Funding & Exits—Chapter 12: Venture Debt
Some use “venture debt” to describe any loan provided to a venture backed startup — whether it be the seed stage convertible note, the commercial bank term loan to financing working capital needs, or a high interest rate, warrant-backed loan. For our purposes, we use the term venture debt solely to describe the latter. Lending to venture backed startups in the US is estimated at about $3.9B.¹ Only a subset of this is venture debt.
Venture debt is a specialty finance instrument, offered as a senior secured term loan. Its roots are in venture leasing. Back in the 1980’s, venture backed tech companies spent boatloads of cash on computer equipment. Large leasing companies like Comdisco and GATX provided companies the alternative of leasing that equipment, substantially reducing the initial cash hit. Although these companies were washed out in the dot com bust, their successors evolved into venture debt providers — financing operating losses instead of equipment.
Generally, a venture debt lender will include a blanket lien on all of the company’s assets. Unlike a commercial bank term loan, the interest rate is much higher — often in the 10% to 13% range. The term might range from three to five years. Repayment usually involves a period of interest only payments followed by principal and interest payments. Warrants are an important component of the venture debt model — averaging about 8–12% of the amount of the loan. Early repayment generally includes fees and payment of future interest. When other loans sit on the balance sheet, all lenders will need to enter into an intercreditor agreement that specifies priority of the various liens and enforcement rights.
Venture debt lenders seek returns in the 20%-30% range for earlier stage companies; target returns fall to as low as 12% for late stage companies. These returns are driven by interest payments, fees, and equity returns.
Securing venture debt is less onerous than securing venture capital. Whereas closing an equity VC round might require three to four months of work and diligence, a venture debt round might close in two to three months — sometimes faster. For earlier stage companies, venture debt providers are generally willing to loan between ⅓ and ½ of the most recent equity round, as long as that round has been closed within the past six months and the equity investors verbally indicate an intention to invest in future rounds. For later stage companies, loan amounts can be for as much as 20% of the company’s enterprise value, if there is strong investor support and high confidence in its capacity to raise capital, get to cash flow positive or complete an M&A transaction.
Venture debt is designed to extend runway while decreasing the effects of dilution. There are various reasons for considering venture debt, including:
- To extend runway to next value inflection point should it take longer to achieve than expected
- To build valuation ahead of the next equity financing in cases where businesses are executing well
- To finance one-time items like acquisitions
- To over-capitalize in anticipation of an economic downturn
- To extend runway to profitability (so as to avoid another equity round)
- To avoid an equity down round
Usually, it’s the first of these. When it works as intended, venture debt delivers two antidilutive benefits. First, it shifts the funding mix, reducing equity cash and increasing debt cash. Second, it enables you to push out the next equity funding event by a few months. Assuming you post strong growth during these months, your pre-money valuation in the equity round will be higher than would have been true had you taken the round earlier. The combination can significantly reduce management dilution, as shown in the example below:
The fifth purpose scenario — getting to profitability — is a “no brainer”. If you’re that close to cash flow positive, venture debt can be a great way to avoid another hit to management’s equity stake.
As to the sixth purpose scenario — to avoid a down round — it’s theoretically attractive. But if your company faces a down round, it’s struggling. So your ability to even secure the loan is questionable. Even if you do, the company’s shaky performance increases the odds you’ll lose out on the intended benefit. You don’t want to take the loan, add the runway, fail to improve the business, pay off a very costly loan, and still end up with an equity down round.
Before you seek venture debt, consider three questions:
- Is your growth rate sufficiently predictable to embrace the risk of this type of funding?
- Considering your burn rate, cash position and existing loan stack, and remembering that the moment you take down the loan you must begin to pay it back, how much cash will be left when it matters, and how many months of runway extension will it get you?
- Assuming you gain this runway extension, by what amount can you reasonably estimate your pre-money valuation will increase?
Predictable Growth Rate
Venture debt works best if you are growing valuation. Its case hinges on positive pre-money valuation arbitrage from pushing out the next equity funding event. If you take on the debt and growth flattens (or worse, begins to slide), the benefit goes away and the expensive loan still must be repaid. At worst, if you fall into delinquency, you’ll trigger punitive covenants that could put your company’s entire future at risk. It is critically important that you partner with high-quality lenders that have a reputation for supporting companies when the “chips are down”.
