Deciphering Debt for Startups
A breakdown of when the right time is to take venture debt — and how to use it
For the high-risk, high-reward business of startups, venture capital plays an integral role in financing early-stage development. But as a company grows, establishing its technology and securing its first customers, the inherent risk profile reduces. For many, a complement to equity capital should be found, namely venture debt.
What is venture debt, and when should I get it?
Venture debt is often referred to as “growth capital,” which is exactly what it should be used for — growth. It originally grew out of the venture leasing product in the pre-dotcom era, with very few players offering it in the market. Venture leasing was when funds would provide leases to tech startups for everything from lab equipment to office furniture to microwaves. Ownership of the assets would stay with the venture fund, and the startup would simply make monthly payments. Over time, as the financing needs grew, it morphed into a debt facility known today as “venture debt,” with larger amounts available but blanket liens on all company assets. Venture debt is typically put in place alongside a recent round of equity; it is usually around 20% to 30% of the equity investment value. A typical structure would be an upfront interest-only period followed by an amortization period with overall tenures of 36 to 48 months. There typically are no financial covenants, and pricing would include the fee, interest rate and a warrant component.
The purpose of venture debt is to provide companies with an additional quarter or two of runway to allow them to hit additional milestones and raise that next round of equity at a higher valuation, as illustrated by the following diagram.
For a “Frontier Tech” company developing complex technologies, the extra time afforded by venture debt can be the difference between success and failure. Take Robotics-as-a-Service (RaaS) startups. In this model, customers enter various contracts and pay a subscription fee to use the robots. For the customer this is very appealing as they can more naturally match cost with usage, rather than pay a large capital outlay upfront. For the company though, this puts more strain on capital as the cost to develop and produce the robot will not be recovered for several periods, let alone a profit. To raise a Series A teams must prove they can to build a production-ready, low cost, simple machine. For a Series B, the machine must have above 95% uptime, repetitively execute the given task, and hold a meaningful shelf life. These types of milestones are difficult to achieve, so any extra time afforded is extremely valuable.
Silicon Valley Bank is one of the market leaders; along with some other early players in the market, we pioneered the venture debt product. The number of banks offering venture debt has historically been limited to those with a long-term presence in the tech ecosystem; they understand the ups and downs that early-stage tech companies experience in their life cycles and the interplay among the industry, technology, investors and founders. Traditional banks typically underwrite their debt facilities to cash flow, collateral and/or a guarantee — none of which early-stage tech companies have in abundance. As a result, most banks view the risk of lending to startup tech companies as too great.
Venture lenders have to take a different approach, underwriting to things like the management team, the product, investors, market traction and other potential value drivers. Ultimately, venture lenders need to take a position on the company’s ability to raise future rounds of equity because that will ultimately be the repayment source for the venture debt, assuming the company remains unprofitable. This criteria is evolving with the increased use of industry-specific key performance indicators (KPIs). For example, in the robotics industry, we’re starting to consider such KPIs as annual recurring revenue per robot and bill of materials per robot. The number of robots deployed, the useful life of the robot, and the payback period are also valuable considerations. Due to reducing hardware costs, companies now can deploy a robot to the customer for no initial fee and collect a monthly revenue in return. This model emphasizes a focus on unit economics to allow a greater customization of debt solutions and a better understanding of risk drivers. Another example is the emergence of micro-mobility solutions, such as e-scooters, have necessitated a new way of scrutinizing these types of startups. The payback period of an e-scooter is a little less than 4 months when taking into account all operating costs and based on a minimum of 5 rides per day. The challenge today, however, is maximizing fleet usage while finding hardware that can withstand more than 4 months of fleet use. In addition, the uncertain regulatory landscape emphasizes the need to dig deeper than the “typical” fundamentals.
Today venture debt is used for a wide variety of purposes, but in some ways it has again morphed into a general catch-all for financing needs — to accelerate hiring, capital expenditures, acquisitions, working capital and the like. This is because venture debt is very flexible. But for many of the purposes companies are using it for, it is not the best financing option. Banks like SVB offer products that match a specific need and are more scalable and cost-effective. As I’ve written about previously, we are dedicated to creating and structuring facilities that match our clients’ evolving needs.
When should I use venture debt — and when should I not?
Before deciding whether venture debt is the right product for your company, there are several things to consider.
Time to put it in place. The best time to start discussions is as you’re getting ready to close a new outside investor–led equity round, or within a month or two of doing so. It is always easier for lenders to put a commitment in place when there is a fresh injection of capital. It’s extremely difficult for any lender to put a facility in place if a company has less than six months of cash left and there is uncertainty around raising its next round.
The amount of debt to raise. A rule of thumb for Series A companies is that lenders are willing to give venture debt commitments equal to 20% to 30% of the previous equity round. Be aware that this is a rule of thumb and doesn’t always scale to Series B and Series C companies. Consider an amount of debt that provides you with a quarter or two of extra cushion or satisfies a specific need. It’s important to avoid too much leverage. When times are good and capital is flowing freely, more debt doesn’t seem to be such an issue. If the market gets tighter or the company isn’t performing quite up to expectations, however, venture debt can become a burden and possibly inhibit raising the next equity round.
The experience and added value of the lender. Selecting a stable financial institution with a track record of supporting its borrowers in good times and bad is key. All companies experience bumps in the road, so when that happens a lender that has the experience to work through these issues with the company is vital. A lender should have a broad platform that can scale with the company, provide the right debt products at the right time and have been in the market throughout several cycles.
When informed, venture debt is a valuable market product that can be extremely beneficial for companies. It is a cheaper alternative to equity and doesn’t result in dilution.
Remember, there is a time and a place for debt, and not all debt is created equal. To plan fundraising efforts and ensure that the process runs smoothly, the timing and the need of capital are critically important to understand. If you are a startup and thinking about debt financing, please feel free to reach out for advice.
