Read this before securing your Series A
Venture debt financing has increased markedly in recent years as startups have taken advantage of the low-interest rate environment. Despite the surge of activity, venture debt is largely misunderstood even by experienced entrepreneurs. At Emergence, we have helped dozens of our entrepreneurs secure different types of venture debt facilities as part of a comprehensive financing plan. Here is our quick guide to understanding and negotiating a Series A venture debt facility.
What is a venture debt facility and why should I consider it?
A venture debt facility is a flexible form of financing provided by banks and dedicated venture debt funds to early-stage startups. A venture debt facility is an option for a specified period of time (12–18 months) during which a company can draw down a predetermined amount of capital. If the company exercises the option for debt, then a loan is created and that capital plus interest needs to be repaid over time. Once drawn down, venture debt is senior to equity and, as such, is repaid first in the event of an exit or bankruptcy.
Many entrepreneurs falsely assume that debt financing should only be pursued as a last resort. In reality, venture debt presents a low-cost alternative financing option for startups. It offers several key attractive features over other funding options. First, in contrast to equity funding, a venture debt facility is non-dilutive and can be secured quickly. Second, the terms of venture debt are much more flexible than traditional debt financing or equity financing. For example, venture debt investors are passive and, as such, do not require board seats or observer positions. Most importantly, venture debt facilities provide a low-cost option for additional capital that startups can choose to use or not. Given that cash is the lifeblood of a startup, we believe having this option is critical.
Most of our startups do not execute the option to draw down their venture debt. However, for the ones that do, the most common use case is to extend their cash runway in order to achieve a meaningful milestone prior to an equity fundraise. Venture debt should not be considered a replacement for equity. Rather, companies should consider it a compliment to a Series A financing that can extend their runway. Venture debt is most effective when it is raised shortly after the Series A round as all due diligence materials are ready and the lender is making a commitment based on the Series A investor’s enthusiasm.
While venture debt can be a great option for startups, it is not for everyone. Should a company default on any of the repayment terms or covenants (if applicable), debt providers can force a company to sell or liquidate.
What are the key terms?
Venture debt facilities include several key terms:
- Loan amount. The amount of capital available for a startup to draw down, typically ~$2–4MM (25–40% of the Series A)
- Drawdown period. The time during which a startup can exercise the option to draw down capital. During this period, the company is only responsible for interest-only payments (on drawn capital). The typical drawdown period is 9–18 months.
- Term. The time allotted to repay the loan principal plus interest, typically 24–36 months after the drawdown period has ended.
- Interest rate. The annual interest rate to be paid, typically tied to WSJ prime rate +/- 1% for banks.
- Fees. There may be various fees listed on term sheets including: Prepayment fees charged for early repayment of the loan (typically up to 1%); a final payment fee required upon repayment of the loan (typically up to 3%); and, closing costs required to complete the loan process (typically $5 — $10K).
- Warrants. The right to purchase shares of the company’s common or preferred stock at a given price. For Series A venture debt facilities, warrants typically represent 0.1% — 0.2% dilution. Warrants are either expressed as a % ownership or as % of loan amount (coverage). If, for example, warrant coverage is 6%, the venture debt line is $2M, and the warrant has a strike price of $2/share, then the lender would receive: (0.06 * $2M) / $2 = a warrant for 60,000 shares.
- Covenants. Any financial or non-financial provisions that require the company to reach a certain target or prevent the company from making specific decisions (selling the company, for example). While Series A venture debt covenants are typically minimal or nonexistent, they can exist.
How should I go about securing venture debt and negotiating the best deal?
When securing a venture debt facility, entrepreneurs should first enlist the assistance of their Series A investors. Ask your investors to recommend and facilitate introductions to two or three banks that offer venture debt financing (Silicon Valley Bank, Square 1 Bank, and Bridge Bank are among the more prominent options). These banks are largely underwriting the venture debt facility based on the reputation of the venture investor so introductions are critical. Over 2–3 weeks, interested banks will conduct due diligence and submit a term sheet.
When negotiating venture debt terms, we recommend optimizing flexibility above all else. As a result, we recommend startups focus on the following key terms in this order: The drawdown period. Given that venture debt is an option to extend the runway, we advise our startups to extend the drawdown period as far as possible. This enables a startup to have the longest option period and delays principal payments so you extend cash runway. Warrants. Warrants provide the upside for lenders offering low-cost financing so you cannot negotiate them away completely. However, you can structure the warrants to align with your interests. For example, you can target warrants for common shares versus preferred shares. You can push to have a portion of the warrants issued at the closing of the loan and the balance issued at drawdown (or even proportionally to drawdown amounts). Loan Amount. We advise our startups to target a loan amount that will provide at least 6 months of additional runway (with 9 months being preferred). Sometimes this requires adding milestones so the bank feels comfortable unlocking a larger amount.
Fees. Banks have to earn a return on capital so you cannot eliminate fees. However, you can align fees with your motivation to extend the runway. For example, you can opt for a lower interest rate and a larger final payment so the rate of return is identical to the bank but the timing of your payments extends cash runway.
In addition to negotiating terms, it’s critical to consider your debt provider as a capital partner for the long term. You should conduct your diligence to ascertain how different providers have worked with similar clients in the past. You should understand what other types of services banks can provide that may benefit you (such as international banking or corporate credit cards). Finally, it is important to understand how a lender will act in a downside scenario.
For Series A startups, venture debt facilities offer a flexible complement to venture equity. By securing a venture debt facility after your Series A, you’ll have an invaluable option that can extend your runway when you might critically need it.