Why growth-stage tech companies are choosing debt over equity when raising capital

Reading the press releases of any AIM or Top 100 stock index, you’ll undoubtedly come across the words ‘leveraged’, ‘gearing’, ‘expansion’ and ‘acquisition’ in some variation. These words put together are just another way of saying a company has indebted itself in order to raise the capital necessary to buy an asset or grow its business – much like taking out a mortgage to buy a property. So, why are growing tech companies increasingly opting for this approach over handing out equity at an early stage?

Speaking on the subject, RWT Growth Founder, Reece Tomlinson, said: “For growth stage companies, particularly tech companies, the known path to accessing capital is this; go out and raise money by giving shares away in the process. It’s a simple premise and it works. The majority of tech companies will utilise some form of seed, angel and venture funding in their lifetime. These capital sources serve a purpose and the ability for tech entrepreneurs to access the capital they need via equity financing worked well.”

“The majority of business owners we speak to are under the opinion that debt financing is all but shut down in today’s economy. Whilst the landscape may be more challenging than ever, we are seeing tech businesses get lending deals across the finish line.”

And, according to the investment banking advisory firm, there are five reasons why the risk profile has flipped from tech firms to lenders. First, Tomlinson notes that the nature of the economy has fundamentally changed the way people are consuming goods and in turn, how businesses function. Tech enabled businesses with strong margins, recurring revenues and easily scalable operations continue to grow, with the benefit that they are not quite as bound by geographic limitations and can grow exponentially at a lower marginal cost.

Second, he notes that lenders are motivated by maximising returns while minimising risk. While big tech firms have typically been seen as the riskier option versus traditional businesses, COVID has meant that tech-enabled businesses represent far less risk to lenders than those who aren’t.

Third, and as has been seen during the pandemic, the more sophisticated financial and less real estate intensive nature of tech businesses mean that they tend to operate with a lower amount of debt on their balance sheet versus their physical store counterparts. In unpredictable economic environments – for instance, during an outgoing presidency, Brexit and a pandemic – this puts them in the ideal position of being more agile, and able to make snap adjustments because of their free capital.

Fourth, as seen with the rise of loan-specific investment platforms such as Mintos, private lending is a rising asset class. Since the onset of COVID, there has been a ‘massive’ influx of capital by family offices, funds and private investors, all of whom are now looking for deals and even “directly competing with chartered lenders for mezzanine and subordinated debt”.

Fifth, and finally, lenders have ‘finally’ begun understanding how tech business models work. With this in mind, many have now adapted to offer bespoke lending programmes designed specifically for ambitious tech companies to leverage ARR and even users.

Mr Tomlinson was keen to note that these trends, though significant, do not mean that money is simply being handed out. Concluding, and speaking on risk evaluation when lending to a tech company, he says:

“Lenders have more reason to be weary today then anytime in the past 90 years. Therefore, in order to have the highest chance of success acquiring capital from a lender, businesses need to; provide finely tuned lending packages that meet the criteria of lenders, demonstrate how the company will manage risk in this COVID-19 environment and indicate how the company will remain a going concern in both the short and long-term.”