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THE FOUNDER’S GUIDE TO VENTURE DEBT

Venture Debt

An Attractive Financing Option for VC-Backed and Non-VC-Backed Companies

Also known as venture lending, venture debt is an attractive financing option for early and growth-stage companies. This form of alternative debt generally consists of a term loan lasting up to three years with warrants on company stocks.

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Table of Contents

Uses of Venture Debt

Extend Cash Runway

Top up your equity round with venture debt to extend your cash runway.

Prevent a Bridge Round

Borrow between venture rounds to fund new growth projects.

The Insurance Policy

An extra cushion in the event that a company needs more time to get to its next milestone.

Avoid Setting a Valuation

Finance your company without having to set a valuation.

Fund Large Capital Expenditures

A cheaper alternative to equity when funding purchases of equipment or acquisitions.

Bridge to Profitability

Eliminate your need for a final equity round to bring the company to breakeven.

Extending Cash Runway

Startups receive funding in stages (Seed, Series A, Series B, Series C, etc.), benefiting both the VCs and the entrepreneur. VCs reduce their risk by introducing multiple yes/no and valuation checkpoints while the entrepreneur reduces dilution by raising successive rounds at higher valuations. 

Each funding round is designed to get the business to its next funding round, allowing the company to achieve tangible development milestones. Funding rounds are typically designed to fund 12 to 24 months of operations. To help extend the cash runway of a business, venture debt can provide companies an extra cushion of cash in case of delays without significantly increasing dilution.

Read more about extending cash runway.

Preventing a Bridge Round

Bridge rounds are a small round of funding to hold a startup over until its next larger round of funding. These are structured as loans that convert into shares when the company raises its next round. Although this can be done quickly, it can be expensive could be a signal to new investors that the company did not hit its target in the time planned. Instead, venture debt provides no signalling risk, frees up the full amount of equity to be raised fresh at the round, and it does not require a valuation.

Read more about preventing a bridge round.

The Insurance Policy

As mentioned before, each funding round is designed to get the company to its next funding round. Before closing a round, VCs look at how much cash the company is forecasted to use (burn) to reach the next milestone. This amount is spread over the cash runway and the rate at which the money is spent is called the burn rate. 

Using venture debt can act as an insurance policy in the event the company needs more time to get to its next milestone.

Read more about the insurance policy.

Avoid Setting a Valuation

A valuation determines the present value of a company using a variety of factors such as financial projections, market value of the company’s assets, its capital structure composition, and the management of the business. This objective valuation is often used when negotiating with banks or equity investors. There are times when a business may be underperforming or market conditions change. This may cause concern that the next round of capital will result in a down round. Venture debt is a way of financing your business without having to set a valuation. Instead, it allows you to fund growth initiatives and achieve milestones so that the your company is in a better position for valuation at the next equity round.

Read more about avoiding setting a valuation.

Funding Large Capital Expenditures

Some growth initiatives require an amount of capital too small for an entire equity round, such as funding equipment purchases or even acquisitions. Venture debt can be used to fund these large purchases without depleting the company’s cash balance or going through a round of equity.

Read more about funding large capital expenditures.

Bridge to Profitability

For companies on the cusp of reaching breakeven, venture debt can propel your company forward during a critical period of growth. This form of financing is minimally dilutive and can completely eliminate the need for a final round of equity. 

Read more about bridging to profitability.

Founder’s Tip: Try delaying the drawdown period as much as possible. Delaying when you begin paying interest and principal extends your runway and reduces the actual cost of the debt. If you are unable to delay the draw period, try pushing for a 6 to 12-month interest-only period.

When to Raise Venture Debt

Post-Revenue

Venture debt is best suited for companies that are revenue-generating. This is important because companies need sufficient cash flow to be able to service its debt, including interest payments and principal repayments.  

Alongside an Equity Round

One of the best times to raise venture debt is alongside an equity raise. In fact, companies can lower their equity round amount and supplement it with a venture debt loan as a way to minimize dilution. The venture loan provides an extra cushion in the event the company needs more time to get to its next milestone, eliminating the need for an emergency bridge round or down round. Once the company is back on track, they can proceed with its next equity round.

Funding Large Capital Expenditures

Every round of equity financing comes with more dilution. If your company is in need of funding a large capital expenditure, such as buying a new piece of equipment or acquiring a business, but does not have the cash on hand to do so, it may make more sense to use venture debt. Debt financing will significantly lower your overall cost of capital. 

