On Friday, The Information reported that productivity app Notion was closing $10 million in angel funding and was seeking a valuation at $800 million. This is the three-year-old company's second round of outside financing.
As early rounds like Notion's have ballooned in size, other startups hoping to crack into the tech industry have turned to easier, but inherently more risky, forms of financing.
A recent study released July 8 from Fenwick & West, a prominent law firm that represents startups, found that more startups in various growth stages are utilizing debt financing. Debt financing can take many forms, but at its core acts similarly to a loan that the founder must repay with interest at an agreed upon date.
According to Fenwick & West Corporate Partner and study author Evan Bienstock, debt financing used to be common for later stage companies looking to get quick access to funds from existing investors between larger venture funded rounds. Over the last ten years, Bienstock said debt financing has been moving to earlier and earlier stage companies, often provided by a wealthy friend or family member instead of an institutional investor.
"It is an efficient way of funding a company without necessarily placing a valuation on it," Bienstock said. "You can raise $1 million in convertible notes, and because you are not selling equity at a price, you don't place a firm valuation in it. It's still what we call a bridge, but now it's a bridge from the start."
Bienstock explained that debt financing is attractive to early stage founders now more than ever because it is a quick and "relatively efficient" way to raise funds.
"Those are magic words for founders running young companies," Bienstock said.
According to the study, median debt financing deals in 2018 rose to $1.6 million from $1.4 million in 2017. But Bienstock said he regularly cautions founders against having too much more debt on their balance sheets, especially in the early days, because he thinks that makes the company less attractive to future venture investors.
"I don't like to see companies with more than $2 million in convertible debt," Bienstock said.
According to Bienstock, companies that rack up too much debt are signalling that they are in deep financial trouble. While this is troubling, he explained that debt backers aren't always concerned with that scenario because they are the first to be made whole if the company goes bankrupt.
"Investors will sometimes say, 'Okay, you are on your last breath so I can't give [funding] to you in equity but I will give it in debt so if you go belly up I'm the first out," Bienstock said. "It's a life extension, if you will."
As earlier rounds grow to eye-popping amounts and valuations regularly surpass the $1 billion mark earlier in a company's lifecycle, founders are under immense pressure to provide early investors with massive returns to justify their valuation. In fact, Bienstock said that debt financing makes the most sense when a company's valuation is on the upswing. That way, he said, founders don't have to risk diluting their own stake in the company and buy themselves time to increase valuation ahead of the next venture round.
"There certainly are some frothy valuations in certain sectors," Bienstock said. "That said, I don't know that debt is necessarily used as a device to avoid a down round. If a down round is coming there are other problems with the business."
