• December 27, 2016

Extend Your Startup’s Runway: How Venture Debt Works

Extend Your Startup’s Runway: How Venture Debt Works

click-to-tweet

This post was contributed to VentureApp by Derek Ridgley, Credit Research and Development Officer at Silicon Valley Bank, a bank known for helping startups, enterprises and investors move forward, fast, with financial solutions for starting up, managing growth, expanding globally and more.

Venture debt is widely discussed in startup circles, but often misunderstood. For the thousands of startup companies we work with, venture debt has been a core part of our lending practice for decades. To help those that might misunderstand venture debt, we compiled this list of commonly asked questions to help explain the fundamentals.

Extend Your Startup's Runway- How Venture Debt Works

What is venture debt?

Venture debt is a catch-all term referring to loans that are tailored to the needs and the risks associated with investor-backed startup companies in technology, life science and the innovation economy. These loans are targeted toward companies that have raised equity from venture capital firms or similar institutional sources as opposed to capital raised from “friends and family.”

What makes venture debt different?

The majority of credit available to commercial borrowers is underwritten based on the amount of cash flow they generate. The second largest category provides short-term advances against liquid assets, such as accounts receivable and inventory, until they convert to cash. These asset-based loans focus more on the collateral as the source of repayment instead of cash flow. Neither approach works for startups that are pre-product or recently began generating revenue. The cash flow approach also doesn’t work well for revenue stage companies that consciously opt to maximize growth at the expense of profitability. Instead of focusing on historical cash flow or working capital assets as the source of repayment, venture debt emphasizes the borrower’s ability to raise additional capital to fund growth and repay the debt.

Wondering which venture debt provider is best for your business? Sign up for VentureApp today to explore providers with the best reputation.

Why does venture debt make sense for startups and fast growth companies?

The cost of equity fluctuates significantly in innovation economy business cycles but one thing stays true: debt is cheaper than equity. Thus, the primary benefit of venture debt is that it leverages the equity raised by a startup and reduces the average cost of the capital required to fund operations when a company is “burning” more cash than it generates. A secondary benefit is flexibility, since venture debt can be used as insurance against operational glitches, hiccups in fundraising and unforeseen capital needs, such as performance bond requirements.

Here’s how it works: If a Series A round of $10 million provides the new investor with 20 percent ownership (on a fully diluted basis), then the stake held by the existing shareholders is valued at $50 million. Let’s assume the company has a monthly cash burn of $1 million, meaning the Series A proceeds provide a 10-month runway. A venture debt loan of $3 million in this scenario might require warrants with dilution equivalent to 25-50 basis points (fully diluted). In this example, the venture debt would extend the operating runway by another three months. The venture debt loan, provides roughly 30 percent additional runway but carries only 1/40th the dilution, even with a 50 bps warrant in the pricing.

Is venture debt available to seed-stage and pre-revenue companies?

Yes, but availability depends largely on the type of investors backing the company. The typical venture debt borrower is a fast-growth company that has raised money from venture capital firms, or similar institutional sources, and has a defined strategy for continuing to raise capital. Many seed-stage companies will not align with this profile because of the composition of their investor base. Venture debt lenders focus their underwriting on the probability and the capacity of the existing “inside” investors to independently close one or more follow-on rounds, should the company prove unable to attract a new “outside” investors. Most seed investors fail to meet this standard either because they lack a committed capital base or because they don’t intend to participate in follow-on rounds.

When is the right or wrong time to raise venture debt?

When you are working on an equity term sheet, you should consider initiating a conversation with a lender about venture debt. Typically, venture debt is synced up to close a few months after a fresh round of equity. Raising debt when the company is flush with cash may seem counterintuitive, but in many cases the debt can be structured with an extended “draw period” so that the loan need not be funded right away. Regardless of when you want to actually fund the loan, your creditworthiness and bargaining leverage are highest immediately after closing on new equity.

Conversely, soliciting venture debt when liquidity is diminished and the operating runway is minimal will inevitably prove more arduous and more expensive. It helps to recall that the venture industry is highly cyclical and venture debt availability is highly correlated to industry valuation trends. The availability of venture debt and the variety of loan structure options will expand and contract in response to venture capital trends, the direction of valuations in your particular sector and the business cycle across the broader economy. Think of yourself as the proverbial “umbrella shopper.” The best time to test the market is when there isn’t a cloud in the sky, and the worst time is when the storm is already lashing at your windows.

What criteria do lenders use to underwrite venture debt?

Underwriting criteria are closely correlated to the applicant’s life stage and capital strategy. For early-stage companies with limited operating history, the focus is primarily on the investors and the characteristics of the most recent round of equity. The amount of venture debt is generally calibrated to the size of the equity round, and the company’s current and projected cash-burn rate. Companies with high burn rates are considered risker venture debt candidates because they are even more dependent on external capital to “fuel the burn.” The lender will also assess the track record and the amount of committed capital each existing investor has in reserve for follow-on rounds. For later-stage companies, the ability to attract non-dilutive capital from new investors is a consideration when setting loan price and terms, as is a proven track record of hitting product development and financial milestones.

How do venture capital investors evaluate venture debt?

Venture investors generally appreciate the role venture debt plays in reducing the cost of capitalizing their portfolio companies. Some investors view drawn venture debt as a way of signaling expanded liquidity and increasing momentum – helping to attract customers, vendors and talent. Others view undrawn venture debt as useful insurance to hedge against performance blips or valuation hurdles. Still others like the notion of venture debt as “other people’s money” since it leverages their equity. Regardless of their goals, experienced investors also understand that debt comes with trade-offs that need to be evaluated. Too much debt can create problems with next-round fundraising. Some new investors may balk at fresh equity being used to repay pre-existing debt. Financial covenants and tranched funding milestones also may limit a company’s strategic options and spending decisions.

