Avoid These 7 Mistakes While Raising Venture Debt
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Venture debt is a great option for companies who have nailed their value proposition, have established revenue traction and growth, and are ready to scale their company further while minimizing equity dilution. However, be sure to avoid the following mistakes while raising venture debt.
Mistake #1: Asking For Too Much
Starting at the top of the list is a mistake we often see startups make: asking for too much money. While a nice cushion of cash creates a comfortable runway, it does signal to the venture debt lender that you are trying to maximize the terms on your size and aren’t worried about paying the debt back. Raising too much money can also lead to disaster – resulting in budget cuts, firing rounds, and closing office spaces.
The general rule of thumb when it calculating the right amount of venture debt is either 1) 25-40% of your equity raise or 2) 3-6 months of cash runway extension.
Mistake #2: Asking For Too Little
On the flip side, asking for too little won’t set your company up to achieve its next milestone. Raising venture debt is all about propelling your company forward, which may help in raising your company’s valuations. Running out of cash will leave you vulnerable, so you will want to make sure you have an appropriate cushion of cash to tide you over in the event the company experiences a slow sales cycle or unexpected market conditions.
Mistake #3: Not Reviewing the Lender’s Reputation
Many founders fall under the risk of shopping around until they land on the cheapest term sheet they can get their hands on. Remember – venture debt lenders are in it for the long term and they will become the senior part of your capital structure.
When it comes to assessing a lender’s reputation, founders can often look at how long the lenders have been in the market. New entrants will typically offer very cheap term sheets. However, they don’t have an established track record of riding out the wave if things get bumpy and rough along the way. Lenders who have been in the market for a long time have a large incentive to protect their reputation, and therefore, are typically the better types of lenders to pursue.
Mistake #4: Prioritizing Cost Over Flexibility
While selecting the cheapest term sheet can be very enticing, you need to make sure the term sheet matches what plans you have for your company. If we take a look at the cheapest option, banks offer single-digit interest rates. However, these come with strict covenants in order to protect themselves and limits your use of the funds. This would be a great option if you are treating the money as a cheap insurance policy or are trying to dress up your balance sheet. However, if you have solid plans on how your company is going to use the money and why it needs it, you should use a fund lender instead. While they are more expensive, they are way more flexible and should be what you prioritize.
Mistake #5: Accepting a Short Term or Interest-Only Period
To get back to basics, one of the main purposes of venture debt is to extend your cash runway by a solid 3-6 months. In order to take advantage of this runway extension, you should stretch out your amortization period and interest-only period for as long as possible so that you don’t have to pay the debt back before you actually end up using it.
Target Interest-Only Period: 6-12 months
Target Term Period: 30-36 months
Mistake #6: Using Venture Debt As a Bridge Loan
If your company is experiencing a tough time and need some money to hold you over to the next round, moments like these should be reserved for equity investors due to the high-risk nature of these particular situations. Venture debt is not priced in a way that matches the risk-reward profile, which would result in additional covenants to limit the company’s use of that money.
Venture debt should be used when things are running smoothly and you just need an extra boost to extend your runway.
Mistake #7: Lacking Open and Constant Communication
The last mistake while raising venture debt is the lack of communication. As with any type of relationship, communication is one of the strongest themes that helps establish strong relationships. Companies should provide regular updates to their venture lenders to help ensure lenders are kept in the loop. If your company experiences a rough patch, do not go silent. Keeping open and honest communication with your lender will help establish trust and can be a huge benefit during tough times because lenders can help restructure the loan or offer interest-only periods.