Why are so many start-ups piling on debt?
(This post originally appeared on The Washington Post)
More and more U.S. start-ups are taking loans to finance their businesses. Why?
According to Lizette Chapman at Bloomberg venture capitalists invested more than $79 billion in start-ups at “often unsustainable valuations” in 2015. VC’s, recognizing the problem, have become more conservative this year. As a result, the market for equity investments has dropped 10 percent from its high point in 2015. With cash becoming harder to find, many start-ups have responded by turning away from equity deals – where a piece of the company is yielded – to chasing debt instead.
Which is why debt activity spiked this past year, with many lenders reporting loan volumes increasing by anywhere from 16 to 25 percent. Haim Zaltzman, a partner at law firm Latham & Watkins says this year’s activity compares to 2008’s debt boom. His clients are choosing to borrow instead of undergoing round after round of de-valuation that’s common each time new equity is raised. “You don’t have to grow 20 percent or 30 percent every year to be a good candidate for debt credit,” he told Bloomberg.
But there are risks to debt financing. Interest rates can range as much as 9 to 15 percent. The terms usually weigh heavily towards the lenders. Financial covenants are often stringent–Bloomberg said one lender even required a company to pay back its loan if it failed to hit 80 percent of its revenue projections.
Also, if things go wrong the consequences can be significant. That’s because most lenders are in the business of getting their loans paid back and enjoy no great benefits even if a company’s valuation goes up. That model makes them quite merciless when a company runs into cash flow challenges.
Regardless, the trend towards getting debt financing over equity is expected to continue for the next year. Zaltzman told Bloomberg, adding that even “some start-ups valued at north of $1 billion will fall into that category.”