First debt facilities: An unsolved problem for climate finance startups

July 13, 2023
solar array

This month, we look at a problem that many climate founders face - and which we have faced with our own Ezra portfolio companies. It is also a problem we are actively trying to solve. We would love to talk to you if you have either experienced the challenges of raising a first debt facility, or have thought about how to solve it.

What is the role of debt in the climate transition?

Debt financing is a critical part of the climate transition. Many green technologies have high up-front costs for customers, even if they end up paying for themselves over time. Heat pumps, for example, cost up to $10,000 and can take an average of 12.5 years to generate power savings that offset their cost. Debt is a critical tool for green technologies with similar cost profiles, enabling customers to smooth outlays over time.

This is a significant component of the energy transition: ~80% of the emissions reductions required by 2030 come from technologies available today, many of which have a similar cost profile to heat pumps. This means that the speed at which debt financing can be deployed towards climate will be a critical driver of the global transition.

Why do climate companies need a debt facility to grow?

Companies that provide debt financing for green technologies will constantly have to raise debt capital, which is used to finance end-customer use of the relevant technologies. This is central to these companies’ ability to grow - a solar lender, for example, can only provide loans to new customers if it has enough debt capital to deploy in the first place.

In many cases, early-stage climate finance companies that are lending to customers either do not consider - or cannot raise - a first debt facility. This is the case even though a first asset-backed debt facility is generally preferable to other types of capital available. These are:

  • Equity - This is precious capital for all companies, but in particular early-stage companies that often measure their growth curve by runway. Using equity to finance assets is incredibly inefficient for multiple reasons; for one, it eats into capital that is otherwise usable to grow a company’s products and operations. However, it can be relatively accessible and can be an option when other forms of capital have not been secured.
  • Corporate debt (AKA venture debt) - This is debt lent to the company itself, which requires company cash and other corporate assets for repayment. Corporate debt is typically used to fund company growth and extend runway. It includes short-term loans and working capital lines of credit. However, early-stage companies ought to avoid this where possible, given that loan terms can be challenging and creditors often have claim over the assets of the company itself.  Also, this debt tends to be shorter in duration and higher in pricing than a true asset-backed facility.
  • Asset-backed debt - This is lent against the pool of assets (e.g., the set of loans that a solar lender has originated), and ideally is structured against contracted customer cash flows. It includes warehouses, forward flow agreements, traditional project finance, and it usually scales to securitization. This is the ideal form of capital for many young climate finance companies, because it is structured against customer assets and typically is sized and tenored to match those cash flows. In addition to being a more efficient way to structure asset financing, these facilities limit dilution (unlike equity) and protect company assets from being claimed by creditors (unlike corporate debt).

What difficulties do start-ups face today with raising asset-backed debt?

Despite the benefits of a first asset-backed debt facility for many climate finance companies, often they do not - or are unable to - raise one. There are a number of challenges that deter companies from building these sorts of facilities. These include the facts that asset-backed first debt facilities:

  • Are complicated and require deep technical expertise - For a team inexperienced in asset-backed lending, raising early-stage debt is complicated. These facilities have niche structures, financial models, terminology, and more, which takes time to learn. The decisions that companies make can have profound implications for how a company’s loan portfolio performs (e.g., covenants). Early-stage teams without deep capital markets expertise can struggle to navigate the terms on offer. Moreover, very often, the borrowers’ only options are specialty lenders that have rigid structures that aren’t generally designed for company growth. This inhibits a company’s ability to grow, and requires the ability to navigate a complicated lending landscape.
  • Offer unfavorable loan terms - Because early-stage climate finance companies have not yet proven their model at scale, lenders automatically assume a greater amount of risk. This translates into high interest rates and shorter loan durations, among other perceived lender protections. In the climate space, this can be a significant challenge for a climate finance company’s model. Consider solar loans: The price of these loans has a ceiling (since most customers would not pay more for solar than they already pay for electricity), and can take 10+ years to pay off.
  • Generate transaction costs - Even a small debt facility entails tens (or hundreds) of thousands of dollars in costs for start-ups and capital providers. This covers lawyers, independent engineers, and more. The cost can be the same for a $500K or a $5M facility. For start-ups who have to stitch together a first debt facility of a few million dollars from multiple six-figure checks, this can become prohibitively expensive.

How can climate finance companies overcome this problem?

The problem of raising a debt facility remains a major hurdle for climate finance companies. To solve this, some companies leverage the in-house knowledge of studios or other accelerator networks.For example, at Ezra we have a Capital Markets team who works with our companies to meet and reach agreements with capital providers. This enables our companies to navigate the complexities of raising a first debt facility without directly incurring all of the costs of hiring experts in capital markets. Not all studios or accelerators have experience with asset-backed debt, however, so companies need to ensure they partner with those that do.

FinTech solutions are beginning to emerging - however none of these quite meet the needs of climate finance companies. Companies such as Sivo, Percent, and Lendable have begun to deploy venture debt and warehouse facilities to start-ups.

However, none of these are quite tailored to the specific needs of climate finance companies - i.e., for long-duration asset lending. For example, Sivo typically only offers debt with a <12 month tenor, which is hard for companies lending against solar, EVs, and other climate technology with longer payback periods.

In lieu of more solutions, we are actively exploring ways to improve opportunities to make the process of raising a first debt facility easier for early-stage climate companies. We are keen to talk with people in our network who have been asset-backed lenders to early stage companies and/or have borrowed at an early stage with more traditional project lending structures. Please reach out to us if this is you!