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When Should Startups Use Debt?

March 23, 2017, 3:14 PM UTC
Boom With A View by Erin Griffith: Startups and Venture Capital
Illustration by Aleksandar Savic

This article first appeared in Term Sheet, Fortune’s newsletter about deals and deal-makers. Sign up here.

The fall of Visible Measures, an ad-tech startup, is as much a cautionary tale about the advertising technology market as it is about the danger of startups using debt. Considering recent commentary from venture investor Fred Wilson and writer Dan Primack about the same issue with ModCloth, it might seem like startup debt is a dangerous, risky drug to be avoided at all costs. In conversations, several debt-providing readers predicted more debt-related collapses – there are “ticking time bombs” out there. But they’re worried that startups will get the wrong impression about their product. (They’re not drug dealers!) The gist:

The best time for startups to raise debt are: (1) when the company is growing, but not fast enough to get a bunch of new equity investors interested, (2) when unit economics actually work but there is a valuation gap or management does not want to be diluted further, (3) when the company is close to profitable and equity is too expensive or will take too long to raise, (4) the company is more than ten years old and equity investors are tapped out in their older funds.

The exact wrong time to raise debt is when you’re in a situation like Visible Measures or ModCloth — revenue is stalled or declining and you’re in the middle of a business model shift or pivot. “In that case, a lot of the lenders are saying, ‘I’m relying on the equity to come in to save my butt here,'” one debt provider said. Often debt providers only make the loan on faith that the startup’s well-connected venture investor will pull strings to get the next round done.

In his blog post, Wilson named Foursquare as an example of a startup that had success using debt. (It raised $41 million from buyout firm Silver Lake in 2013.) He’s right, but it’s worth noting that Foursquare raised debt at the riskiest possible time: It had little to no revenue, and it was embarking on a big pivot. Again, it worked out well for the company, but as one debt provider cautioned, “it easily could have gone the other way.”