Funding growth - which way forward for the founders?

Most founding management teams get going through a blend of funding from friends and family and good old boot-strapping. But as a high-growth company begins to prove that it has reached first base (let’s call that product-market fit), it will begin to appear on the radar of a broader range of investors.

The founding management team will then be presented with a set of choices that are a trade-off between the following factors:

(i) The rate of growth they want to achieve

(ii) The size of the business they think they can become

(iii) Willingness to invite new investors onto the cap table

(iv) Level of acceptance of dilution to their founding equity

(v) Overall confidence in the ability to hit the plan

Where do you want to get to?

Taking the first two points together, a management team will quickly arrive at a funding requirement that they calculate will be required to enable them to hit their objectives. In many cases internally generated funds (retained profits) will not be sufficient to get them to their goal.

To fully achieve their ambition, many high growth businesses must raise external funding, and, in many cases, this comes in the shape of a VC funder helping to put together a seed and then a series A round.

Widening the board table

Point (iii) will be debated here as new investor(s) come onto the cap table and inevitably change the dynamics of those board conversations and bring fresh thinking to the dialogue. The good news here, of course, is that there are many funding routes open to companies and the route chosen will be unique to a company’s individual circumstances.

Which funding route?

Once product market fit is clearly proven, the company can accelerate that growth and here points (iv) and (v) become important to balance.

Continually choosing an equity path will see continued dilution, and, for the right businesses, debt funding should be explored as it largely removes the dilution. Debt brings some advantages but also comes with other constraints that should be understood.

In North America debt funding for earlier stage companies has been an established market practice for some time. The market in Europe is expanding with new funds and banks entering the market in the last couple of years.

The typical use case for earlier stage companies taking debt was to boost the balance sheet and extend the runway to defer to when the timing for the next equity round could be optimised. This is still a strong case for taking on debt and another one has emerged in recent years - M&A. Rather than use a large slice of a company’s cash, a complimentary asset debt funding can be used instead and preserve cash balances for a later day.

So – debt can be used in at least two constructive ways but of course has other considerations that should be understood:

  • Cost of carry – what is the interest rate – is it fixed or floating
  • Other lending fees payable – either going in or as back end / early repayment fees
  • Are warrants being asked for
  • Reporting requirements and covenants
  • What security package will the lender require
  • What are the legal costs involved

Quite a lot to think about. The good news is that the number of providers is expanding so try and get two or three term sheets if you can – the terms can vary significantly.

Finally – let’s not forget point (v). Debt funding isn’t a good idea for all businesses. Companies that are growing well and exhibit low client churn (e.g. enterprise software) are good candidates for this type of funding. B2C businesses that can experience volatility in the top line are less obvious candidates for the debt route and tend to choose this type of funding less frequently.

Whilst the last two years have seen a meaningful fall in equity funding there remains a large amount of funding looking for the next generation of companies and as the founding team you are the most sought-after people. The fall in funding does not translate directly into a drop in potentially successful businesses. Europe and UK-based tech companies raised over €30 billion from venture debt in 2022, close to double that of 2021, which is why, for the right founders, debt can certainly be the right choice moving forward as a cost-effective tool to grow your business.