How is venture debt priced?

Venture debt typically has three pricing components: the interest rate charged on the loan balance, an origination fee and stock purchase warrants granted to the lender. The all-in cost of varies significantly based on the lender’s assessment of the risk. Investors with an established track record and ample follow-on investment capacity compensate for the lack of company history and will lower the cost of venture debt for early-stage companies. Later-stage companies that demonstrate exceptional growth and rapidly increase enterprise value are more attractive to lenders. Companies in sectors with binary risks such as regulatory oversight or unproven technologies are less attractive. Loan structure also influences the pricing. Loans with more structure – financial covenants, milestones that regulate loan draws or broader lien rights – are more aggressively priced because they reduce lender risk.

What are the most common deal terms for venture debt?

Most venture debt loans are offered with a three-to-five year timetable and are sized based on the amount of equity raised in the most recent round. There are two key variables in venture debt term sheets: The length of time during which advances can be made (the “draw period”) and the length of time before the borrower has to begin making principal payments to amortize the debt (the “interest only” period). As these lengthen, lender risk increases as the borrower may use the loan as a bridge mechanism – drawing the loan only after all other sources of liquidity have been exhausted. This scenario reduces the interest earned by the lender and maximizes the outstanding loan balance at the point of greatest lender risk (when the price and availability of additional equity is unclear). Many term sheets also offer “deferred pricing” by requiring a back-end loan fee that is not paid until the loan matures or is refinanced. This feature allows the company to pay a portion of the all-in cost of the loan with next-round dollars instead of current liquidity.

Do loan terms differ based on company stage?

Yes. Early-stage investments are often based on the promise of a disruptive idea or new technology and the investors understand that there are significant execution risks involved in realizing that vision. As a result, early-stage investors are slightly more accustomed to supporting their portfolio companies through “inside rounds” when execution does not occur exactly as planned, or key milestones require more time than anticipated. Later-stage investments are premised more on the growth and product development record of the company. When execution falters, it can adversely impact the company’s ability to attract new investors, and the existing syndicate may struggle to adapt to the valuation pressure or increased need for capital that results from the loss of momentum. Thus, venture debt for later-stage companies typically has more stringent revenue or performance covenants and loan availability is tranched to performance or fundraising milestones.

Why do venture debt lenders include warrants in the pricing?

Venture debt is markedly riskier when compared to cash flow lending. Addressing these risks strictly by charging an appropriate risk-adjusted interest rate would consume too much of a young company’s precious cash to make sense. Warrant pricing seeks to true up the risk/return associated with venture debt while keeping debt payments manageable. Warrant pricing reduces the cash cost of repaying the loan and provides potential upside for the lender.

Do venture debt lenders typically take warrants on common or preferred stock?

Both. There are important differences in the voting rights and liquidation treatment of preferred and common stock. However, it is important to understand that the vast majority of venture debt lenders have no interest in exercising their warrants prior to a defined liquidation event. In this context, the advantages in voting rights enjoyed by preferred stock holders are largely irrelevant. Most venture debt lenders are willing to consider either form of stock as compensation and can gauge the relative value of preferred versus common stock, so they will adjust the number of shares they seek in compensation according to the class of shares the borrower prefers to use.

Is venture debt considered senior debt in terms of the lender’s security interest?

Venture debt is available with either senior (first position) or junior (second behind another lender) lien structures. It is important to understand that subordinated lenders (junior position) are taking significant incremental risks, and that those risks are reflected in higher loan costs. Another consideration is the structure of the inter-creditor agreement between the senior and junior debtholders. Some junior lenders may describe their loans as “covenant free,” for example, even though the junior debt is in default if the company defaults on any aspect of the loan agreement with the senior lender. In effect, both loans are covenanted.

Who offers venture debt?

Most commercial banks do not offer venture debt with any regularity. A few banks, including Silicon Valley Bank, specialize in working with innovation companies and their investors and consider venture debt to be a core product offering. The remainder of the market comprises debt funds.

What is a venture debt fund?

Banks use deposits to fund their lending activities. In exchange for access to this relatively cheap source of funds, banks are heavily regulated in terms of the types of lending and the amount of risk they can take. Debt funds, like venture capital firms, use equity invested by their shareholders or limited partners to fund lending activity. This source of capital is subject to much less regulation, but the cost is much higher. As a result, many debt funds are able to take risks that blur the distinction between debt and equity, but the cost of their loans is likewise much higher.

What are key considerations when selecting a venture debt lender?

As the adage goes: you’re only as good as the company you keep. In the venture industry, where risks lurk around every corner, this truism is apt. Given the dynamic environment and the high mortality rate of startups, predictability is one of the primary characteristics every entrepreneur should seek in key business partners. Are you talking to a lender with a solid institutional track record as a venture debt provider? What is their approach to managing through off-plan performance, missed milestones or a valuation squeeze? Do they have established relationships with the investors on your Board of Directors? It’s a rare startup that actually executes on the precise strategy and capital plan contained in their early- stage business plans, which means that transparency and predictability are the most important criteria to seek in a venture debt lender.

What is the biggest mistake entrepreneurs make when taking on venture debt?

Too many entrepreneurs focus their loan selection strictly on price and loan size. There is significant value in developing a partnership with a lender that has the experience and ability to be flexible and calm when companies encounter delays, strategy changes and missed milestones, which are inevitable for startups in the innovation sector.

Want to join 10,000 people from companies like HubSpot, Drizly, and DraftKings that receive our newsletter once a week? Sign up below.