For this post, we want to thank Layer 7 Capital founder & MD Steve K. Lee. Steve is an investment banker specializing in the cloud space. Steve graciously shared his knowledge from brokering multiple M&A and investment deals in tech services companies to provide us with several of the key benchmarks used in this post.
Picture this: you’ve just launched a neat little tech services company, your very first. Things are going great! You’re starting to get clients, projects are rolling in, and so is the revenue. Sure, you may not have broken the $5 million threshold yet but you’re not doing bad for a company as young as yours. Not bad at all. But growth is expensive and you know if you want to hit the 5+ million threshold, you’re going to need to raise debt. Not a whole lot - maybe even 25% of your revenue. That sounds doable, right?
Here’s where the bubble bursts: raising debt at that level is very, very hard. We already know traditional VCs have no love for tech services companies, but as it turns out, even those entities that do invest in tech services companies tend to stay away from tech services companies making less than $5 million in revenue. The market need for this is wide open because, frankly, very few institutional lenders are in that space.
So what options do you have? Let’s take a look.
Commercial Loans
While your local bank may not give you much, it will give you something. Don’t hold your breath, because commercial loans for companies of this size are usually capped at small amounts. If you’re very lucky (or the lending bank is very generous) you may get a loan of up to $500,000. A more typical amount is in the $100,000-300,000 range. Expect it to cost you somewhere around the high single digits or up to 10% in interest rates. One of our portfolio companies secured a commercial loan of $150,000 - against $5 Million in annual revenue.
But if you can’t secure a commercial bank line of credit, you may be looking at 10-15% interest (some of which you may be paid in kind) with anywhere from 2% to 15% warrants. At this point, your search would shift away from institutional lenders and towards the most illiquid end of the market: private lenders and alternative financing.
Private Lenders & Angel Investors
You may be able to raise debt through private lenders and angel investors more successfully. These lenders are not institutional and may charge the higher end of interest rates (typically 10%) given the risk they take on, but they may also be willing to lend you bigger amounts. An added benefit is that angel investors willing to lend to small tech services companies tend to be former founders of successful tech services companies themselves. This means you can leverage their mentorship to guide your growth. They can also introduce you to their own networks, rapidly expanding your own.
Asset-based Lending
In the absence of other lending sources, you can explore alternative financing options as well. Asset-based loans are a great - cheaper - option among these. This is easier for tech service companies with recurring revenue services than project-based services. If your contracts are typically 12 months or longer, you can get up to a year’s worth of ARR. If you have S&P 500 and above customers, you apply for Accounts Receivables-based loans amounting to up to 70% of your A/R. Your A/R line of credit is considered asset-based. If you can’t leverage your A/R, you can also opt for cashflow-based loans - but keep in mind those will be more expensive.
Royalty Funding
This particular flavor of debt is a popular one with software companies. You can apply for a royalty line of credit, which means you’ll pay a percentage of your monthly revenue. This is typically something along the lines of 2% of your revenue every month. The principal amount increases dramatically, typically 0.25x of the original every quarter. Accrual usually stops once you reach 2.5-3x of your original principal amount. After that, you keep paying the royalty until your payments equal whatever your new principal amount is unless you paid them back early.
Most royalty funding has a relatively long maturity date. In practice that means it’s like a downside-protected equity investment. But as with commercial loans, the total loan amount tends to be on the lower side - think, maybe 25% of your ARR. But if 25% is your debt target, like in our scenario right at the beginning of this article, then congratulations! You’ve raised the debt you needed!
Venture Debt
Venture Debt is debt where the expectation is to repay the debt from fundraising rather than from the cashflows of the business. It usually requires a VC sponsor committing to future raises and warrants. Venture debt is extremely common in the product world but very rare in the services world. We’ve seen venture debt used to fix deal timing issues, for example where it will take additional time to close the deal but an initial tranche is needed.
Wrapping Up
It’s isn’t easy being small & green. It’s especially difficult if you’re trying to raise debt to cover the growth you actually need to not be quite so small. It can also be more than a little frustrating. Debt is a very different experience from venture funding for different business goals. As a business leader, you need to understand both to deploy them appropriately. As you’re going through the intricacies of raising money, it’s good to have a seasoned hand by your side. Steve Lee guided us in our journey at Flux7 and we highly recommend reaching out to him as you’re going through this journey