A Founder’s Guide to Venture Debt
Building a strong runway for your startup
The CEO job is four-pronged: 1) setting strategy, 2) recruiting talent, 3) driving business growth, and 4) maintaining runway. This latter role is often evaluated through the lens of how to raise venture capital and what milestones you need to hit to raise subsequent rounds. Less discussed is the role that venture debt has to play in strengthening your bank account.
At Inovia Capital, we’ve been educating ourselves and our founders on this source of capital. Over the past decade, our portfolio companies have collectively raised over $300M in venture debt and credit facilities. We’ve shared best practices with our portfolio companies, and now we’re opening that up to the broader startup community. The guidance offered in this piece skews towards early stage companies where debt deals are relatively straightforward and don’t have the same range of variance. In this post, I’ll cover why to consider raising, how lenders differentiate themselves, what market rates look like, and what you can expect to negotiate.
Why raise venture debt?
Most rationales for raising venture debt can be broken into four buckets:
- If you realize post equity raise that you would benefit from extending the cash runway of your business to hit the company’s next milestone (e.g. you’ve raised $10 million of equity, but realize you would have been better served by raising $15 million to get to raise your Series B at an appealing valuation);
- Somewhat related, raising venture debt can help prevent the need for an equity bridge round or a potential down round to get through a tough cash crunch period without creating a negative signal;
- If you’re funding capital expenditures or company acquisitions, venture debt can be a cheaper way to fund those initiatives; or
- Acting as insurance! Right now, interest rates are relatively low in both Canada and the US, and arming yourself with additional cash reserves can be relatively cheap.
Note to self: Do not raise debt if you need to use the proceeds of the debt facility itself to repay the debt! Debt is not to be taken lightly as it is ahead of equity in terms of repayment, and is expensive if you don’t have the cash flows to service it!
If you’re concerned about being able to repay the debt when it becomes due, or believe the terms are too onerous, then raising debt is a bad idea. Unlike equity, debt needs to be repaid and your lenders have a much lower level of tolerance for default. Discussions with venture debt providers can also offer you a window into how your business is viewed by financial investors in a context which is different from an equity fundraising process. If you’re only able to access capital at prime + 4% (ie at an expensive price), you’re likely viewed as a risky or slow-growth business.
How do FIs differentiate themselves?
There are three main gating criteria when you’re evaluating different FI partners:
- Product offerings: Many debt providers offer slightly different products, including: 1) Revolving lines of credit (a line that the borrower can draw on when needed and pay down at will), term loans (a lump sum repayment), MRR lending (typically a line of credit where the amount available for borrowing is tied directly to the borrower’s MRR), convertible debt (under certain conditions, the loan is not repaid but rather converted to equity, more commonly issued from large organizations that both invest and offer debt than from traditional FIs), and products that smooth cash flows in anticipation of future income sources (ie. R&D tax credit financing and purchase order financing)
- Stage: Different lenders are comfortable funding businesses at different stages in their equity financing lifecycle. Lending partners will express this in both stated round size (ie. Series A and above) and company proximity to profitability (ie. will fund companies that have a credible plan to be EBITDA-positive within 24 months).
- Sector: Some lenders will only fund B2B businesses or companies with recurring cash flows, others may not be comfortable with hardware businesses, and some are sector-agnostic.
These features are set in stone, and you’re unlikely to convince a firm that specializes in MRR lending to fund your non-recurring hardware business. However, once you’ve evaluated lenders that match your criteria on those three dimensions, you should also be mindful of two other factors:
- Covenants: Each FI will impose different covenant requirements. The more covenants and the more onerous they appear, the less risky the lender likely is;
- Decision-making process: Every firm will ask for different data points and have a different approval process. The closer you are to having completed your equity fundraise, the easier this process will be for you as generally debt providers want similar information that you’ll already have pulled together for your prospective VCs.
Canadian banks, such as RBC, National Bank, TD, BMO, and CIBC, are increasingly active and aggressive, mirroring their US counterparts like Comerica, SVB, JP Morgan, Square 1 Bank, and Hercules. They all have solutions, but each offer slightly different credit facilitates. We’ve worked with all of them at Inovia, and you will need to find the one that’s the right fit for your company; you need to understand the nuances of your business and find the right partner given those factors. As a firm, we have undertaken a deep analysis of the comparables and provide coaching to help portfolio founders evaluate each lender’s specialty to understand how to make the best decision for their companies.
What can I negotiate?
The factors above aren’t likely to be negotiable, with the exception of covenants, which you may be able to negotiate (more on this below). However, depending on your negotiating power (ie. your company performance and relative competitiveness amongst debt providers), you can consider these factors in your discussions:
- Size of the loan: This is likely determined through a calculation of your balance sheet and/or monthly revenue, but you may be able to increase the loan size a bit. If you’re looking to reduce the debt on your balance sheet, focus on making sure that there’s no minimum drawdown amount (or that you’re comfortable with that amount).
- Timing: When the loan has to be repaid, when the amortization period begins, and when a forced drawdown period come into effect all impact your economics. Similarly, you may be able to negotiate if the loan is revolving or not, the dates of fixed drawdown periods, and if you have fixed drawdown dates at all. Be mindful of forced drawdown periods. The longer you delay a drawdown, the more you delay repaying the loan which increases your runway and reduces the actual cost of the debt.
- Cost of capital: Pay attention to the interest rate, as well as other fees/costs. Legal and closing costs are common, but you might also see fees that take effect when you first borrow or standby fees on any undrawn capital.
- Warrants: The number of warrants and the price at which they’re granted are negotiable, although if a lender is looking for warrants as a condition of the loan, you’re unlikely to negotiate them away altogether. Warrants are dilutive and you’ll be repaying them through your sale/IPO proceeds, rather than repayment cash flows. However, don’t forget to factor them into your cost of capital calculations.
- Covenants: Revenue and burn covenants are common, although different lenders may have a different ratio or metric they use. Make sure that you’re able to stay above those minimum values, but differentiate between covenants that are helpful indicators of business health and those that are overly punitive in your negotiations. Instead, gain clarity on the consequences of failing to hit those covenants.
When to raise?
You’ll be in the best position if you kick off a raise within 6 to 12 months after an equity financing, while your cash runway is still over a year. Raising too early simply becomes a cost to your company as the debt isn’t put at use, yet fees are being paid (unless you’re able to delay repayment until your first drawdown). Having freshly updated diligence materials and momentum (with cash in the bank) will positively impact loan pricing and accelerate the process.
Debt providers actively rely on the credibility of investors on a company’s cap table to help them diligence opportunities. A top-tier VC will send a strong signal, especially as an early stage company that doesn’t have substantial revenues or still has meaningful technology risk. At Inovia, we frequently spend time with debt providers who are proactively looking for insights into our portfolio companies that may have future debt need. Looping your angels and other investors into the venture-debt process is a good idea and can help speed up your process.
Words of wisdom: “Don’t run out of cash!”
