What to Know Before Going Into Venture Debt
Entrepreneurs who are lucky enough to receive funding from a Venture Capital firm are eligible for a double whammy: Venture Debt. This obscure form of funding isn’t even tracked by the National Venture Capital Association, which publishes market data and statistics on venture capital.
According to Maurice Werdegar, the CEO of Western Technology Investment, venture debt makes up about 10% of the venture market, and it’s growing every year. Last year, venture capitalists invested $84.2B in companies. If Werdegar’s figures are right, this means that over $8B was lent as venture debt in 2017. So what is venture debt all about? This additional form of financing has its merits and some dangers to look out for.
What Is Venture Debt?
The idea of venture debt is simple. Offer a company additional capital in the form of debt to reduce the already heavy dilution suffered by the founding team. Take, for example, a new startup which has raised a seed round of $500K at a $2M valuation and then raised $8M through Series A at a $20M valuation.
At this point, the founders have given away X% to the investors. The entrepreneurs may still have a need for more capital to purchase equipment or fund advertisement for additional growth, but instead of adding to the dilution, the entrepreneurs chose to add some venture debt to their raise and save dilution for a future Series B round.
How Does It Work?
Venture debt is a debt offering in which a fund lends a set percentage of the last equity raise. The amount of the loan is usually around 30% of the last round. In the previous example, this would be $2.4M, bringing the total Series A raise to $10.4M. The terms of the loan are a little complicated. There is a cost for borrowing the money, a cost while the money is being loaned, and a cost to exit the loan. Plus, the loan has a period of interest repayment only, usually for a short term around 6 months, and then repayment and interest repayment over a 2 year period.
Venture debt is a short term financing instrument that costs around 20% of the loan over the two year period. The fund also receives a number of warrants, which if the company is sold down the road can turn that 20% into a 2X or more in terms of returns for the lender. Clearly, being in the venture debt business is lucrative.
When to Go Into Venture Debt
However, there is a place for venture debt in a capital structure for some companies. Most importantly, if a company needs to purchase equipment while in a growth phase and has eliminated the concept phase risk and found a product market fit, then venture debt will reduce the founder and investor dilution while receiving the capital needed to grow.
In an article with Inc, Elliot Bohm, the CEO of CardCash, talked about his company’s decision to go into venture debt, noting “[he] wanted to make sure that [CardCash] had the capital needed to buy enough inventory for the holiday season. But raising more venture capital in this scenario didn’t make sense…remember, holding on to equity isn’t just about maximizing your payout down the line. It’s about maintaining control over strategy and operations. Equity is precious. Giving it up to capitalize on a short-term opportunity, one that could be funded just as easily with debt, is a shoddy way to run a business.”
When to Avoid Venture Debt
That being said, the downside to venture debt can be devastating. Should the company default on any of the repayment terms or covenants, the venture debt managers can call the loan and force the company to be sold or liquidate. While this is rare, it is a risk.
Most of the time, the existing venture capital company that sits on the board will help renegotiate new terms, which can be costly. At this point, a company which may have had a bump in their plan will see the founder equity disappear while the venture capital managers need to raise additional funding or even sell the company to repay the debt, and whatever’s left is paid to the venture capital firm and angel investors. The founders get nothing.
Common advice regarding venture debt is “don’t raise capital through venture debt if you don’t already have access to capital.” Fred Wilson, a VC, wrote on his blog that “financing companies with debt when the company has no obvious means other than their VC investors to pay the loan back is bad financial management.”
Venture debt can also create problems in later equity rounds. When a company has venture debt and needs to raise additional capital with an equity round, the new investors will have to agree to either repay the debt or invest below the debt in order of preference. Both situations are not ideal for new investors who would rather see their capital go directly to the company, and they could be discouraged from investing.
Spinta co-founders Todd Schneider and Austin Dean further caution that raising through venture debt is a bad idea when a company has a high burn rate, variable revenue stream, the use of the loan is unclear, or the debt payments would account for more than 25% of operating expenses. Above all, a company has to pay off the loan, not get buried under it.
Why Do Companies Take On Venture Debt?
The allure to reduce dilution is attractive and addictive, as is the ability to quickly raise additional capital, even though it’s expensive. The thought that the company will not be able to meet its obligations is not considered.
All in all, venture debt is only for a very selective type of situation and company and should be carefully used by entrepreneurs. Ultimately, no one can predict the future, and even with a product market fit, entrepreneurs cannot predict the success of their company. Many times companies find themselves in trouble before they succeed, and venture debt is a nail in the coffin. Equity is the safest route in every situation, but the cost can scare young entrepreneurs.
Having a smaller piece of a big pie is always better than having a big piece of a small pie that no one wants to eat, so unless venture debt is a clear fit for a company, it’s best for that company to raise capital through more traditional means.
Editor’s note: This article was originally published in Forbes on May 13, 2018
