Venture Debt: Why You Need It and When to Pursue It
First things first, let’s define “venture debt”. Venture debt refers to a loan that banks or other lenders provide to venture-backed early-stage or emerging companies. This type of loan can be a great way to fuel growth for a startup. Not only can the financing be used for working capital but also for buying inventory and equipment. For early-stage companies in between financing rounds like a Series A or B, it can be ideal. The same applies to companies that either do not have significant assets to use as collateral or don’t have positive cash flows.
Of course, there are risks involved with venture debt. Providers won’t freely commit to giving this type of financing unless they get something back in the bargain. In the case of venture debt, the right to get paid back first plus equity or the right to buy equity in the startup is the other side of the “bargain” from the debt providers.
Additionally, venture debt usually involves the granting of some equity upside to the lenders — most commonly, in the form of warrants. While not that dilutive, it is still something startups should keep their eyes on when reviewing all their options for further funding.
But here’s the upside: the cost of venture debt can be very low. If your startup isn’t generating significant revenue, these low interest rates can be a godsend. Additionally, an “interest only” period where the borrower doesn’t have to repay principal can also help extend a company’s runway.
But if a venture-backed startup isn’t flush with cash yet, why would a bank or a well-known financial institution provide venture debt? The answer is simple: The bank or financial institution is wagering that the startup’s previous institutional investors, which might include venture capital firms, will support the company if additional capital is needed down the road. Remember, debt is always paid before equity in any company sale, so this support isn’t charity either. This support is often contingent on the company executing on its operating milestones and the investors believing that the company will continue to do so.
And yes, the cache of a well-known name counts. If your startup has raised seed and/or Series A funding from prominent Silicon Valley venture capital firms like New Enterprise Associates or Andreessen Horowitz, you will probably stand a much higher chance of securing venture debt than if you received backing from unknown angel investors. This will likely be the case even if you’ve snagged $5 million from family/friends and some high net-worth angels. The banks need that assurance from the well-known (and deep-pocketed) investors before they take a bet on your startup.
So, who provides venture debt?
Banks and financial institutions that deal primarily with startups, such as Silicon Valley Bank and Square 1 Bank are leading providers. Other venture debt lenders include specialty companies such as WTI, Hercules, Lighthouse Capital, and Triple Point Capital.
Why would a startup want venture debt?
Debt is cheaper than equity and because of this, venture debt can leverage the equity raised by a startup, slashing the costs of money needed to finance an emerging company when it’s burning more cash than it generates. Another reason why startups would consider the possibility of raising venture debt is that it can be used as insurance against operational problems, stalled fundraising, and other unforeseen financial issues.
The drawback is that venture debt is still debt, which means it will have to be repaid. Timing is everything: if a startup is raising venture capital at the same time that the venture debt needs to be repaid, the company could find itself in a sticky situation. In this case, the capital that’s coming in will have to go out to pay the venture debt, and in the meantime, your new investors have signed up for a stake in your startup! Talk about stress.
How much should you ask for?
That depends on how much venture debt is available to the startup. Most venture lenders offer two types of debt facilities: term loans and revolving lines of credit. A term loan can give startups that have still not generated sufficient revenue the option of repaying it later, while a revolving line of credit works better for companies that are generating consistent cash flow and revenue.
How venture debt works:
Even if you don’t have significant assets—yet—that does not exclude intellectual property. The latter can be used as collateral for a venture lender to guarantee repayment.
Also, venture lenders might ask you to provide documents, such as balance sheets or monthly income statements to prove the financial health of your company. You might be asked to submit to regular audits until they’re satisfied you won’t stiff them once it’s comes time to cut that check and repay them. And with debt often comes a covenant structure that requires the borrower to adhere to certain financial performance metrics or risk losing the debt.
When is it time to pursue venture debt?
- The company is growing but equity is too expensive, or it will take too long to raise;
- The company is generating predictable and recurring revenue;
- The company is more than ten years old and the equity investors are tapped out;
- The cash flow is near breaking even;
- The company has raised equity from an institutional investor; and,
- The company is viewing debt as a possible solution to float the business for a few months while putting together a business strategy to use when raising more money.
Conversely, what’s the wrong time to raise venture debt?
- Revenue is stalled or declining;
- The company is in the middle of a business model shift or pivot;
- The company has limited cash reserves and wants to use the debt as a last resort for capital;
- The company lacks momentum; and,
- The purpose of the debt is to fund your startup’s losses until it’s able to raise additional capital. Debt should be used to invest in areas that drive revenue growth.
For those that have made their minds up, the following tips should help ace the process of raising venture debt for your startup:
- Develop an early relationship with the venture lenders.
- Talk to your board or investors to get their perspective on debt and when the company should pursue it.
- Make sure you have a very detailed financial model to present and impress your prospective lenders with. Do not provide financial data that is incomplete and not prepared by an accountant or finance professional.
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