Why (and how) to Raise Debt Financing for your Technology Company
Why you shouldn’t use your free cash flows for every thing
From my experience building a technology company (Jobsahead) in the early 2000s, and later investing in such companies (at Canaan Partners, and as a founding member of the Indian Angel Network), there are two primary areas where you need to invest capital - Growth initiatives for your business, and working capital.
Growth is a relatively high risk area. When you need to invest to develop a new product line, unlock new geographies or client segments, the stakes are high. You could double your revenue, or the investment may come to nothing. Such investments are best funded using equity capital or the company’s retained earnings.
However, companies need to invest in working capital as well. Your B2B clients often insist on a 30-60 day payment cycle, or more. But you need to pay salaries, over heads, etc. while waiting for these payments. Such working capital investments are lower risk-once you've provided a service, you know your client will pay, even if a few days late.
Funding this working capital using your company’s cash flows / retained earnings is problematic. For two reasons:
1. The amount of capital you have could constrain you. You may have to let a large project pass, because your finances don't allow you to deliver per the required SLAs.
2. Far more important is the opportunity cost of that capital. Using your cash flows for working capital prevents you from investing the same amount in growth. We all know staying at the cutting edge of technology takes effort and investment. You don’t want to delay that just because you have to manage this month’s expenses.
How to raise debt for working capital
Now, there are two challenges for tech companies (especially young ones) in raising debt from banks or NBFCs. The lack of an extended track record makes it hard to raise unsecured debt. Secured debt could be an option, but it’s difficult for asset light businesses (and most software companies are asset light!) to shore up the collateral for this.
Banks are usually more comfortable discounting letters of credit (or LCs) from your buyers, where the buyer deposits the invoice amount with a bank in advance
Thankfully, that’s changing now.
There is a way for asset light businesses to raise working capital debt, getting around the issues of low vintage and lack of collateral.
How? By taking financing against your receivables from corporate buyers.
Your own business may be deemed risky by lenders, but your buyers are often far more secure credits – larger, more stable businesses,with good credit ratings and payment histories.So,by financing your receivables, you’d in effect be taking credit against your buyers’ creditworthiness, and the strength of your relationships with them. So, not only would you now have easier access to credit, but the interest rate would also be lower to reflect the reduced risk of the transaction!
So, whether you’re a bootstrapped tech startup looking to grow steadily or a 50person software firm with no physical assets-if you have strong B2B customer relationships,you can now access debt financing against them.
We call this 'invoice discounting' in the lending space. When you invoice your customer, a lender would ‘discount’ this invoice-pay you 70-80 percent of the invoice value upfront. Then, when your customer pays, the lender would recover the money from that amount.
There are a few options available in the market for this. For starters, you can check with your bank. Banks are usually more comfortable discounting letters of credit (or LCs) from your buyers, where the buyer deposits the invoice amount with a bank in advance. This is harder to arrange. However, depending on the strength of your banking relationship, they may be able to discount your invoices without LCs.
Alternatively, you can go to specialist invoice discounting companies. For instance,Indifi(the small business lending platform I run),has launched a specific working capital program for startups through the invoice discounting route. This can be availed by software/tech companies as well,leveraging your client relationships to raise debt financing from lenders - we would be happy to discuss your requirements.
So use your cash flows for the right investments - to stay at the cutting edge. And use debt instead, for low risk areas like working capital.