Venture debt has become an increasingly popular way to finance SaaS businesses. Venture debt lenders typically lend more than a traditional bank loan or line, but they require a higher interest rate (and often warrants to buy stock in your company) in exchange for the higher risk.
There is a time and place for debt financing.
Debt financing… and especially venture debt financing… is an accelerator.
If things are going well and you’re flying high, debt will accelerate your upside.
If things are going poorly and you’re headed toward a crash, debt will accelerate your downside too.
So, when do you use debt, and when do you not?
Let me answer this question, starting with when not to use debt.
Don’t use debt when things aren’t going well. Debt has a tail. It has a debt service.
Everyone pays attention to the receipt of funds. Comparatively, fewer really think through the debt service.
If there’s a major drop in market demand, don’t use debt. You have a market-demand problem. Not a debt problem.
When you acquire debt in the face of a drop in the market demand, you now have two problems: a market-demand problem and a debt-service problem.
If you had a good product-market fit, but the market shifted, and you no longer have that fit, don’t use debt. Product-market-fit problems are product-market-fit problems. They are not financing problems.
If your go-to-market approach (a.k.a. your combined sales and marketing efforts) isn’t working, don’t use debt. You don’t have a financing problem. You have a go-to-market problem. Go fix the problem by figuring out what go-to-market approach will work. You want to iterate and experiment until you find a good message-to-market match.
So in these instances, what should you do instead?
If you’re an established business, you want to cut expenses and get to cash flow positive… or you raise equity on terrible terms. I prefer the former.
So, when should you use debt?
Debt is a financing tool to solve a financing problem.
A classic financing problem is when you have a good business with a cash-flow timing issue.
The classic example in the non-SaaS world would be a seasonal business. A farmer needs cash to buy seed, but they have the cash for it six months later, during the harvest. If the cost of seed and labor is low and the price of produce is high, then this is fundamentally a profitable business with a seasonal cash-flow problem.
This is a financing problem.
Here’s the analogous situation in SaaS. You have product-market fit, you have sales, you have a replicable sales model, you have a scalable sales model, you have good retention, you have a customer lifetime value (LTV) many times your customer acquisition cost (CAC)… but it takes a while for a new customer’s lifetime worth of payments to be received.
For example, let’s say it costs you $1 to acquire a customer who produces $10 in LTV. But, it takes five years to collect the $10.
If you look at this from a return-on-investment standpoint (and you should), that’s a ten-to-one return. If your system for customer acquisition and retention were a savings account, it would be the equivalent of a savings account that pays 1,000% simple interest over five years. You put $1 into the account and out comes $10 five years later.
There aren’t very many opportunities out there that offer a 1,000% return on investment.
Question: How much money should you invest in your go-to-market efforts that produce a 1,000% return?
Answer: As much as you possibly can.
But, what happens if you have no extra cash available?
You’ve already put every spare dollar into this 10:1 opportunity.
You can certainly wait until all the customer payments come in over the next five years.
You have a business with incredibly profitable unit economics… with a cash-flow timing problem.
Now, you have a financing problem.
I’m a firm believer in using debt financing to solve true financing problems.
I think it’s a terrible idea (but also terribly tempting) to use debt financing to “solve” (a.k.a. obscure) problems with product-market fit, message-to-market match, or minimum viable scalability.
There’s a right tool to solve every problem. The key is to not confuse them.
You don’t use a saw to hammer a nail into a piece of wood. You don’t use a scalpel to see if a bone is broken in two. You don’t use debt to solve problems with business models, go-to-market strategies, or scalability.
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