Why Debt Is Now A Great Option For Tech Companies Looking To Grow

November 24, 2020
Reece Tomlinson

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 utilize 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.

Equity financing works very well when interest rates are higher, thereby lowering the cost differential between the cost of debt and the cost of equity (re: the cost of capital).  As I write this, the Bank of Canada’s Overnight rate is at .21%, which means debt financing in Canada has never been cheaper. This low interest rate environment has a wide number of implications, the majority of which I will not get into, however it does indicate that the cost of capital for debt financing is now significantly less expensive then the cost of capital for equity financing. This presents a large opportunity for growing businesses, including tech businesses.

Thanks to COVID-19 and its economic impacts on Canada and the global economy, we will see a very low interest rate environment (sub 1%) for the next three years at a minimum (some economists are even suggesting 7 to 10 years).  As a result, companies looking to access capital need to rethink their capital strategies as debt financing is now a very attractive option and the debt markets are now, more than ever, open to tech businesses.

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 then ever, we are seeing tech businesses get lending deals across the finish line. Here are five big reasons why:

  1. The economy has fundamentally changed the way people are consuming products and how businesses function. Tech enabled businesses with strong margins, recurring revenues and easily scalable operations are generally not bound by geographic footprints and can grow exponentially with a lower marginal cost.
  2. It is important to note that lenders are not motivated to take risk. Their mandate is to make the highest possible return on the lowest possible risk. Historically, tech businesses were perceived as more risky than traditional businesses and were shied away from, however thanks to COVID-19, tech enabled businesses now represent far less risk to lenders then those that do not.
  3. As a whole, tech businesses generally have a lower amount of debt on the balance sheet then traditional businesses. This makes them more agile in an unpredictable economic environment.
  4. Private lending is a booming asset class, which has seen a massive influx of capital since the onset of COVID-19 by family offices, funds and private investors[1] alike who are now eager to find deals and are, in some ways, directly competing with chartered lenders[2] for mezzanine and subordinated debt.
  5. Lenders have finally begun to understand how tech business models work and many now have lending programs specifically designed for companies to leverage ARR and even users.

All of the above does not mean lenders are simply just giving money out. 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.

[1] As per the data firm Preqin, private lending is at an all-time high due the holding position currently being adhered to by private equity, which has completed 33% less global transactions between April and June 2020 than normal for the same period. Private lending is often used as a hedge for Private Equity and with an increased migration to Private Lending has come increased competition thereby causing the Private Lending market to be historically accessible and inexpensive.

[2] Chartered Lenders generally consist of banks, credit unions and other organizations who have a sole purpose of lending money for personal, commercial and other purposes.

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