Mixing Equity and Debt: The Lesser-Known Key to Airbnb, Uber, and Sweetgreen’s Explosive Growth

Airbnb is one of the biggest startup successes of the last decade. Since 2008, the company has revolutionized how people travel and live. Last year alone, people across the globe booked more than 100 million stays through Airbnb.[1] And nearly a quarter of leisure and business travelers now use Airbnb instead of traditional hotels. Although the company has experienced some downturns, the future looks rosy: Airbnb is valued at $38 billion, and is one of the few unicorns that’s actually profitable.[2]

Last year, the company announced a new service called Airbnb Experiences, and discussed forays into a potential new airline.[3][4] All of this came on the heels of Airbnb raising $1 billion to reverse a creative slump and expand outside the home rental market. The key is that all of that money was debt, not venture capital.

Other household names including Uber, Netflix, and WeWork have also raised billions of dollars through debt financing recently, taking advantage of the still low-interest rate environment. Alongside equity, the companies we think of as Silicon Valley superstars are using debt—and lots of it—to grow.

When raising money for a business, debt financing and equity financing are the two big buckets that entrepreneurs can choose from. But what many entrepreneurs miss or realize too late is that things aren’t so black and white. This doesn’t need to be an either/or choice.

Equity and debt can complement each other and help you succeed sooner than using just one or the other. We dove into research, our own files, and spoke to investors and founders to find out when successful startups opted for equity financing, when they opted for debt, and when they used both to gain a competitive advantage.

The Financing Ecosystem for Startups Offers Up Lots of Choices

Startup costs for new businesses vary significantly, from just a few thousand dollars for home-based microbusinesses to millions of dollars for technology startups and big brick-and-mortar shops. There are three main ways to fund a new company: personal savings, debt, or equity.

sources of financing for startups

Of these options, debt is the most popular. According to the Kauffman Foundation’s survey of more than 5,000 startups, upwards of one-third of founders primarily used debt to launch their companies.[5]

We often equate equity with innovation, glamour, and big money. And when we think of debt, we conjure the mom and pop shop down the road from our house. But the truth is that equity actually plays a very small role in funding all types of startups. Just around 10% of startup funding comes from venture capitalists and angel investors.[6] And as successful startups mature, they’re less likely to use equity and more likely to use debt.

Not only is debt the most common way to finance a business, but it is also the more predictive of success. We analyzed profit data for businesses that obtained loans through the Fundera platform in the last three months. More than three-quarters of the businesses were consistently profitable. In contrast, only a tiny fraction of venture-backed startups go on to turn a profit and provide projected returns to investors.[6]

profitability of debt funded buisnesses

If debt is so prevalent and a marker of future success, why do we read, hear, and see so much more about venture-backed companies in the media? According to Jules Miller, a Venture Partner at LunaCap Ventures, it’s a branding problem. LunaCap has invested in Brooklyn-based pastry company Ovenly, Millennial beauty brand Winky Lux, and direct-to-consumer shoe brand Paul Evans, among others. Here’s how Miller explains the overriding popularity of equity financing:

The VC industry has done a great job of branding themselves. The industry is high risk, but when investors win, they win big. Debt is less glamorous because there’s less of a “what if” factor; these businesses are typically already generating revenue and are already quite successful. However, debt should be more glamorous because these are real businesses with real success.

I think the hype is starting to shift more towards businesses that are making money already because a lot of investors have been burned. Compared to Silicon Valley which funds and probably will continue to fund the the next big thing, funding ecosystems in NYC, Europe, and elsewhere are becoming revenue-forward.

If Miller is right, debt financing might get more of a spotlight over the next few years, especially if interest rates don’t rise too much. Equity financing is also at a historical high in terms of money invested. Over the past decade, 2017 set a record for most venture capital invested globally in a single year.[7]  The environment is prime for combining debt and equity financing, but first, let’s look at when each makes the most sense.

