Ten Questions Every Founder Should Ask Before Raising Venture Debt
There’s an adage that says your first job as a startup CEO is to make sure your company never runs out of cash. When financing a growing company,venture debt can be a great supplement to venture capital. Much has been written to help founders think through venture capital, but venture debtremains a bit of a black box.
That’s why we partnered with our friends at Columbia Lake Partners, a leading European venture debt fund, to put together a white paper that helps startups approach venture debt in a thoughtful way. Here are ten questions you should ask when considering venture debt:
1) Why venture debt?
Venture debt is provided by banks or dedicated venture debt funds as a complement to equity financing. It is typically a lump sum of money that is repaid over time and can act as an attractive way to finance a business with less dilution than equity. It has a number of nice qualities—it doesn’t require a valuation to be set for the business, venture lenders don’t take board seats, and there are few governance requirements. But like any loan, venture debtdemands interest payments and needs to be repaid over time.
2) When should I raise venture debt?
There is no “one size fits all” approach to venture debt, but there are four common use cases:
a) Extending the cash runway of a business to hit the company’s next milestone (e.g. you’ve raised $10 million of equity but think you may need $15 million to get to the next major milestone)
b) Preventing the need for a bridge round or a down round to get through a tough period
c) Funding large capital expenses, acquisitions, or providing a bridge to profitability
d) Acting as insurance in case it takes longer than expected to execute on the company’s plan
Most companies raise venture debt immediately following an equity financing, when it is most accessible, all of your diligence materials are fresh, and your business has momentum.
3) When should I avoid venture debt?
It’s a bad idea to use venture debt if any of the following apply:
a) You don’t think you can repay the debt by refinancing or raising more equity
b) The terms or covenants of the loan are too onerous
c) Your venture investors are not supportive
4) What terms should I be thinking about when raising venture debt?
Here are the key things to consider:
b) Duration (when does it need to be repaid?)
c) Price (what are the fees and interest rate?)
d) Covenants (what are the financial and non-financial requirements?)
e) Amortization (when does the loan start being repaid?)
Banks will have the lowest rates, so first talk to banks and then approach venture debt funds if you want additional capital.
One of the most impactful things you can do when using venture debt is to try to delay the time when you draw down the loan. This allows you to push back the timing of when you have to start repaying the loan. It’s not immediately obvious, but this small change can have a dramatic impact on your cash runway and the cost of debt. We’ve created a handy Venture Debt Model to help you assess the value of the delayed draw down and the effective cost of venture debt.
5) What is considered “market” for these terms?
|Interest Rate||Banks: prime (currently 3.5%) + 0-4%; Funds: prime + 4-9%|
|Amortization||Within 12 months of when a loan is drawn down|
|Warrants||Banks: <1% dilution; Funds: ~1% dilution|
6) How should I react to covenants?
Non-financial covenants are common. Be cautious around financial covenants, which act as financial tests that must be met or else your company will be in default.
7) What happens if I can’t repay the loan?
When the time comes to repay the venture loan, you have three options:
a) Repay: Use cash on your balance sheet or equity from investors to pay it back.
b) Refinance: Find another lender who will refinance the loan.
c) Restructure: Negotiate a repayment plan with the lender.
If things are going well, repayment or refinancing is easy. But if your company is in trouble, you will need to work with your lender to restructure the debtand avoid default. Once you are in default, the lender has the ability to foreclose on your company.
8) How do I decide which venture lenders to work with?
The most important thing to research when choosing a lender is how they’ve behaved in the past. In the event that things go south, you want a lender who will work with you to restructure the loan rather than forcing a sale or onerous terms as part of a restructuring. You should conduct reference calls on the lender to see how they’ve behaved in tough times with other companies.
9) What is the venture lender’s typical diligence process?
Venture loan diligence resembles the venture capital diligence process, although less intense. Be prepared to provide much of the same information you provided in your venture capital raise.
10) What’s the best way to run a venture debt fundraising process?
Much like the venture capital world, you need to talk to a number of different banks and venture debt funds. We recommend engaging a venture lawyer who will have a feel for what is “market” and will be able to advise you on getting the best possible terms. And just as you would with an equity round, make sure you have a few horses in the race so you can negotiate the best terms.
Venture debt won’t be the right fit for all companies, but if structured properly, it can be a less dilutive way for you to finance your journey to the next milestone.