity
  financing

Knowing the category characteristics of each financial product, the Founder runs a calculation on the cap table dilution and cash impact for achieving a certain goal (e.g. break-even).

The dilution and cash impact calculations can be computed across the four products and compared, thereby allowing the founder to reach a rational decision: E.g. choosing venture debt saves 0.9% net cap table dilution when compared to convertible loan note financing for the same $3m financing raised.

However, we are only part of the way there. Founders are not the only party around the table. Understanding the different incentives and motivations of other involved parties is paramount. E.g. How would any new equity investors in the future react when they see $2m debt is still outstanding on the balance sheet, which needs to be repaid from the equity financing to be raised? This is a very valid question.

First, it is good to understand that a company that is optimally financed (most cash received for least amount of net cap table dilution), could look as follows: 10% of financing comes from a senior secured credit line, 20% of financing from senior secured venture debt (subordinated to the credit line), 20% is outstanding in convertible loan notes financing and the remainder chunk is equity.

Now imagine that you are the Bank issuing the senior secured credit line to a start-up. In a liquidation event, the credit line will always be paid back first including any interest outstanding. Hence, the bank would like to see additional equity and CLNs being invested to increase the cash buffer of the start-up and help it become more stable. The bank would also approve of additional venture debt coming in for the same reason, under the condition that the additional monthly cash burn to repay the debt doesn’t cause a drag on the start-up (something venture debt providers will look out for too). Hence, the Bank issuing the credit line is generally always positive when more financing (regardless of type) flows into the company.

Next, assume that you are the venture debt provider (Bank or Fund) that issued a venture debt facility to the start-up. You would welcome more equity investment in the business (or CLN) to create cash buffer and growth. However, you would be less welcoming to an increased credit line on top of your pay-out. Venture debt providers typically restrict access to credit lines (or any other senior ranking product) and you would need to get a specific carve-out approval for a limited amount of credit line for this reason.

For any new investors looking to invest, the picture is more ambivalent. Having a credit line and venture debt outstanding, means that there is a higher risk profile for the new investor. After all, in a downside event, the new investor gets paid only after the other funders are paid back in full. On the other hand, an argument can be made that there are now more financing parties around the table with deep pockets. Hence, in a downside event, having more parties also means more room for a financing solution (restructuring of debt or extra investment to bridge to exit/profitability). An even stronger argument is that the new investors will buy into a more favourable cap table if the start-up has previously raised venture debt (instead of equity) as most dilution is spared. The new investor might even take slightly more equity in the round, knowing that part of its money is used to repay debt.

For the Founders and existing investors on the cap table, again there are mixed feelings around the different financing products. When raising more venture debt or financing through credit lines, the start-up gets funded without diluting the founders (save for impact from the 1-2% dilution from warrants when raising venture debt / credit lines). In the downside case, however, this means that those parties get paid out first and there might not be anything left to pay out founders / internal investors. Inherently, the business is riskier (more upside from keeping more equity but downside looks worse) and the cash burn goes up due to the monthly interest and principal payments. With regard to the CLN, the Founders could be optimistic if the business is fast growing (and no cap is agreed) but a CLN does cost dilution (albeit postponed). If the business is not growing too well, this could be an expensive product.

For the Founders it is also worth noting that raising more equity/CLNs will quickly deplete the reserve pockets of the investors. When raising equity from new investors, this is considered positive in a downside case. There is now a new investor on board with capital and reserve pockets. In an upside case, raising from new investors is causing valuable dilution for Founders and internal investors alike, whereby ownership stakes can only be kept by investing more money (so keeping e.g. 20% of the cap table costs you money).

The different viewpoints are summarised in the table below.

EquityCLNVenture DebtCredit LinesCredit Line IssuerPositivePositivePositive-VD ProviderPositivePositive-NegativeNew Investors-N/ANegative/

Positive

Negative/

Positive

Founder/

Internal Investors

Positive/

Negative

Positive/

Negative

Positive/

Negative in downside

Positive/

Negative in downside

Next time when you are fundraising, you not only need to look at the cash impact and the cap table impact but also what the different parties around the table are thinking.