• May 14, 2016

Venture Debt 101 for Startups

Venture Debt 101 for Startups

Have you considered venture debt for your business? If you haven’t yet, you might want to.

I sat down with a finance expert — our CFO-in-Residence, Craig Gainsboro — and got the scoop on what raising venture debt means for startups, what & when they need to consider it, how to negotiate the best terms, and more. Here are the top takeaways from our conversation.

Venture debt is exactly that – debt. You have to pay it back, unlike equity which is the typical method that comes to mind when we think of startup financing.

Who provides venture debt? 

A considerable number of banks and financial institutions, all which specialize in this type of financing.

Why is venture debt desirable? 

Venture debt is a no-brainer if you have liquidity and/or backing from an institutional investor.  The cost of venture debt capital is very, very low. If you’re generating a lot of revenue, you can get incredibly low interest rates. It’s essentially free money.

venture debt

Wait, wait, wait – it’s not actually free money right? 

No, it’s not. But, it’s a cheaper way to get financing from an interest rate perspective.

Why are banks giving money to startups, which are known for failing

Banks aren’t loaning money to startups because they’re good for it or because the bank is confident in their business model. Banks are loaning to startups that have access to the pockets of institutional investors, like a well-known VC firm. Banks are investing in startups with investors that will likely stick with their investment past the terms of the loan. They also know that most VC firms will give a startup a certain amount of capital, but include a reserve should the startup need more down the road. Basically, banks are betting on VCs bailing out a startup if needed.

So, it’s not available to any old startup? 

Sadly, no. And that’s an important message we want to get across in this blog — before you get into the process of trying to obtain venture debt, understand what the banks are looking for so you don’t waste your time.

OK, what type of startups qualify for venture debt then?

A great time to consider venture debt is after you’ve received a seed or A round of VC or institutional funding, as this is a pretty big requirement for banks. As mentioned, banks want to know that your startup has a well-known investor backing the business. Unfortunately for many early startups, banks won’t grant venture debt if you’re backed by unknown or angel investors. For example, even if you’ve raised $2M from friends & family and have a lot of capital to work with, you don’t have the reliable reserve from institutional investors that then insures the bank’s investment.

Another big qualification? Revenue. It’s very hard to raise venture debt pre-revenue, and banks will look to see if you’re breaking even or profitable. Banks might also look to see if they can grant you an asset-backed loan as part of the venture debt. So, they might loan against your revenue – a factor of MRR or a factor of receivables. Asset-based borrowings are limited by collateral base, measured by liquidation value of accounts receivable, inventory and fixed assets, instead of your ability to generate cash.

Finally, like traditional investors, banks will also evaluate the team and the product to determine if they see a fit.

Are there any downsides to venture debt?

While the interest rates can be quite low, you do have to pay it back. Additionally, you’re opening up your “financial kimono” to another large, external source that’s not your traditional VC or institutional investor. There’s a good deal of extra reporting that goes into keeping the bank happy. Most banks have you sending updates on a monthly basis – items such as monthly income statements, balance sheets and compliance certificates, annual tax returns, collateral audits, and more.

Speaking of collateral, lenders can take a lien against your assets – basically a right to keep assets until you pay them back. This sometimes even includes your IP assets though this is negotiable and should be part of your decision on the lender you choose to work with.

Finally, while the amount can vary based on the lender, you will have to cover the legal fees associated with securing the financing. Something to keep in mind when legal fees can be tens of thousands of dollars on top of your debt.

What are typical terms from a lender?

Terms can vary – Wikipedia does a solid job breaking them down and how they differ from typical bank loans:

  • Repayment: ranging from 12 months to 48 months. Can be interest-only for a period, followed by interest plus principal, or a balloon payment (with rolled-up interest) at the end of the term.
  • Interest rate: varies based on the yield curve prevalent in the market where the debt is being offered. In the US, interest for equipment financing as low as prime rate plus 1% or 2%. For accounts receivable and growth capital financing, prime plus 3%.
  • Warrant coverage: the lender will request warrants over equity in the range of 5% to 20% of the value of the loan. A percentage of the loan’s face value can be converted into equity at the per-share price of the last (or concurrent) venture financing round. The warrants are usually exercised when the company is acquired or goes public, yielding an ‘equity kicker’ return to the lender.
  • Rights to invest: On occasion, the lender may also seek to obtain some rights to invest in the borrower’s subsequent equity round on the same terms, conditions and pricing offered to its investors in those rounds.
  • Covenants: borrowers face fewer operational restrictions or covenants with venture debt. Accounts receivable loans will typically include some minimum profitability or cash flow covenants.

For the most part, startups shouldn’t have an interest rate higher than 4-5%. Most banks will charge an origination fee but this should be compared amongst providers – if they’re trying to charge you upwards of $25,000, that’s probably too high. Further, banks can also write into the terms that they can charge you ~1.5% on unused funds per year should you not leverage all the money.

Generally speaking, there is room for negotiation so don’t settle on terms you aren’t comfortable with.

Which are the best lenders to work with?

There are many, but we have a few lenders we typically recommend based on the size and stage of startup. Want a personalized recommendation on which lender to work with? VentureApp can help – fill out this quick form and we’ll get started.