Bridging to Profitability

Using debt to propel your company forward during a critical period of growth can eliminate the need for a final round of equity financing.

When Not to Raise Venture Debt

If You Can’t Repay

If your company is performing poorly, lacks momentum, has a high burn rate, has a highly variable revenue stream, has less than six months of cash, and is considering debt as a last resort for funding, you not use venture debt. You should only raise venture debt if you have sufficient cash flow to service the debt, or if you believe you can successfully raise another round of equity in the future to repay the loan. 

If the Terms or Covenants Are Too Heavy

Before agreeing to a venture debt loan, you should have someone on your team model the cost of the debt and understand the impact of any covenants on the company.

If Your Investors Are Not Supportive

Although VCs are generally okay with venture debt, you should avoid it if you do not have the approval of your existing investors or board. 

Warrants in Venture Debt

What are Warrants?

Warrants are a security that gives the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period of time. Expiration dates can range anywhere from 1 to 15 years. 

Why Are Warrants Used?

Warrants are used in venture debt deals to further attract lenders. This “sweetener” is attractive because it enables additional participation in the company’s growth. Companies issue warrants because it can bring down the cost of financing (e.g. lower interest rate) and is a potential source of capital in the future when the company needs to raise more capital. 

Read our Guide to Warrants in Venture Debt

 

How to Negotiate Venture Debt

Principal Amount

Sometimes loans are needed to solve immediate cash needs, while other times the capital provides a support cushion. Before agreeing to a principal amount, be sure to take into careful consideration how much money you need, when you need the money, and most importantly, how much your cash flow will be able to support.

Payment Schedule

Venture debt is typically structured as a term loan involving interest payments and principal repayment over a fixed period of time. To delay paying back the principal, you can try negotiating an interest-only period. 

Cost of Capital

Lenders may charge additional fees and expenses, such as legal fees, commitment fees, final payment fees, or pre-payment fees. In case cash is tight, you could consider negotiating these amounts.

Covenants

Covenants are a list of do’s and don’ts lenders give while you owe them money. 

Do’s: List of compliance requirements (e.g. delivery of financial information, maintenance of insurance coverage)

Don’ts: List similar in scope to the veto rights demanded by equity investors

Default Events

‘Default’ status may be declared based on a list of events constituting a default. These will almost always include failure to make payments on time. However, the exact circumstances are subject to negotiation and should be discussed prior to signing the agreement. 

What Happens If I Can’t Repay the Loan?

Repayment

Pay back the loan using the cash on your balance sheet or equity from investors. 

Refinancing

Find another lender who is willing to refinance the loan. This involves giving you a new loan to repay the existing loan.

Restructuring

Try negotiating a more favorable repayment plan with the lender. If you are unable to raise equity or refinance, your company will be at risk of default. 

Although venture lenders do have the right to foreclose and sell off your company’s assets, they will try avoiding this by working with you and your investors to restructure the loan to provide more flexibility. It is in times like these where choosing the right lender is key. You want to choose a lender who is able to work with founders in a constructive way during tough times.

Choosing a Venture Debt Lender

Positive References

Prior to selecting a venture debt lender, you can try reaching out to current and past portfolio companies to understand how each lender acts during the good, the bad, and the ugly.  

Competitive Terms

Companies should aim to get the best terms they can get from the best lender. 

Timely and Dependable Funding

Entrepreneurs should be focused on growing their business and adapting to customer needs. Taking the time to select a lender who has a strong reputation of funding on time and per the agreed-upon terms can relieve unnecessary distraction from your company’s development.  

Partner Mentality

Commitment doesn’t end when the term sheet is signed and the transaction is closed. Select a lender that will be a good financial partner over the duration of the loan.

How to Apply for Venture Debt 

Pitch Deck

Creating a clear and concise pitch deck will provide venture debt lenders an overview of where you company is and where you want it to be. Make sure to showcase existing traction through post-product-market fit.

 

Historical Financial Statements

Since venture debt lenders focus on post-revenue companies, your income statement, balance sheet, and cash flow statement are important resources lenders will look through to gain insight into your company’s traction.

Pro Forma Model

Finally, lenders will be looking for a pro forma model, which show the financial projections for a specific period of time. These projections are based on hypothetical scenarios. For example, “what would my income, account balances, and cash flow look like with a $1 million loan?”

Read more about the 3 Documents You Need to Apply for Venture Debt.

 

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