Unlike equity investments, debt has to be repaid on a fixed schedule

For startup founders, the offer is tempting for — take a $1M loan now to get over the hump. Once sales ramp up, it’ll be easy to find venture investors.

Or a startup is in a cash crunch. The founders agree to put in extra $100K to make payroll and pay the rent. They structure it as a loan so that they can get paid back as soon as they complete their funding round. Or so they think.

Unfortunately, for early-stage startups, once you have a loan on the books, you’ve locked yourself out of venture investment. So make sure you understand the implications before you take the cash.

For loans from founders or friends and family, investors will require you to convert the debt into an equity investment before they’ll agree to invest.

The Sword of Damocles Hanging Over Your Head

When you sign a loan, you’re agreeing to a fixed repayment schedule. That’s fine for later stage startups that have the cash flow to support repayment.

But early-stage startups? You’re going to be losing money for years. There’s a high probability you won’t have the cash flow to pay back the loan no matter what your financial models say.

And even if the company does have revenues, venture investors who are funding the enterprise are loath to put in money if they know a significant fraction of it has to go right back out to pay off debt holders instead of driving growth and expansion.

The Debt Pinch

Imagine you have a $2M interest-only loan at 12% that matures in 2 years. Every month, you need to pay $20K. Lose your biggest customer? Too bad — you still have to pay $20K. Have a big order where the customer won’t pay for 90 days? Too bad — you still have to pay $60K in interest. Fail to pay and you’re in default. There no flexibility.

Then in 2 years, that loan matures. You have to pay back the $2M. Will the lender roll it over to a new loan? Well, that depends. If you’re doing great and have $2M sitting in the bank, they’ll probably be happy to extend the loan term. But if you’re struggling, if you actually need the money, sorry, they’ll say, pay up now. And with that, you’re dead.

Even worse for investors, if the company goes belly up, the debt holders get paid first. For a startup, that never leaves anything for the equity holders. Anything of value, from the cash in the bank, to the office furniture, to the patents and intellectual property get turned over to the debt holders.

It doesn’t matter if you have $10M in venture investment with 1x or 2x or 10x liquidation preferences and only $100K in debt, until you pay off that $100K (plus salaries owed, taxes, accounts payable, credit cards, and everything else you contractually owe), equity holders get zip.

The Advantage of Equity Investment

There’s a lot of downsides to equity investment, but there’s one big upside that trumps everything — there’s no repayment. If the company pays dividends (typical for traditional businesses, unheard of for startups), equity investors get their share.

For startups, equity investors expect no repayment of their investment, no interest, no dividends, no anything except quarterly status updates until you sell the business in an acquisition or IPO. If you never get to an exit, well…they won’t be happy but that’s the risk they take.

If it takes you longer to get to that exit than you planned (it always does), that doesn’t change anything. If you need more capital than you expected (startups always do), then you raise more and everyone gets diluted. So long as there aren’t any debt holders demanding to be paid back now.

In other words, equity investors aren’t loaning you money that they expect you to repay with interest. They’re buying a fractional share of your business and betting on your success.

How About Venture Debt?

There’s been a lot of talk in recent years about venture debt as an alternative to venture capital. It isn’t. At least not for early-stage startups.

If you look into the details, you’ll find everyone offering venture debt is only offering it to startups that already have the cash flow to support repayment. In other words, later-stage startups. Not you guys.

The one exception was Silicon Valley Bank. And look where it got them. (It’s always ironic when a bank goes bankrupt for making bad investments.) The headline story was how their pile of long-dated treasury bills had lost value when interest rates rose. The real story, and the reason no other bank wanted to acquire SVB was their piles and piles of venture debt made to early-stage startups that couldn’t repay them. Nobody is going to make that mistake again.

But What About Convertible Notes???

Yeah. This is weird. Convertible notes, the traditional way of funding early-stage startups (and still preferred by many angel investors) is technically a loan.

If you read the convertible note document, it has a loan amount, a maturity date, and an interest rate. Yup, that’s a loan. Even the word, “note”, means loan. (And don’t ever make the mistake of calling a SAFE a “SAFE Note” or you’ll incur the wrath of the lawyer and accountants.)

But…the point of a convertible note is not to earn interest. It’s to purchase equity when preferred stock is issued in the big next round. But we’re giving you the cash now and calling it a loan. What looks like interest is just additional equity we earn for getting in early and waiting.

But…but…but…if you don’t raise that big next round before the maturity date, you could be in trouble. Here’s where the fine print matters.

Founder-friendly convertible notes automatically convert at maturity at the valuation cap, or at some discount to the valuation cap, so it’s clear the principal and “interest” never have to be repaid. Investor-friendly convertible notes require repayment of the loan at maturity if not converted to equity before then.

In that case, you owe the full principal plus interest. In cash. At least technically. But nobody ever has the cash to pay back a convertible note. And if you did have the cash to pay back the note, investors would rather the note convert to equity.

In every case I’ve ever seen (and I’ve seen a lot of cases), the investors agree to an extension. Sometimes we might demand warrants or some other concession as an incentive to agree to the extension. Usually, we just want to hear that the company is nearing funding and needs a little extra time to get there.

Legally, we could demand the company pay us back. But if we do, we know we’ll get nothing except the office furniture and a thumb drive with the source code. So we grumble and agree to an extension because there’s nothing else we can do.

So yes, the convertible note is a legally loan, but it really isn’t. Still, it’s another reason for both founders and investors to prefer the SAFE over the convertible note.

Debt is useful for traditional businesses with somewhat predictable cash flows. Even later stage startups are usually leveraged with debt to manage working capital and capital expenses.

But for early-stage startups, no matter how detailed your financial models, growth always takes at least twice as long as expected and costs at least twice as much. Loans provide no flexibility if the business isn’t growing according to plan (it never is.)

So if you plan to raise equity investment — venture capital and angels — avoid taking any debt now. If you need to tide the business over with a quick cash infusion to pay the bills in an emergency, get that loan off the books as soon as you can, before venture investors start looking over the books.