Late-stage mega-debt is just the latest way of putting off the IPO boogieman

By Michael Carney , written on April 8, 2014

From The News Desk

With successful startups waiting longer than ever to go public, the way these companies fund their late stage growth has changed in recent years. Or at least it seems that way from the outside.

Seemingly every month some company on the IPO watchlist announces a mega-round of funding from traditional public markets investors like hedge funds or investment banks. By the same token, it’s becoming common to see mega-debt rounds announced, including most recently those by Square and Dropbox.

But what gives? That’s the question asked by Re/Code yesterday in its blog post, “So what’s up with debt financing?” – the suggestion being that these companies have somehow lost their appetite for venture capital or equity cash all together.

Of course not. What’s really happening is that traditional downstream funding strategies are making their way into the startup ecosystem. Raising debt is much cheaper than raising equity from a dilution standpoint, making it a favorable avenue for late stage management teams – assuming they’re confident they can pay it back.

These aren’t the convertible notes that accelerator grads have come to know. These multi-hundred million dollar credit facilities are like giant credit cards, with clearly defined interest rates and maturity dates. Often, companies view these as rainy day funds, and don’t even deploy them. (In most cases, they only pay interest on the capital they use, although some may encounter origination fees.)

One reason companies used to go public earlier was to access the sort of high-risk debt that high-growth, but unprofitable private companies are now securing. Amazon, for example, financed years of growth with junk bonds once in the public markets. The difference today is that it’s becoming more mainstream and it’s happening before, not after a liquidity event.

This isn’t a strategy that every company should adopt. For a hot but risky pre-revenue company, equity funding at a nosebleed price is still a better option than a debt payment they aren’t sure they can make. The only time that a company can (or should) raise and subsequently deploy debt is when its current cashflow dictates that it can make its payments or when – more riskily – the company believes that future profit growth or equity financing will allow such payback (see Tesla).

And this is precisely why we’re seeing late stage startups take on debt. Five or ten years ago, these companies would have been public or acquired long before achieving nine-figure revenues and ten-figure valuations. In many ways, these mature technology companies are more akin to the public companies of a decade ago, and their financing strategies indicate as much.

The more interesting question to ask isn’t why companies are raising debt versus equity, but rather how they plan to use the debt once they’ve raised it. For example, you typically don't pay salaries with debt. That’s like a consumer putting everyday essentials like groceries on their credit card and not paying it off at the end of the month. It’s a good way to make affordable items like that $5 jug of milk cost $15 before all is said and done.

Corporations more often use debt to factor receivables (cover delays in receiving payment), to pay for infrastructure buildout (like data centers), or to finance inventory.

In the case of Dropbox, it’s unclear whether the company has plans to build out its own data centers and shift away from its reliance on Amazon’s S3 storage infrastructure or if it has another use in mind. Square, for that matter, may plan to use its new credit line as part of a lease or financing program for its merchant iPad register program. But these are just speculation.

At the end of the day, companies raise debt because they can. Those who do get access to large credit lines should be viewed simply as mature companies that convinced one or more lenders that their risk profile is worthy of debt level returns, which are decidedly less than the upside for equity investors.

Private market mega-debt isn’t being raised “instead of venture capital.” Really, it’s being used as another tool to put off a dreaded IPO.

[Illustration by Brad Jonas for Pando]