Venture Debt 101 – Part II (I had originally though of just writing a 2-parter, but think a multi-parter is needed, with the next post being the anatomy of a Venture Debt term sheet).
Banks vs. Venture Debt Providers:
In part I of my Venture Debt 101 series, I outlined the basics of Venture Debt financing for start-ups. It’s fairly straightforward and provides a very high level roadmap of navigating if and when a Company should consider Venture Debt financing.
A topic that garners significant confusion is how to choose a partner when signing up for Venture Debt. There’s certainly no shortage of institutions that provide Venture Debt financing, but who you choose may be critical in ensuring long-term financial viability for your company.
I’m going to again reinforce a point from my last post: Think long and hard about who you’re taking debt from and what type of provider you’re using. Cash can be different shades of green, so use the same level of diligence you used with your equity sponsors as you would with your venture debt provider.
Fundamentally, there are 2 forms of Venture Debt Providers – Banks and Venture Debt Firms.
Banks: Everyone of course knows what a Bank is. Banks that offer Venture debt source capital from client deposits and offer Venture Debt as part of an overall debt/banking solution. Banks most active in the Venture Debt space include organizations such as Silicon Valley Bank, Comerica, City National (fairly new entrant) and, Square 1 Bank (I’m defining Venture Debt here as term loans designed to help pre-profit early to growth companies extend cash runways. As such, I’m not including traditional middle-market lenders that provide late stage covenanted term loans or working capital financing). Other banks such as Wells Fargo may also provide Venture Debt on a discretionary basis.
Venture Debt Firms: Venture Debt firms, which first started forming nearly 30 years ago, are firms that primarily operate as closed ended funds with capital coming from 3rd party Limited Partners (and in certain cases public capital). The Venture debt firm universe is fairly large and fragmented with many smaller niche players surfacing over the past 10 years. Some of the larger and more notable names include Western Technology Investment (WTI), Triplepoint Capital, Hercules Technology, Lighthouse Capital, Pinnacle Ventures, Horizon Ventures, Pivotal Capital, Structural Capital, Orix Capital, and Escalate Partners. Pivotal and Structural are newer Venture Debt firms (although are led by tenured venture debt professionals).
To be able to understand the difference between the 2, it’s important to understand the risk/return profiles of each. The table below provides an illustration of this – I’ve added in Venture Capital Equity financing as a measure as well.
A couple of things to highlight off this chart:
- Banks are ALWAYS going to be the cheapest form of financing you can find (optically at least, but more on that in another post), but rarely will take on significant amounts of risk (Sidebar – financing early stage companies backed by strong Venture sponsors is much more predictable than you’d think). Most banks operating in this space expect losses of 1-1.5% on their Venture Debt portfolio. This is even more true today as the competitive landscape is fierce.
- Termsheets from Venture Debt firms, while often contrasted side by side with Bank termsheets, are usually not an appropriate comparison. Financing from Venture Debt firms, is really more of a hybrid between Bank financing and VC financing and should be evaluated as such.
So let’s now get into specifically how they are different:
|Term||Banks||Venture Debt Firms|
|Typical Interest Rates (usually Based of off Prime Rate)||5%-7.5%||9%-13%|
|Warrant Coverage||As low as 2-3%, but typically in 4%-5% range||Usually 8%-12%|
|Draw or Interest only period||6-12 months||6-18 months|
|Amortization Period||<=36months||<=48 months|
|Financial Covenants||Sometimes, but not typically||No|
|MAC clause||Yes||Sometimes, but typically not|
|Size of loan||20-40% of Recent Venture Round||Depending on the Company profile, may go up to 100% of last round if appropriate. Usually 30-50% of Recent Venture Round.|
|Pre-Payment Penalty||3% Year 12% Year 21% Year 3(Can be reduced in many cases)||Same as Banks, but sometimes “Full Metal Jacket” (all future interest payments are accelerated)|
|Other Conditions||Company must keep primary depository and operating accounts with Bank||Deposits can be kept anywhere, although a Deposit Control Agreement document must be executed, which provides lender a legal security interest over cash held in a bank.|
 Warrant Coverage determines the # of shares you have to provide to the lender in exchange for the debt (in the form of a priced option). The # of shares you provide is calculated by Warrant coverage (%) * amount of debt you pay warrants on (commitment and/or amounts borrowed) / Price Per Share specified by warrant. For example:
5% Warrant coverage on a $2MM loan, where Warrants are based on full commitment translates to 5% * $2MM / $1.00 Per Share (let’s just say that was the last round price)= 100,000 Shares. As an option, the lender has the right to buy 100,000 shares at $1.00/share for some period of time, usually 7-10 years.
 The Draw period represents the time you have to “draw down” or borrow on the line. At each draw, the amount borrowed might immediately start amortizing or may go into an interest-only period for some time.
 This is a fun one. MAC clauses, or Material Adverse Change clauses, essentially provide the lender the ability to call a default call a loan if they believe there has been a material change in the business that could impact the prospects of repayment. These material changes do not need to be financial in nature and could be anything the lender deems is significant and negative. It’s important to note that on occasion, lenders will substitute an Investor Abandonment clause that says a default can be called if the Investors communicate a clear unwillingness to further back the company. It’s a bit of a bullshit clause in practice as investors rarely articulate they are throwing in the towel without exhausting every dollar to explore options, but I suppose it drives some level of social responsibility by the investor to lender.
So what’s right for you??
It depends. The easy (and lazy) answer is to pick bank financing because of the cost, but that surface level analysis will rarely yield you the RIGHT deal. Here are a few questions to ask before choosing a lender:
- Is there good compatibility with the lender sitting across the table? Does the lender have a good understanding of your space and have the right temperament for the inevitable ups and downs of the economy and/or your business? Remember, this will be a multi-year relationship.
- What are the reputations of the lenders when times are tough? Which of them have a good relationship with your investors?
- Why do I really need this debt? Basic runway is a standard answer, but I’d rather hear what critical milestones will likely be incrementally met using the debt.
- What’s the right amount I really need to make this worthwhile? If I have a capital-intensive business, will I need more follow-on debt financing prior to the next round (and can the lenders provide it)?
- Am I ready to take on the responsibility of debt? Lenders expect you to pay their capital back and you need to prepare for ongoing conversations with your lenders – which will become increasingly frequent (with you and the investors) depending on the lender’s risk level.
The answers above should go a long way in determining what form of provider is best (and who within each class of provider is best).
On my next post, I’ll be deconstructing a sample Venture Debt proposal.