The case for venture debt for early stage companies is fairly easy to understand.
Company X raises a $5MM Series A round from venture capitalists, providing for approximately a year of cash runway based on a projected cash burn of $400K/month.
During this time, the company will scratch and claw to meet as many operating milestones as possible to with hope that the next round of capital is completed at a significantly higher valuation.
Time being rarely a friend to a startup, the management team contemplates layering on $2MM in venture debt to increase cash runway by 4-5 months. The incremental financing is expected to provide the company with the needed breathing room to cushion against inevitable milestones delays and/or will provide the added juice to move the company into hyper growth earlier than originally planned.
All the company needs to do is pay a small interest charge and take on a bit more dilution by providing warrants to the lender (typically 10-20x less dilutive than equity).
Factor in the current hyper competitive debt landscape where capital is both cheap and abundant (particularly with regard to bank lenders), and you have the perfect product right?
Well. Sometimes. Maybe. But maybe not.
Last year I mentioned that venture debt at the early stages was probably overused as a default vehicle. I think that’s even more true today.
— Jonathan Abrams (@abrams) March 10, 2015
I won’t reiterate my last post, but I do want to emphasize that the seductive nature of easily attainable non-dilutive capital has creates a world where companies are going too far on the risk curve too early.
What I’m specifically referring to is the disturbing trend I’m seeing of management teams treating debt analogous to equity. And many lenders are happy to oblige to this through increasingly more flexible structures and larger commitment sizes.
Where I’m most concerned is when I see companies utilizing the additional dollars in the vault by prematurely going into hyper growth mode. It’s not too dissimilar to what we’ve observed within the “unicorn” landscape where some companies have seemingly eschewed financial fundamentals in favor of optimizing for growth of a single top line metric.
The truth is that excess capital of any size lowers adversity to risk taking.
With just equity, if major milestones are not hit, it’s a bad thing, but often recoverable. When debt is added to the equation, the results can be catastrophic and non-recoverable. Fundraising becomes more complex and balancing fiduciary responsibility with the lender can be both difficult and distracting (usually at a time when distractions can be ill-afforded).
So is venture debt bad for early stage companies – Of course not, although I’m not in favor of companies taking debt until they’ve truly passed product-market fit and entered early scale. I just think that risk awareness and analysis needs to be a more prevalent part of the decision matrix today.
While leverage amplifies return for shareholders, it also amplifies risk. In today’s market, it’s far too easy to get sucked into taking abnormal controllable risk, which when coupled with the uncontrollable, translates to something very dangerous.
Timing, moderation, and maintaining perspective are the key elements of mitigating debt risk, along with of course and perhaps most importantly, picking the right debt partner.