Please follow me @samirkaji for my random, sometimes relevant musings on venture capital.
“If one of my companies is taking on venture debt from a bank in today’s market, will they f*ck me by not letting me borrow the money when I need it?”
It’s a question that a investor recently posed to me. While blunt, it’s wasn’t an unreasonable question to ask when the private markets have started to see a marked reset.
To be clear, in conjunction with a fresh equity raise, venture debt remains an incredibly cheap, non-dilutive way to extend runway and/or support growth. Over the last few years, the price of bank issued venture debt has dropped dramatically, leading to a surge of companies taking on bank debt financing shortly after an equity raise.
Now going back to my friend’s question. For reference, most venture debt deals allow for some period of time (6–18 months) during which a company can draw capital. Traditionally, companies opt to draw down capital close to the end of the draw period to reduce paying interest on cash they don’t yet need. However bank issued venture debt often comes with what is referred to as a “contingency funding clause”, which allows banks to reject a draw down request subjectively in its own sole discretion.
In the past, companies and investors haven’t worried too much about this clause, but many boards have recently begun to instruct portfolio companies to draw down capital immediately after the venture debt deal is inked to avoid a catastrophic situation of not having access to debt capital when it’s most needed.
While banks haven’t historically activated this clause, boards are right to have some consternation. Nearly all venture debt banks are publicly traded and highly regulated, and it’s possible that if things get really messy, we may see more aggressive bank behavior, especially in situations where:
– The company has missed any significant milestones.
– The company doesn’t have a “name brand” investor syndicate (banks will go to great lengths to avoid relationship and reputation risk with the top VC firms).
– The draw request comes at a time where the company has < 6 months of runway, inclusive of the debt draw, without a defined path to further funding.
While the counsel of an immediate draw has some merits, there are some inherent flaws to this line of thinking:
1/ It results in paying interest on cash that you already have on the balance sheet from your equity round.
2/ The utility of the debt is significantly reduced if you have to pay back 25%-33% of the line before you would theoretically need it. If this happens, the cost of the line is severely understated by the published interest rate.
3/ If things are going well with the company during the draw down period (the scenario where debt actually makes sense), the bank will almost certainly allow the loan to be drawn. If you’ve missed a bunch of milestones and don’t know where the next round is going to come from, you really don’t want debt anyway — It’ll be more of an anchor versus a lifeboat.
4/ Banks sometimes include something called a Material Adverse Change clause that allows them to require payback based on subjective measures. Drawing early doesn’t address this risk.
Luckily, there are a few ways companies can solve for some of the drawbacks.
– Taking money from a debt fund instead of a bank. Debt funds typically are much more aggressive in structure and eliminate contingency clauses and MAC clauses altogether.
– Negotiating out the MAC clause. This is easier with a strong investor syndicate. Also as mentioned above, with a strong investor syndicate, it’s very unlikely a bank will act on the contingency clause – especially if that investor syndicate includes Sequoia, Accel, Greylock, Andreesen, Union Square, Benchmark, etc.
– Negotiate a long interest only period. For boards that remain nervous about the funding clause and want to draw early on regardless of the draw backs, a long interest only period drastically reduces the amount that is paid back before you actually need it, therefore preserving maximum utility of the debt.
Finally, I’d encourage founders and investors not to view venture debt as an insurance policy if things aren’t going up and to the right. It’s not. Used appropriately however, it’s a great tool as part of a growth capitalization strategy.