The Ideal Conditions for Venture Capital Financing

If you have an office in New York, Boston, San Francisco, or another major city, you’ve likely walked by a branch of the salad chain Sweetgreen. Probably even eaten there. The popular chain got started in 2007 with a single shop in Washington, DC. The three co-founders, all classmates at Georgetown, funded the restaurant with a mix of gifts and loans from 40 friends and relatives.[8] They also received a $50,000 business loan from the Latino Economic Development Center in Washington, DC.[9]

The founders’ initial goals were pretty humble: to build a business instead of work a 9-to-5 job, and to create healthier dining options in the neighborhood. But once the first shop took off, Sweetgreen’s market positioning and financing strategy changed as well. Selling tasty, healthy salads was important, but not enough to catapult Sweetgreen’s growth.

To attract more awareness and growth capital, the founders began pitching Sweetgreen as the brand at the intersection of food and technology.[10] This company was going to change how office workers ate lunch. In a 2016 press release announcing a new app, Sweetgreen wrote, “We’ve always acted more like a tech company than a food one.”[12] They also took actions to prove their case.

For example. Sweetgreen was one of the first restaurant chains to go fully cashless in 2017, emphasizing pre-orders and efficiency.[13] The company also built out an in-house tech team and has focused on getting customers in and out the door, salad in hand, in fewer than 10 minutes. Sweetgreen is living and breathing technology, the language that investors are most familiar with.

Sweetgreen’s emphasis on tech clicked with investors, and they were able to raise $95 million in venture capital.[14] In a sort of feedback effect, Sweetgreen’s success also made it easier for other food service companies, which investors normally don’t see as prime opportunities, to raise money. Way back in 1998, when the fast casual Mexican food chain Chipotle (now worth more than $17 billion) tried to raise money to expand beyond the initial 16 stores, not one investor said yes.[15] But now, food service companies like Blue Bottle and Momentum Machines are a staple in venture capital portfolios.

This trend—investment capital going to food service companies—shows that your industry doesn’t need to dictate your choice of equity or debt. Investors ultimately want to put money into companies that have high growth potential. With the right ingredients (no pun intended), any founder who sees that kind of growth as a possibility for their company can pitch to investors.

Venture capital investors sometimes specialize in a particular industry or have a preference for a particular stage of growth. A later-stage startup, for instance, obviously wouldn’t be seen pitching to investors at a seed fund. Most venture firms also have a specialized focus for investing, such as software, healthcare, or financial technology. But as Sweetgreen proves, there are plenty of opportunities for businesses outside of those industries as well.

ideal conditions for equity financing

There are generally four conditions you should meet if you want equity financing:

  • Your business concept should be unique.
  • Your business is growing fast.
  • You should have an experienced team or an “in” with investors.
  • You’re okay with not having 100% ownership over your business.

Here’s more on each:

1. Unique Business Model

In the startup world, similar-minded companies often pop up around the same time. DoorDash, Postmates, and Uber Eats—all food delivery startups—began within a few years of each other. Similar things happened in the ridesharing industry, and for fashion and beauty subscription startups, too. Usually, one big player like Uber creates a break-out product or service, and several smaller competitors enter the space.

The key is that even if you’re part of a critical mass of similar companies, you need to have a unique spin to attract venture capital funding. From the start, for instance, Lyft branded itself as the friendlier, feel-good competitor to the more distant, “corporate” feel of Uber.[16] If you can get your product, service, or strategy to stand out from the pack, that’s the key to raising venture capital. The reason is that differences in the companies reflect differences in the market and create a potential for high growth.

2. Explosive Growth

Michael Barnes is the CEO of TeacherTalent, a startup that makes software to help schools recruit and retain the best teachers. Barnes knew that if his company was going to “make it,” it would be obvious pretty quickly. He told Fundera:

We chose equity financing by a landslide because once you learn the basics of venture fundraising, you realize it is a system designed to tolerate risk. Debt financing, by contrast, is often risk averse … with high interest rates, or deploys pre-qualifiers like 24 months of operating history. Venture-backed startups often die, evolve, or soar in 9 to 12 month cycles. “Safe” businesses that use debt financing are less likely to disrupt markets sufficient to garner billion-dollar valuations.

TeacherTalent raised upwards $200,000 of pre-seed funding, and within just one year, the company went from having four school districts as clients to 50+ school districts.

