What is Venture Debt?
Trends in the Funding Landscape
Technology innovation, the proliferation of entrepreneurship, and global monetary policy have had a profound impact on the availability and diversity of funding sources for early stage ventures over the past decade. The startup renaissance continues to generate a steady stream of new ventures that can scale relatively quickly and efficiently using new technologies and sales channels. The confluence of an increasing number of startups competing for capital and yield-seeking investors chasing new options to deploy capital has inspired a robust range of funding vehicles.
A growing pool of successfully-exited entrepreneurs continues to create new investors eager to provide capital and acumen to catalyze new ventures. As the funding ecosystem matures, we see a blurring of lines between sources of capital, evidenced by the emergence of the terms “super angels” and “micro VC’s”. Exotic hybrid funding vehicles have emerged, including Y Combinator’s SAFE (Simple Agreement for Future Equity) and 500 Startup’s KISS (Keep It Simple Security). In addition, an element of democratization has been introduced with the emergence of crowdfunding portals that offer mainstream opportunities to support startup ventures.
These trends unquestionably benefit both local startup ecosystems and the global economy. However, with the rising number and complexity of funding sources, it becomes increasingly more important for rapidly-growing ventures to build their capital stack appropriately, thoughtfully and strategically. At each funding milestone, founders must evaluate current needs and options through the larger lens of long- term strategic objectives to preserve future flexibility.
Using Debt to Scale
Most high growth ventures require equity to adequately fund expansion; however, debt has become a critical component of the capital structure of equity-sponsored ventures. Venture debt is a specialty credit solution for growth stage ventures that have raised outside capital from professional investors, wish to leverage their capital structure with debt, and cannot access traditional credit markets. Venture debt offers a flexible, minimally dilutive option that is less expensive than equity and benefits both founders and early investors by extending cash runway and thereby delaying a future equity round until a higher valuation is achieved.
Venture debt is appropriate for rapidly developing ventures that have substantial growth opportunities but do not have historical profits, tangible assets or owners willing to provide personal guarantees for debt. These companies cannot access traditional bank financing, where credit decisions and underwriting models are premised on historical performance, tangible collateral, and the additional security of a founder’s personal guarantee or other forms of credit support (SBA guarantees, pledge of personal assets, etc.). When evaluating prospects, venture lenders weigh the probability of future investor equity rounds, reaching profitability, or a liquidity event (IPO, acquisition, licensing) as sources of repayment in lieu of relying on historical profits for debt repayment and hard assets for collateral.
Why Venture Debt?
In the credit food chain, venture debt sits between equity and more traditional forms of debt financing. It is a form of risk capital with a lower cost than equity when structured and deployed properly, and offers significantly more flexibility than bank debt.
Commercial banks with venture-lending groups offer forms of venture debt to early stage, cash burning companies that have raised venture capital from top tier venture capital firms. These lenders rely on investor support and enterprise value as proxies for profitability and hard assets, and risk analysis is closely tied to large, captive deposits provided by recently closed equity rounds. While commercial banks that extend venture debt offer the lowest rates (due to their lower cost of capital and additional income generated from low cost, sticky deposit accounts), these loans are typically limited to ventures with top tier equity sponsors that have long-term relationships with the bank.
Alternatively, venture debt is also provided by dedicated specialty finance firms that operate in a less restrictive regulatory environment and have a higher risk tolerance than commercial banks. These firms have a higher cost of capital because they fund ventures that are not credit candidates for banks, may not have top tier investors, or are experiencing investor fatigue due to slower than expected growth. Venture debt funds do not have access to a base of low cost deposit accounts as a source of capital, nor do they benefit from the additional income stream of deposit account transaction fees. Therefore, a higher interest rate is necessary for these funds to meet their investors’ IRR requirements.
When venture debt is utilized appropriately, the blended cost of capital is more attractive than relying solely on fully dilutive equity to fund growth, and the cost is captured at the next valuation.
Benefits of Venture Debt
The primary benefits of venture debt are:
- Minimally dilutive source of capital to fund growth
- Extends cash runway allowing venture to achieve higher valuation at next milestone
- Increases investor portfolio IRR by delaying equity rounds
- Preserves/enhances liquidity
- Attractive alternative to down round
- Does not require a valuation to be set
- Venture lenders do not require board seat
- Covenant light/free
- Less expensive and time consuming than raising equity
The primary components of a venture debt term sheet include:
- Generally structured as senior secured term loan collateralized by all business assets, amortized over 24-36 months, and includes warrants or exit fee
- Interest Rate: Priced to risk profile
- Draw period: 0-6 months
- Warrants: 8-10% coverage
- Back or front end fee: Varies depending on perceived risk and fund IRR
- Prepayment premium: Varies
- Covenants: None or light
- Reporting: Monthly and Annual GAAP Financial Statements and Annual Operating Plan
Is Venture Debt a good fit?
Venture debt is best utilized by accelerated or hyper growth ventures that are generating predictable revenue, have raised equity, have a high probability of raising a future equity round or reaching near-term profitability, and have a credible plan to deploy the funds to create a higher valuation at the next critical milestone. Venture debt is a funding tool that can facilitate rapid growth, drive valuation, and minimize dilution when sourced and deployed properly. However, in contrast to equity funding, debt creates a monthly fixed cash expense, must be paid back over time or refinanced, and assigns collateral rights to lender.
If you are considering this funding option, build the cost of the debt into your model, evaluate the lower cost and control relative to equity, and review with your investors. Once you have consensus that this is the appropriate funding vehicle, your investors can provide introductions to reputable sources.