The economic outlook in the UK had been deteriorating rapidly at the end of 2022. The fall-out from Liz Truss’ so-called ‘mini-Budget’, the war in Ukraine, and supply chain challenges have contributed to high inflation and rising interest rates which has dented investor confidence. Business confidence has been knocked at the start of 2023, which has consequences for the demand for products and services.

In this environment, business leaders will be relying more heavily on investor cash. Taking equity funding is typically the most common route for high growth businesses as your investment partner will be incentivised to help the business succeed, without becoming over-burdened with debt early on in the growth journey. But that’s finite – until you can raise more. Investors are holding back on new investments, and are more inclined to reinvest in proven companies within their current portfolio. Even if you do want to raise again, you may have to do so at a lower or diluted valuation.

Founders and investors are often poles apart when it comes to valuing the business, especially  in recent years when the market has been fluffy, valuations have been sky-high. So what options do you have if your sources have run dry and you don’t agree with the valuation proposed by your investors?

Well, there are a few other options that can give you the cash to continue to grow revenues, before pricing an equity round. These include Convertible Loan Notes (CLNs), Advance Subscription Agreements (ASAs) and Venture Debt.

The peaks and pits of using a CLN

CLNs are short-term debt instruments that allow the creditor to convert an initial investment - and any accrued interest - into an equity investment at a later date. A CLN is effectively a hybrid of debt and equity funding.

Participating parties don’t need to agree on the size of a funding round or a valuation figure - often points of contention between founders and investors. CLNs serve as good bridge capital options as they are generally simple to document, quick to execute and don’t involve large legal fees unlike most equity financings where numerous corporate documents need to be updated in order to close the round.

The other notable benefit is that you don’t have to give up a stake in your company upfront. This means you will maintain control of the company – a lender has no ownership and therefore no involvement in business decisions. Be aware, however, that if a company is unable to complete a future equity round then the CLN will remain debt that needs to be paid. If the company is short of cash, this could lead to bankruptcy – bad for both parties.

With a CLN, you will be tied to regular interest payments which are even less attractive as interest rates continue to rise. If revenues don’t take off like you think they will, then these payments might become a drag when you can least afford them.

For particularly early stage businesses, with some IP but few concrete assets against which you can borrow, it may be overly risky to opt for a CLN that often comes with conditions such as giving over your house as collateral to a lender.

Other ways to use debt besides CLNs

An Advanced Subscription Agreement (ASA) is a 100% equity instrument where investors 'pre-pay' for shares in a company. Effectively investors agree to purchase shares, but don’t receive their actual shares until the completion of a qualifying funding round or if the company is sold.

If another funding round or sale is not realised, a fixed long stop date is set at which point the investors receive their shares either way. As it’s an equity investment, money invested through an ASA cannot be repaid in cash. As with a CLN, it’s possible to include both a discount and a cap to the valuation to recognise the added risk for the investor.

Finally, there is also venture debt, which allows companies to take debt funding at an earlier stage and in larger amounts than traditional bank loans. Venture debt providers are interested in the current and expected performance of a firm, rather than its historical financial performance. What’s more, it generally does not require any personal guarantees by the company owners. Instead of borrowing against hard assets, companies borrow against accounts receivable.

Rising interest rates and debt funding

It’s important to factor in the impact of rising interest rates on all of the debt financing options outlined above. The Bank of England has raised interest rates again this month to 4%, the highest level since the financial crisis.

Increasing interest rates subsequently increase the cost of borrowing, so rising interest rates are effectively a tax on borrowing. This is not the only factor to consider when deciding whether to take on debt or sell equity. Interest payments are usually tax deductible, and the ‘real’ interest you will pay won’t be as high as headline interest rate figures.

In difficult times, many founders and CEOs will consider debt financing options. While taking on debt rather than selling equity solves the valuation problem, there are lots of factors to consider before deciding which option is the right one for you and your business. CLNs are arguably the ‘go-to’ choice for high growth tech businesses, but should be handled with caution in a high interest rate environment if an equity round is not on the horizon.