Bank Debt and Middle Market Technology Firms
By: John Hoesley & Josh Roberts
Early- and mid-stage technology firms face trade-offs in raising equity. The need for growth capital vs. dilution. Money today vs. potentially higher valuations later. Self-governance vs. ceding some strategic and operational control. In the technology sector, change is the only constant – management teams and capital structures must be adaptable while balancing the cost of capital with adequate liquidity to fund investments in research and development, sales and marketing and the firm’s infrastructure.
Many founders’ focus on equity alternatives stems from the misunderstanding that bank debt is only available for investor-backed firms, or that founder-owned companies can only access high-cost, non-bank options. Unlike holiday M&Ms®, less- or non-dilutive bank debt alternatives do exist for mid-market technology firms…but there are considerations founders should undertake before pursuing it.
The choice of a banking partner is critical. Founders often work with larger, less-focused financial institutions – they’ve ‘always banked there’ but now find their bank doesn’t understand their business. Among tech-focused banking practices, overly aggressive lending to quickly build market share can foster a pullback if even a small set of borrowers experience difficulty. Or knee-jerk reactions to inevitable speed bumps in a firm’s path leave founders wondering whether they’ll have access to debt capital, usually, it seems, when opportunities are most abundant.
All bank lenders are regulated; there are limits to what they can, and should, provide. But banks underwriting primarily to business risk (whether investors are involved or not) develop a better understanding of firms’ unique opportunities and challenges. Armed with that knowledge, these banks are better able to respond to changes impacting the firm. More important, knowledge of the business and its economics and broader market trends should result in a banking partner able to identify opportunities and anticipate challenges.
Finally, firms should challenge banks’ experiences in their sectors and with their business models. Comfort should extend in both directions.
Various types of bank debt for firms at different stages. Within the bank debt market, lenders should match solutions with borrowers’ stages and cash flow burn/generation profile (again, within their regulatory and internal frameworks). Potential solutions include:
- Venture debt. For early-stage firms, venture debt typically follows and extends the lives of equity rounds by adding debt equal to 25-50% of the raise. Warrants come and go in this segment but the debt typically includes a 12-24 month interestonly period that allows firms to continue investing by deferring principal amortization.
- Asset-based lending. Mid-stage firms with service-intensive models may explore asset-based financing to support working capital requirements. With advance rates typically up to 90% of eligible A/R and 50% of eligible inventory, firms can leverage the existing asset base to provide required working capital.
- Recurring revenue-based solutions. For mid-stage technology firms with subscription or highly-repeatable revenue, recurring revenue-based revolvers, based on multiples of monthly recurring revenue ranging from three to twenty-four times, depending on the firm’s size, provide growth working capital to support investment in the business. As growth continues, the structure yields additional availability based on higher levels of recurring revenue.
- Traditional leveraged lending. Finally, late-stage firms with positive EBITDA may explore traditional leveraged solutions for organic investment, acquisitions and management or leveraged buyouts.
Importantly, there are rarely ‘one size fits all’ solutions. Firms should look for banking partners offering credit solutions across businesses’ stages of development, who can grow with the company. Bank debt typically includes financial and other covenants; while commonly set with reasonable cushions to forecasted performance, firms must be comfortable with the constraints covenants impose.
Timing considerations. The timing of bank debt availability is often misunderstood. Founders often assume bank debt is not available to firms burning cash, or absent significant asset bases or investor support. However, by understanding the firm’s business model – and that growth investments often consume excess cash but drive enterprise value – experienced specialty lenders may underwrite to firms with cash burn profiles.
Whether firms have historically borrowed, management must be comfortable the business can support proposed debt – so the business continues to drive the balance sheet, not the other way around.
Debt often can be a non-dilutive, low-cost way to drive additional growth but it can negatively impact operating flexibility if there are covenant compliance issues. As a result, having a banker that truly understands the business, with a history of working with founders and investors to devise solutions that work for all parties, is critically important.
John Hoesley (312.909.7904; firstname.lastname@example.org) and Josh Roberts (630.777.5777; email@example.com) co-founded the Innovation Banking Group for Sterling National Bank, where they provide senior debt and banking solutions to founder-owned and investor-backed mid-market technology firms across the U.S. Previously, they co-founded the U.S. Innovation Banking group for CIBC Bank USA after prior positions in corporate finance, corporate and investment banking, venture capital and mezzanine debt focused on the technology, media and telecom and life sciences sectors.