In recent years the term “venture debt” has been circulated more and more frequently in startup entrepreneurship and venture circles. An innovation generally attributed to Silicon Valley Bank venture debt is now a relatively common method whereby entrepreneurs can extend cash runway beyond that secured as part of an equity fundraising round.
Considering venture debt financing?
Many of the startup focused banks, including Silicon Valley Bank, PacWest, First Republic, HSBC, Signature and others, offer venture debt solutions alongside dedicated venture banking services. There are also dedicated funds, such as TriplePoint Partners and Western Tech Investments, that have developed strong portfolios of technology companies using venture debt and similar investment structures.
Although a relatively well understood approach it is still important for those new to the sector to understand the basics and know what to expect in discussing and negotiating venture debt. We’ll cover these recommendations in the rest of this article.
There are other valuable and highly recommended resources available from leading experts such as Kauffman Fellows and Forbes. This article gives our perspective on venture debt based on experience in supporting high-growth venture companies through the fundraising process.
What is venture debt?
Venture debt is essentially a specialized term loan, providing capital up-front with interest rate and repayment term and so on. Warrants to purchase stock are almost always a component and form a major part of upside from the lender’s perspective.
The lender may issue the debt in tranches, with a guaranteed amount up-front followed by amounts contingent on meeting various milestones or performance objectives.
Terms are usually 18 to 48 months, with interest only and repayment periods, and interest rates vary depending on the nature of the lending institution. In reviewing term sheets you should look out for charge-through fees, pre-payment penalties and other contractual terms.
How does venture debt work – how would you qualify?
An important principle in venture debt to understand is why a lender is willing to lend in the first place. The majority of companies seeking venture debt are far from cash-flow positive and so repayment of the loan is unlikely to be from excess cashflow. Lenders, instead, base their assessment criteria on the likelihood of a subsequent round of equity fundraising. Accordingly, when in negotiations for venture debt a lender will look at historical financials and projections but will also perform diligence on the current investors and the prospects for the company to raise additional funds at a future date. In that respect, venture debt is very different from a typical bank loan or common convertible note.
Note that the identity of the investor will be important to the venture lender. They’ll correlate the strength and provenance of the company’s current investors with the potential for additional fundraising in a following equity round. Companies with solely strategic investors can still secure venture debt but it is markedly less common.
Why should you consider venture debt and what are the costs?
Cash and runway are of priority importance in a startup. Venture debt is a means to increase that cash and extend runway beyond what is funded with the equity round. It’s not always the case that securing venture debt is the best strategy, depending on your company’s progress and planned milestones it might be reasonable to manage to the runway provided by the equity capitalization only.
The eventual costs of the venture debt will vary. Drawdowns of the capital are not compulsory, there may be minimum fees associated with the debt but startups might not ever make use of the offered capital. Drawdowns can be timed to suit the company’s expected needs and then negotiate favorable interest rate package to limit actual cash impact of the debt.
The non-cash cost is typically in the form of warrants, and the dilutive effects of those warrants should be carefully considered. Some lenders will ask for warrants on common stock, some on preferred stock. A minimum warrant award may be linked to agreement on the debt package and then pro rata thereafter based on total drawdowns. These are very negotiable terms in venture debt, so be sure to position yourself by valuing the equity and opportunity for the lender to participate in the capital structure.
One approach to assessing the benefit and impact of venture debt is to compare the cash and dilutive impact of the warrants to just raising more equity. It’s often a very complementary solution but in some cases a company’s access to equity might make venture debt redundant.
Note also that lenders that offer deposit banking, such as the startup banks, will generally require the company to open bank accounts and deposit funds with that particular institution.
When is the right time for you to consider venture debt financing?
As described above it should be noted that the time to raise venture debt is immediately after closing on a round of equity capital. Typical industry norm is for total loan around 20-30% of the just-raised equity amount, assuming that that equity round falls into the typical categories of preferred stock and reasonable pre- and post-money valuations. It’s also the point in time where the company has the strongest negotiating position given the equity cash sitting in the bank.
Venture debt is now a fairly standard instrument in the startup marketplace. Recent economic growth and subsequent availability of capital has meant a commensurate increase in the number of venture lenders in the market, so it can be a very positive experience for startups seeking cash for extra runway. However, enthusiasm should be tempered by recognizing the underlying motivation for lending and the typical assessments lenders will make in considering whether to offer a debt solution.
And as with any financial decision, it’s important to have a clear understanding of what you’re getting into before signing on the dotted line.
It is always helpful to work with a CFO who can guide you through he complex world of venture debt and ensure you make the best decision for your business.
About The Author
Johnnie Walker is co-Founder of Rooled, which provides outsourced accounting, fractional CFO, and tax services to venture-backed and high-growth companies.
Johnnie was previously VP Sales with inDinero, providing fully outsourced accounting solutions to start-up, emerging high-growth, and established companies where he led sales and BD activities nationwide for the company. Previously, at tempCFO, Johnnie led the East Coast office and provided strategic CFO advisory services to technology ventures and other businesses.
Johnnie is also an Adjunct Associate Professor in impact investing at Columbia Business School also advises several startup businesses, focusing on financial management and investment strategy. Educated in business and engineering, Johnnie has held senior roles in the defense electronics industry, venture capital, and non-profit sectors.
You can connect with him on Linkedin here.