Venture Debt?

I was just reading an interesting article from NextView Ventures — What is venture debt and how should startups use it?

Really good overview and gives a solid basis for a cursory understanding. I won’t rehash the article (you should read it) but there are some key insights that the article doesn’t mention.

For quick background, while I was at GE Capital, I actually did a rotation in the GE’s venture debt shop and learned quite a bit about the business….

So here’s the quick need to knows:

Venture debt can be broken down mostly into two separate camps: debt funds and finance co’s (WTI, Horizon Technology Finance, TriplePoint) and banks (SVB, Square 1, Comerica). The debt funds and finance co’s typically take more risk — ie, lend greater amounts (25%+ of equity raise), charger higher rates (typically 8–15% in today’s market), ask for higher warrant coverage (8–20% of the loan amount in warrants priced at the last priced round) while the banks typically lend smaller amounts (15–25% of the equity raise), charge a lower rate (5–10%), and require your deposits business (more on this later).

The pro’s of raising venture debt is largely that it’s cheaper than equity. You take significantly less dilution. Instead of raising $10MM of equity, you can raise $8MM of equity and $2MM of debt.

The con’s, and here’s where most people don’t really talk publicly, are numerous:

  1. You have to pay it back — $2MM of debt isn’t $2MM of burn. You have to pay it back on a monthly basis (typically in a 36–48 month period). So while founder thinks he has $10MM of proceeds in the above example, he really has less than that.
  2. It’s senior to the equity — well of course it is, it’s debt — what’s the big deal? The big deal is when you need to go to your existing investors to ask for a bridge because things aren’t going exactly as planned, they will be injecting money that sits behind the debt facility (or whatever you owe on it). That introduces another variable into the equation precisely when you don’t want another variable. I’ve seen equity investors pass up on a bridge loan because it was sitting beneath the debt.
  3. MAC clause — look carefully in your term sheet — is there a MAC (Material Adverse Change) clause? This clause basically means the term is subjective — ie, your company didn’t hit the projections, there’s a material adverse change in the business. Your competitor got funded $40MM, there’s a material adverse change in the business. The market has gone south, there’s a material adverse change in the business.
  4. They own the deposits — do you bank with them? If you do, see if they have a clause where they can sweep the cash (ie take over your bank account and ACH the money out). It may or may not be justified, but if the cash is swept, you don’t have the money to sue the bank and you’re done.

There are definitely instances where venture debt may make sense: the startup is performing well, you’ve figured out your growth formula, and you’re using the debt to push your metrics to get a healthier valuation. However, there is DEFINITELY a downside to the debt, particularly when things aren’t going as planned (and that never happens in venture backed startups, right?).

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