(Note: This will be a
2 Multi-part blog, with the next post focused on comparing and contrasting Venture debt from Venture Debt firms vs. Banks).
For the uninitiated, Venture debt is simply debt financing for Venture Capital backed companies for the purpose of accelerating growth in a way that’s minimally dilutive for shareholders.
While there are several forms of debt available to start-ups (Asset Based Accounts receivable, Equipment, Recurring Revenue), Venture debt in the purest sense is non-formula based term financing with durations of 3-5 years.
On a typical week I speak to 3-4 entrepreneurs a week regarding the relative pros and cons of taking on Venture Debt. As such, I thought I’d put together a quick synopsis about the topic.
When is it appropriate for a Company to explore Venture Debt?
▪ The company is backed by a strong syndicate of Venture partners that has the ability to further support the Company financially with or without the introduction of a new lead.
▪ For early stage companies, the management team should be able to clearly define the milestones prior to the next equity fundraising, and should have a high degree of confidence of reasonably hitting them. In addition to the aforementioned, later stage companies will need sustained revenue traction and have some customer diversity.
▪ The Company has a management team that preferably has worked with secured creditors in the past (not necessary of course!).
What type of situations do Lenders often find challenging in providing Venture Debt?
▪ No backing from Venture Capital firms.
▪ Companies that are just entering commercialization with marginal visibility into timing and significance of near term sales opportunities.
▪ Companies that have recently restarted or have recently gone through a significant business model reorganization.
▪ Companies that have incomplete executive management teams (i.e. searching for a CEO).
▪ Companies that have raised significant amounts of equity capital with very little progress.
▪ Companies that are completely reliant on bringing in an external investor or a liquidity event for repayment of loan.
What are some of the benefits of Venture Debt?
▪ Used appropriately, venture debt can provide incremental runway between equity rounds for early stage companies, allowing for additional time to meet critical milestones.
▪ For later stage companies, and in conjunction with a working capital line, Venture debt can alleviate and smooth out liquidity needs.
▪ Results in nominal dilution to shareholders and can greatly impact shareholder returns.
What are the risks of taking on Venture Debt?
▪ Overleveraging is common and can impact fundraising efforts if Company is not performing well.
– Venture debt should not be more than 50% of last institutional raise and in most cases should not exceed 30% of last raise.
– Monthly P&I payments should not exceed 15% of monthly cash burn. Under 10% is considered ideal.
▪ Not using a reputable partner can put the Company’s shareholders in a very precarious position if the lender is uncooperative or decides to exercise debt acceleration or foreclosure remedies. Many lenders get nervous when cash levels equal debt. If the lender isn’t comfortable with debt levels below cash under any circumstance, you’re essentially paying interest against your hard-earned (and expensive) equity dollars. I can’t say this enough – LENDER REPUTATION SHOULD NOT BE OVERLOOKED.
▪ Planning around Venture debt as a “hail mary” is a dangerous game as lenders often have the right to withhold advances or called a subjective default (“MAC” clause) if the business significantly deteriorates and investors no longer find the Company attractive as an ongoing investment. Venture debt should not be viewed as a pre-negotiated bridge loan.
▪ Preference of secured debt holders may reduce or eliminate investor / management economics during a liquidation/distressed asset sale.
What are the key terms to be aware of?
▪ What is the all-in IRR? This should include all fees, backend payments, etc. IRR’s can range from 6% to 15%+ depending on risk profile of transaction and other economics of the deal (warrants). A simple surface level analysis isn’t usually sufficient to measure “true” cost of the debt. More on this in the next post.
▪ Are there any MAC clauses after debt is funded? What are the lender’s rights to withhold advances? A MAC basically is a subjective default that allows a lender to “call” a loan if the lender deems, in their sole discretion, that a material deterioration in the business has occured.
▪ How are the warrants being calculated? Are there any unique equity or exit provisions?
▪ What is the collateral? Blanket lien on all assets is standard; IP may be included if the risk level is considered higher.
▪ Are there any financial covenants that restrict liquidity levels or track performance?
▪ What is the real runway provided by the debt?
– Is the lender requiring draw far in advance of cash-out? If so, how amortization will there be prior to projected cash out?
These are some of the high level basics. In the next post, I’ll cover the differences between Venture Debt from Venture debt funds and Banks.