Venture debt 101
Main features of Venture debt and a small comparison against a traditional Venture Capital transaction to underline the dilution advantage of Venture debt.
Equity capital is often seen as an important milestone for Tech companies while debt is generally conceived as too risky at an early stage and too hard to raise in a timely manner. Venture debt breaks out this statement offering substantial amounts of money to Tech companies showing high visibility on earnings despite negative cash-flows.
Is it debt, is it equity? How does it work?
Venture debt is structured as a loan, generally with a grace period -6 to 12months- in order to help the company to surpass the J-curve of the investments. As a loan, it must be fully repaid and it has an interest rate, generally on the low double digits given the high risk of the investment.
- So…what makes it different from a bank loan?
The secret sauce of the Venture debt financing is called Equity-Kicker. The reason why banks are not able to finance Tech companies its rather simple, they have a very similar downside while their upside is limited to the interest rate.
The Equity Kicker is and additional remuneration to the loan, it is expressed as a small percentage of the loan somewhere in between 15–25% of the principal amount.
- It seems expensive…Why would I take a double-digit interest rate loan and then give some additional shares to my lender?
Venture debt should not be understood as a replacement for bank financing or public financing, both are obviously cheaper.
Venture debt is worth as a complement or replacement to equity financing. Typically, Venture debt implies longer maturities but essentially more relevant amounts than retail banking.
“When used as an alternative to traditional Venture Capital the magic word for all entrepreneurs should be dilution. Equity capital preservation should be the first concern to an entrepreneur”
Let’s make a simple example on how Venture debt is cheaper than Venture capital. You’re the CEO of a (Seed — pre-Series A) SaaS company worth €10m pre-money (thanks to PointNine for the insight) and you are looking after a c.€2m ticket.
The impact of these €2m loan in the company is 5% of equity vs. the 17% dilution of a traditional Venture capital financing (not including debt repayment and interests).
At a hypothetical exit of the company at €40m, the company would have saved up to 12% on dilution, which will be translated into €2,2m net savings!
At €40m, the Venture Capital stake is worth €6,8m vs. €2m of the Venture debt. Venture debt will also have the cost principal and debt repayments (€2,6m).
Kind reminder, the more value is captured by the equity, the higher savings from current shareholders. Equity stake in the company fully align the interests of the Venture Debt.
What about smart money and value added?
Stick it to the man! I believe no one knows better a company than the founding team. Venture Debt is truly entrepreneur friendly as it has no political rights.
However, as you would do with an equity investor you should onboard the correct people. Try to gather as many information as possible from your future lenders. Collateral and guarantees requested may give you a hint on how your lender will react in case your company doesn’t perform as expected.
In addition, the equity kicker helps to align the interests of Venture Debt holders and the management. Venture debt may help as much as a Venture capital investor but the final decision on the company relevant issues will remain in the existing shareholders.
I believe many Venture backed companies neglect the positive effects of leverage which not only enhances the returns in a bullish scenario but also the possibility to unlock difficult cap. table situations or obtaining short term liquidity for your business without losing control.
Debt is a double-edged sword and may not always a good idea, my advice for entrepreneurs would be to consider this kind of financing alternative in the same way they consider raising capital. Inspired by Aristotle’s concept of the golden mean I would suggest that the smart decision lies somewhere in the mid-way of both equity and debt financing were your company should find a balanced capital structure.
Notes:
A) Venture Capital ticket: €2m (New Money) ÷ (€12m Post Money) = 17%
Exit Value Venture Capital: €40m x 17% = €6,8m
B) Venture debt ticket: €2m (New Debt) x 25% (Equity-kicker) = 500k ; €500k (equity-kicker)÷ (€10m Pre-Money)= 5%
Exit Value Venture debt: €40 x 5% = 2m (Shares) + 2m (Principal) + 0,6 (interests) = €4,6m total Venture debt remuneration
For the ease of calculation subscription of shares from Venture debt has been accounted as a capital increase at a marginal value (nominal value) and therefore Pre-Money is equal to the Post-Money.
Comparison against a Venture Capital Fund is a simplistic approach based on an exit value €40m (Spanish Median Exit size).