The runway for startups like TeacherTalent is short, in part because investors are impatient. Seventy-five percent of startups don’t provide any returns for investors.[17] To make up for the bunch of losses, investors expect high returns from the winners. Veteran investor Paul Graham has developed some guidelines for how quickly startups need to grow to be venture capital material. A very early-stage company should grow at 5% to 10% per week.[18] Fourteen years in, Facebook is growing 1% per week, and people consider that to be high.[19]

Rapid growth goes hand in hand with high funding amounts. If you’re going with equity financing, investors typically expect that you’ll need at least $1 million in funding. As the number of deals has fallen in the last few years, the size of the deals has skyrocketed. Investors are investing in fewer companies but pouring more money into them. At seed stage, even when the business model is virtually untested, two-thirds of deals in 2017 fell between $1 million and $5 million.[20] As the business grows, multimillion dollar rounds are common.

3. Experienced Team and Connections

Chris Shonk is the founder of ATX Seed Ventures, the only institutional seed and Series A fund outside of California and New York. Shonk says the team behind a startup is the first thing he evaluates when a company approaches him for funding:

For pre-revenue startups, venture capitalists really only have the option to look at the market for the product or serve, initial indicators of interest from customers, and most importantly, the team. VCs do a comprehensive “background check” into the team’s industry edge and skillset edge. They want to know if you have what it takes to disrupt the industry.

Angel investors and venture capitalists evaluate people as much as products and services. When you approach investors for money, they will assess your background and the background of your management team.

Some of the questions they’ll ask: Do you have experience in this industry? Have you started other successful companies? How successful were they? Who invested in those companies, or did you use debt financing?

If you’re not well known in your field, having an “in” or some connection with investors is a huge help.[21] For example, the first person to invest in the now-fallen pharmaceutical company Theranos was a family friend of founder Elizabeth Holmes.[22] Unfortunately, needing an “in” makes raising venture capital much more difficult for women and people of color who traditionally haven’t had access to investors.[23] But there’s been progress with the rise of diversity-focused funds and funds led by women and minorities.

4. Less than 100% Ownership

The final condition of equity financing: You should be okay with giving away ownership in your company. On average, investors expect around a 20% cut of your company during a seed round and sometimes more during later rounds.[24] That means, after three fundraising rounds, you might not be a majority owner of the company. Although there’s no debt to pay back, equity financing is very expensive in its own way.

The Ideal Conditions for Debt Financing

As a company matures and figures out what it’s doing, it’s more likely to take on debt. Although we don’t normally think of big-name companies borrowing money, it’s actually very common.

Netflix, for example, is a big time borrower. Since the company started in 1997, executives have raised more than $20 billion in debt.[11] That figure is 200 times higher than the $103.9 millon of venture capital that the company raised through the end of their Series E round![25] The amount of debt often dwarfs equity as a company grows and finds its footing.

Netflix has actually been very open about using debt to pay for original content creation and subscriber growth. These are the next frontiers for Netflix as its DVD business continues to shed users.[26] On their website, Netflix reminds investors that debt is the lower cost, more efficient alternative to venture capital for growth:[27]

In optimizing our balance sheet, we strive for the capital structure that results in the lowest weighted average cost of capital. Given low interest rates, the tax deductibility of debt and our low debt to enterprise value, financing growth through the debt market is currently more efficient than issuing equity.

Netflix and other big startups tend to use debt financing later in their business’s history. But if you’re not a tech giant, and rather a younger business trying to get capital, debt financing could be a part of the mix from the start.

The when and where of debt financing is often the most complicated thing to decide. You’ll find multiple types of business lenders—like individual investors, institutional banks, and online alternative lenders, too.

conditions for debt financing

Regardless of the financing route you pursue, common among them are four prime conditions for debt financing:

  • You have a predictable business model like a traditional restaurant or retail shop.
  • You’re happy with a reasonable income from your business, but aren’t looking to achieve exponential growth.
  • You need smaller amounts of capital to start (less than $1 million).
  • You want 100% ownership over your business.

Here’s more on each:

1. Stable, Predictable Business Model

If equity financing thrives on the novel, debt financing thrives on the common and predictable. The world of small business lending has changed dramatically over the last decade, but lenders are still set in some of their ways.[28]

Bankers like businesses that they can understand, according to Christopher Grey, Co-founder and Chief Operating Officer of CapLinked, a virtual data room platform designed to help startups and large corporations raise funds. “Banks looks at a company very differently from investors,” says Grey. “They work with customers of particular credit profiles. Plus, they take on less risk because they have more regulations to comply with.”  

