Debt in a downturn: How to use non-dilutive funding to buy time and hit milestones

By Steve Lowry, vice president of technology banking at SVB.

With economic uncertainty at its highest levels in more than a decade, tech and life science startups need to prepare now to have enough liquidity to survive the slowdown. Equity markets have pulled back and young companies are wondering what to expect when they go out for capital this year.

The good news is that, when you compare today’s innovation economy to where it was at the onset of the 2000 dotcom bust or global financial crisis of 2007-2009, many sectors, companies and investors now are in a stronger position to face these headwinds. Companies and their investors are generally better capitalized, have proven business models and bigger markets to target, and many provide products and services the world desperately needs – from climate tech to life-saving vaccines. There are a number of steps business builders can take to prepare for longer equity funding cycles, including leveraging non-dilutive and venture debt funding. I’ll share the specific tactics, but first, let’s look at what’s happening in the market.

Assess the Future 

Right now, central banks are intent on taming inflation. Meanwhile, many who haven’t experienced fast-accelerating inflation are wondering what steps to take.

More than just having a booking fee added when buying movie tickets, experience has shown that inflation can cause far-reaching economic pain. A large concern of many companies is that central banks think inflation needs proactive management right now. “Inflation remains elevated,” the Federal Open Market Committee (FOMC) noted in raising the Fed rate a full 75 basis points on July 27, “[and the] Committee is strongly committed to returning inflation to its two percent objective.“ Financial market analysts believe central banks will continue raising interest rates and reducing the money supply.

These expectations about future rate increases have caused the major sell-off in stocks. Growth stocks, in particular, have been hammered because so much of their expected shareholder returns are in the future.

When public market prices drop, VCs, in turn, value private companies lower to try and ensure the businesses achieve a meaningful increase in value when they ultimately go public. The inflation worries are being fueled and compounded by the effects of ongoing war, supply-chain issues, and lingering COVID infections – the ends of which are hard to predict. The bottom line is that most investors are taking a wait-and-see approach before making new fund commitments until there’s a consensus the correction has passed. They are also reserving funds for bridge rounds to help see their existing portfolio companies through a continued downturn.

Given all of this, what can entrepreneurs do to operate during uncertainty and come out even stronger?

Step one: improve operational efficiency 

The most important step is to make a plan to shore up liquidity, which usually involves reducing costs to extend a company’s cash position. David Sacks, a well-known VC with Craft Ventures*, is advising SaaS companies to keep their burn multiple under two – meaning the cash burned in a given period should not be more than double the net new recurring revenue added in that period (burn multiple = net burn / net new ARR). This can be accomplished by common-sense solutions like putting a hold on hiring, postponing large expenditures, preparing multiple plans with different contingencies, and focusing on tactics with a proven high ROI.

Craft’s view, and that of many others, is that extending runway now trumps growth rate. And, somewhat paradoxically, having cash in the bank is key for raising capital because investors are focusing heavily on the length of the company’s existing runway. Therefore, startups that don’t “need the cash” are in a better position to negotiate their next rounds.

Step two: improve capital efficiency 

With equity costing more, companies typically want to avoid increased dilution. However, given economic uncertainties, many investors are advising their portfolio companies to shore up their balance sheets with new funds.

Debt can be a good complement to equity funding because it provides more predictable access to working capital and can extend the cash runway with minimal dilution. One initial step in exploring debt is to figure out how to make the assets on the balance sheet more financially productive. Look at financing receivables (including the Scientific Research & Experimental Development (SR&ED) tax credit) and inventory with lines of credit. Note however, that a line of credit is not intended to extend runway and will often include provisions that preclude it being used that way.

This makes venture debt, in contrast, a more useful tool in some circumstances where the company already has venture-backed financing. A venture-debt term loan is designed to extend runway and give the borrower a buffer for contingencies in a choppy economy.

Venture debt can enable flexibility; it is committed upfront with a gradual payback through the term and often includes the option to draw on the loan or leave it untouched for a number of months. It can be used for acquisitions, extending a company’s runway to its next financing, or as a support mechanism for temporary revenue shortfalls. Note that venture debt is best considered before a venture-backed startup is faced with a cash crunch. Companies that have decent runway, and are considering a future fundraise, may want to explore debt to ensure there is a cushion in case it is needed down the road.

In doing research on lenders, consult advisors and peers about their reputation and work with those who have a track record with similar companies. In particular, patient and supportive lenders who understand tech cycles, and have proven experience in the startup ecosystem, can be helpful partners.

Step three: secure grants efficiently 

Grants are a highly appealing form of non-dilutive capital because often there is little requirement of a return or even payback.

Government budgets for economic development are often targeted at the topical issues of the day, so getting a grant may require being at the right place at the right time. However, there are thousands of perennial programs in Canada with a wider scope of eligibility. There are now many consultants and some new grant sourcing platforms that can help identify relevant opportunities.

Some grants require lengthy submissions, but professional grant writers can take the extra work off a company’s plate. Many smaller grants can be applied for relatively quickly, with no external submission support.

Grants are helpful for enabling companies to build new products or features internally because most are oriented around talent development, including hiring or training existing employees. With things moving slower in a downturn, companies may choose to sacrifice speed and develop capabilities in-house rather than paying an outside firm to deliver services to them.

Well-managed companies can and will persevere, so focus on being one 

In closing, optimism is key for building a great company, and top leadership teams aren’t going to dwell on gloomy headlines.

The reality is many VC firms raised very large funds prior to the market deceleration and will need to deploy them once things shake out. The strongest of companies are still seeing competition for their rounds today.

If startups focus on their strengths and double down on proven strategies, they will attract top talent from larger companies that are shedding roles. And if a company’s capital need isn’t urgent right now, they should consider it a gift of time – to think, optimize, and build a great business. After all, numerous well-known companies like PayPal and Salesforce have been born out of downturns. Experience shows us that often the strongest relationships are built in the toughest times and smart planning provides the launchpad for future growth when the economy improves.

About Silicon Valley Bank

Silicon Valley Bank — the bank of the world’s most innovative companies and investors — provides commercial banking services, expertise, and insights to the technology, life science and healthcare, private equity, venture capital, and premium wine industries. Silicon Valley Bank operates in centers of innovation around the world and is one of SVB’s core businesses with SVB Capital, SVB Private, and SVB Securities. With global commercial banking services, Silicon Valley Bank helps address the unique needs of its dynamic, fast-growing, innovative clients. Learn more »

*Included with permission from Craft Ventures, an SVB client.