To Debt or Not to Debt

Recently, Alex Danco wrote an excellent post about debt and startups. In his piece, he raises an interesting point:” Because equity is how we finance startups, therefore most startups fail”. This is a rare take, for many people would instinctively reject such a claim, one that runs counter to what many believe is the optimal financing instrument for investors to use and for founders to accept. Yet Alex argues that equity, in this context, is a compromising force, a force that compels its maturing recipients to function in ways that only elevate their risk profile — not lower it. Admittedly, this view is persuasive, and I and suspect that others might agree. Indeed, VCs have a singular objective: generate outsized returns. That is what their LPs pay them to do. For a VC, that usually means to ~4x their fund. Indeed, where there is a $50m fund, there is a VC trying to create ~$200m in exit value. Sounds hard, right? But just wait — there are other factors to be considered. Further, VCs must achieve this milestone without necessarily owning huge stakes in their portfolio companies. So assuming an investor owns roughly 10% of their portfolio, a $50m fund must create ~$2B in equity value. And given that only 30% of seed-plus startups exit via IPO or M&A, VCs face quite the task. As such, it is understandable why VCs push startups to grow at rapid rates. In Good to Great, however, Jim Collins identifies some of the factors that explain why certain firms are exceptional, while others are less so. Indeed, one of the factors identified is dubbed the “20 Mile March”, a concept that reflects a firm’s commitment to steady, reasonable performance goals that are not only attainable but also conducive to good business outcomes. The research suggests that firms prioritizing exponential-growth initiatives absent any credible form of constraint are more likely to find themselves vulnerable to and compromised in volatile environments than are their more conservative counterparts. Whether Alex is aware of this research is not relevant. Rather, it appears that his thesis reconciles with the findings that inform Good to Great. Yet while Alex is likely correct that ill-timed equity can elevate the riskiness of a firm in ways that appropriately-timed debt cannot, it is not clear that his calling for more debt will, in fact, produce better startup and VC outcomes. Yes, of course, it is possible that fewer startups would fail and or perform at suboptimal levels, for fewer startups would submit themselves to an all-out growth model that may very well spell their own demise. But it is also possible that given the allure and evasiveness of outsized returns and the speed at which VCs want to monetize their investments, the current blitzkrieg model to which startups subscribe serves as a necessary evil to not only generate the returns VCs seek but also to activate and sustain the capital on which the startup ecosystem depends. In other words: the infusion of debt financing into a startup, insofar that the economics of the former can reasonably support it, may lower a startup’s overall risk profile — but this may come at the expense of an acceptable return profile. Moreover, perhaps the use of debt instead of equity would suppress the urgency under which most startups operate, gifting incumbents additional time to neutralize their challengers, introduce new products, and adapt in useful ways. And should startups increasingly turn to debt rather than equity, it would be hard to imagine how those firms could claim a competitive advantage over their peers given that more and more of their counterparts are adopting similar playbooks. If the latter proves to be true, one might argue that the use of debt does not necessarily lower the risk that a startup carries, even if the use of debt encourages startups to adopt better business-building principles. Instead, it would seem more likely that such an approach would merely reflect an optical change, a substitution of one risk for another, a substitution of a sugary beverage for a sedentary lifestyle, for example. Should this prove to be the case, not only would startups face additional non-financial risks, but they may struggle to raise capital in the first place, as investors might rightfully question whether startups can generate the returns needed to make the economics of a fund work. This, in turn, may affect the capacity of firms to hire, develop, and retain the talent needed to achieve outsized outcomes, ushering in a new wave of concerns that replace the operational risks that were recently shed. Whether more startups should accept debt or not is debatable, for the question goes beyond whether their cash flows can accommodate the leverage. Indeed, the question is whether the introduction of more debt into the startup ecosystem improves startup outcomes, improves risk-adjusted returns, results in a net reduction in risk. As usual, these things will have to play out in practice — not in the abstract. As such, I look forward to what’s in store.