So it is very important to assess your growth rate and to critically evaluate your confidence that the growth will continue. If you’re scaling nicely, then great — venture debt makes a lot of sense. If not, keep away.
Months of Runway Extension
It’s important to conduct a careful financial analysis of your growth projections, cash burn, and the required monthly loan payments per terms. You need the projection of additional runway to be as accurate as possible, because you will be timing your next equity round accordingly. Leave yourself cushion in the baseline plan to handle unexpected events that may crop up. But plan carefully: if you screw it up, you could find yourself exposed.
To be safe, close your next equity round with at least four months of runway in the bank.
Does the additional runway give you time to experience a meaningful bump-up in pre-money valuation? Valuation generally moves in “step functions”. Having additional runway can help reach the next value inflection point, allowing you to capitalize on a higher valuation at the next equity round. Check out the valuation benchmarks and do the math. Make sure the risk is worth the reward.
How to Optimize Terms
There is significant variation in venture debt terms. It’s important that you shop around, to make sure you secure the best. Here are the big ones:
- The interest rate
- The warrant coverage
- The term length and interest only period
- The upfront fees
- Rules regarding taking down the loan — must it all be taken down immediately, or can you take it down in tranches as you need it — reducing the interest rate burden?
- Rules and fees regarding repayment
- Facility fees or end of term payments
- Covenants — is there anything that would restrict your capacity to access or use the cash when you need it, i.e. during the runway extension period?
The following are representative venture debt terms:
- 1% upfront fee (application and closing)
- 10% to 12% interest rate adjusted monthly based on a spread over LIBOR or Prime
- 3% to 5% backend fee (paid with final payment; also known as end of term or exit fees)
- Prepayment penalties of 4%, 3%, 2%, and 1% in years 1, 2, 3, and 4, respectively
- 5% to 10% Warrant “coverage” (e.g. on a $10m loan, 10% “coverage” would give the lender the right to acquire $1m, 10% of the loan amount, of the latest round of preferred stock for 10 years)
- 36 to 48-month terms
- 12 to 18 months interest-only (“IO”) period; principal begins amortization after the IO period
The Venture Debt Funding Process
The first step is to figure out which lenders are worth talking to. Talk only to lenders with solid reputations for quality and a demonstrated track record of supporting entrepreneurs when the company is under duress. Here is a partial list of players operating in the venture debt marketplace:
- ATEL Capital
- Eastward Capital
- Escalate Capital
- Hercules Technology Growth Capital
- Horizon Technology Finance
- Multiplier Capital
- North Atlantic Capital
- ORIX Growth Capital
- Onset Financial
- Oxford Finance
- Pinnacle Ventures
- Pivotal Capital Partners
- River SaaS Capital
- Runway Growth Capital
- Structural Capital
- TriplePoint Capital
- Trinity Capital Investment
- VenSource Capital
- Wellington Fund
- Western Technology Investment
The next step is to identify the lender’s decision process and filters. The following questions will help:
- What are the steps in your evaluation process?
- Do you require venture sponsorship?
- What are your minimum MRR requirements?
- Given our profile what is the maximum loan amount we can receive?
- Do you allow the loan to be taken down in tranches?
- What are your repayment terms?
- What warrant coverage do you require?
- What advice do you provide?
- Can you provide references of CEOs who have defaulted with you?
Once you have clarified which lenders are most attractive, it’s time to prepare your pitch. The venture debt pitch should be slightly different than the VC pitch. Your lender will want to confirm that you have:
- Predictable valuation growth metrics
- Sound unit economics
- A strong VC syndicate
- Asset support for downside protection
Align your pitch accordingly, and you will address the decision factors most important to your audience.
The next step is the term sheet. As with an equity round, the more term sheets the better — you can then negotiate from a position of strength. Once you’ve settled on the lender and accepted terms, the lender will conduct due diligence — probably taking just a couple of weeks.
Under the right conditions, venture debt is a powerful anti-dilution lever. But as with all forms of debt, it carries risks. If you do your homework and if the math works, then, by all means, take the debt. Your management team will appreciate that you did.
- “Venture Debt”, Wikipedia, https://en.wikipedia.org/wiki/Venture_debt.
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