For this reason, common business models like restaurants, beauty salons, and medical offices are the biggest recipients of bank loans and SBA loans.[29] SBA loans are highly desirable government-backed bank loans issued to small businesses. Community and regional bankers still rely to some extent on “soft” underwriting factors like a business owner’s reputation. And when you understand what someone is trying to accomplish, you’re much more likely to loan them money.

For instance, there’s a fine line between opening a restaurant chain, and pushing the boundaries to create something industry-changing, à la Sweetgreen melding food service and technology. To qualify for debt financing, indicators like credit, revenue, and profits should be stable—which generally means the business model should be established and income should be accordingly predictable.

2. Business Is a Job or Regular Source of Income

When people start a business, they’re usually motivated by one of two things. There are entrepreneurs who want to lead high-growth startups or revolutionize an industry. Then, there are “lifestyle entrepreneurs” who see their business as a job or regular source of income.

These aren’t two types of people, but rather, two different sources of motivation. And your reason for starting a business might change over time. But if you mainly want to start a business to get a source of income, without taking on too much risk, that’s a good indication that a business loan might be right for you.

3. Smaller Amounts of Funding (to start)

Business lenders provide far less capital than investors, at least when a company is first starting out. Traditional lenders use historical financial performance to assess a business’s creditworthiness, and tend to be pretty conservative about how much they lend. For example, most lenders on the Fundera platform approve 10% to 30% of a business’s total revenue in funding.

Lenders provide significantly more as a business proves itself, but venture capital starts out high. The average seed funding round was upwards of $1 million in 2017, whereas the average small business loan size from national banks in 2017 was around $600,000.[20] The average loan amount at community banks was even smaller, around $150,000.

If you need a small amount of capital at the beginning, you might have no choice but to get a loan, because investors usually don’t transact in such small amounts.

4. Complete Ownership and Lower Costs

Jeff Yates is the CFO and Co-Founder of Ariix, a nutrition and pharmaceutical company that uses independent distributors to sell products. Yates and his partners used private equity to launch the business so they could retain as much of the business’s cash flow as possible.

But, as the company grew, they began to rely more on debt so they wouldn’t have to give up more ownership in the business. For Yates, cost was the deciding factor:

The cost of debt, at almost any price, was more attractive than giving up equity. As majority shareholders, we constantly evaluate the financial cost of debt versus equity capital, but are keenly aware of the strategic and control risks of each as well.  We highly value the autonomy of internally funding our strategic objectives.

Deciding whether you want complete ownership of your business is a very personal decision. Investors bring positive things to the table, such as expertise in your industry and a sounding board for new ideas. But they also get a piece of your company. When you get a business loan, you have to pay back the lender with interest. But the lender doesn’t get any ownership in or influence over the business.

Since the lender doesn’t get a piece of the pie, debt is usually less expensive than equity. The cost of debt equals the interest expense and fees associated with the loan. For borrowers with exceptional credit, annual interest is in the range of 5% to 10%. The cost of equity is a 20% or higher stake in your company—so, if you can use debt in lieu of equity, that’s more affordable.

Of course, there are always trade offs. If you can use equity to rapidly grow your company, what’s costlier now could be more cost effective down the line if your business valuation ends up skyrocketing.

Mixing Debt and Equity Financing: Why, When, and How

Sometimes, a business falls neatly into the debt or equity box. But for many, the right structure of capital often changes as your business grows. For instance, you might have raised money from investors early on, but now you’re struggling to meet growth targets. Or you might be seeing more potential in a business that started out as a side gig.

mixing debt and equity

These are the kinds of situations in which you can efficiently use a combination of debt and equity financing:

Apply Debt to Routine, Predictable Expenses

TeacherTalent’s Barnes says that his company opted almost 100% for equity financing. They did take on a little bit of debt. “The only debt that we ever accepted was the 30-day window on our awesome American Express Platinum card (no limit!), which has helped us address short-term cash flow.”

Even for business owners who are averse to the idea, debt has advantages. Debt almost always costs less than equity, making it perfect for low-return, day-to-day expenses. SBA loans, business lines of credit, and business credit cards are perfect for routine business expenses, such as paying rent and buying supplies. Using lower-cost dollars for predictable expenses frees up costlier, investor money for lucrative projects.

Phil Barnes is a Partner at venture capital firm First Round Capital, which has invested in companies including Blue Apron, Birchbox, and Refinery29. Barnes agrees that equity and debt can coexist under the right circumstances, saying:

Equity should be used to fund core enterprise value creation (technology, early team, even early distribution). Debt should be used to fund revenue creation and margin expansion, aka the things that you need to repay the debt.

More large startups are raising debt because they have real businesses with positive unit economics that can grow faster and become more profitable when they are fueled with [lower-cost] leverage.

Scott Feldman is a Partner at Susquehanna Growth Equity, an investor in companies including Credit Karma and Boomtown. He echoes the same idea, adding, “It’s very typical for small lines of credit to be put in place for short term working capital needs. However, it’s not a substitute for growth capital.

Growth capital comes from investors, and those funds are expensive. You want to use equity capital only for projects that are going to directly impact your bottom line, such as new product development or building out a team.  

Borrow Debt As Your Company and Business Model Mature

For 10 years after the company’s founding date, Netflix was focused on one thing: Getting DVDs into the hands of consumers. Unlimited DVD rentals set Netflix apart from competitors and allowed it to generate enough sales to go public in 2002.[26] But the company went down a very different path. They started offering a streaming service, and in 2013, they released House of Cards, its first series. The show garnered 33 Emmy nominations and another 8 Golden Globe nods—plus a viewership comparable to top shows on cable television.[30]

After House of Cards’s unexpected success, Netflix made a complete 180 in growth strategy, funneling 85% of spending into creating original content.[31] In sync with the change in strategy, Netflix also started raising debt more aggressively.

The company has raised upwards of $1 billion through bond sales on five separate occasions in the last three years. And, as Netflix has become more successful, with an increase in subscribers and audience favorites in the original content department (think Stranger Things, The Crown, Jessica Jones…), raising debt has become much easier.

Equity fundraising is primarily about investors’ future expectations—what a business can possibly achieve and how quickly. Lending, in contrast, is primarily about lenders’ assessment of a business’s historical numbers—cash flow, revenues, profits, and assets and liabilities. When those numbers stabilize, it’s time to consider adding debt into your capital mix.

If you’re ready for debt financing, there are multiple ways to borrow. Large, public companies like Netflix either sell bonds to institutional investors or acquire millions in venture debt. For smaller amounts of debt (less than $5 million), traditional banks are lending more money to small businesses than they have since the recession started.[32] There are also small business loan platforms like Fundera which increase efficiency for borrowers, collectively providing access to dozens of alternative and bank lenders. Alternative lenders are growing in importance and have high approval rates for small business applicants.[33]

Try Venture Debt Between Rounds of Equity

Airbnb, Netflix, Uber, and other popular startups have all been in the news recently for borrowing billions of dollars in venture debt. As the name suggests, venture debt combines elements of equity and traditional debt financing. It’s an $8 billion industry.[34]

Here’s a look at some large venture debt loans that popular companies have taken out:

venture debt rounds

Like any other lender, venture debt lenders want to know whether the borrower will be able to pay back a loan on time and in full. But instead of reviewing the borrower’s financials and credit history, the lender looks at the company’s current investment backers. Venture debt goes by different names, but ultimately this type of financing rests on the fact that you already received investor backing (e.g. in a seed round or Series A). If Tier 1 investors have already put money into your company, you’re generally a safe bet for venture debt.

Traditionally, tech-focused banks like Silicon Valley Bank (SVB) and SoftBank have dominated the venture debt market. However, bulge-bracket investment banks, including Goldman Sachs, Morgan Stanley, and Citigroup, have now entered the space, too.[35]

According to LunaCap’s Miller, venture debt is attractive because it costs less than and is less dilutive than equity financing. Venture debt lenders (banks or private funds) typically charge interest rates in the range of 5% to 15%, plus they typically ask for 0.5% to 2% equity in the company through stock purchase warrants. That makes venture debt about two to six times less expensive than traditional equity financing.

The terms are as different as the companies seeking venture debt, but it’s typical for the loan to be no larger than half the size of the last round. The repayment period is usually three to four years, with a short period of interest-only payments.

Investors understand a founder’s cost calculus and will look favorably on a company that thoughtfully combines venture debt and equity to leverage growth. In fact, venture debt firms and equity investors work closely together. ATX’s Shonk expands, adding:  

Venture debt lenders don’t like to jump alone; they want to lend money only if an equity investor is also going to help the company grow and pay back the debt sooner. It’s a symbiotic relationship. Venture debt lenders won’t loan you money unless they think you can service that debt, so they’re in close discussions with investors about a company’s growth rate. Also, the debt holder will get paid first before investors if the company defaults, so investors won’t be on board with venture debt if they didn’t think they would get paid as well.  

Since venture debt costs less, it’s ideal for when you need a longer runway to achieve growth targets between funding rounds. Venture debt can help you make up for a shortfall of funding without having to ask your current investors for more money. And in some cases, venture debt can help you maintain growth momentum or serve as the extra bit of help needed to achieve profitability.

SkillShare recently raised $8 million in venture debt during a Series C round of funding.[36] The online learning company has been trying to push the boundaries on online education since 2010. They have both a subscription business for frequent users and a platform business for users taking one-off classes.

SkillShare is at an interesting inflection point. On the one hand, they still have a long way to go. Their goal is to reach 1 million users by the end of 2020, and they haven’t yet tapped into the full potential  of the international market. But, on the other hand, they have experienced 100% year-over-year growth and already had the backing of investors like Union Square Ventures and Spark Capital from earlier rounds of funding.

This positioned the company to raise a lot of money in venture debt. CEO Matt Cooper says, “We are keeping the gas pedal down on growth. We have a lot of momentum right now, so we want to keep that going while starting to make some bets that will drive our growth 18-24 months out.”

Raise Equity When Pivoting or Launching a New Product/Service

Sometimes, you don’t want to just keep the momentum going. You want to transition all your efforts into something completely new. Headspace is a popular meditation and wellness app. The co-founder, Andy Puddicombe, actually trained as a Buddhist Monk in India for several years before starting the app. And in the beginning, the app just connected people to meditation events near them.[37] But Puddicombe discovered that people wanted to learn meditation on their own time, so Headspace put together some online lessons.

These lessons were incredibly popular, forming the core of what Headspace is now focused on. It was only after putting the online lessons together that Headspace attracted the notice of venture capitalists, and now the company has millions of users worldwide and $75 million of venture capital in its war chest.[38]

The lesson of Headspace is that late bloomers are okay in the startup world. If you’ve only ever used debt to finance your business, you might think that equity is not an option for you at all. But you could have an opportunity to raise equity when you pivot your business or launch a new product or service.

Maybe you have a core product or service that generates stable revenues. Devote enough resources to keep this part of the business going, while spinning off a secondary product or service. The new part of your business could be a perfect candidate for equity financing. The stable part of your business could serve as a confidence booster for investors who would otherwise be hesitant to back your company. Investors care a lot about the team behind a project, so if you can show that you’ve already had a successful product or service, that will set you up for success.

Equity and Debt Together Often Work Better Together

Deciding between equity and debt financing is one of the most important choices you’ll likely make as a small business owner. But you might able to use both.

Even if you start out as the perfect candidate for equity financing, there could be room for venture debt or traditional debt between fundraising rounds or for certain kinds of expenses. And if you start out as the perfect candidate for debt financing, you can utilize equity if your product/service or business model pivots.

Ultimately, debt and equity have their own trade offs, and the best advice is to be adaptable and include both in your financing strategy as needed. Finding the right mix of financing for your business involves experimentation—and maybe even some mistakes—before you find what works.

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Image: Noam Galai/Getty Images for TechCrunch via Creative Commons; Disclosure: First Round Capital and Susquehanna Growth Equity are investors in Fundera.  

Senior Contributing Writer at Fundera

Priyanka Prakash, JD

Priyanka Prakash is a senior contributing writer at Fundera.

Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.

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