Financings Options: Venture Debt
It's Monday, time for MBA Mondays and the next post in the Startup Financing Options series. Today we will talk about Venture Debt.
If there were two words less likely to be found together, it would be venture and debt. Startups are not credit worthy enterprises. They have little to no assets and no cash flow. Equity is the appropriate way to finance startups.
However, there is a large, growing, and vibrant market for something called Venture Debt. It is indeed debt, largely provided by a number of banks and finance companies who specialize in this market. The terms are usually three years, interest only, balloon payment, with warrants for the equity kicker. Now that I've just thrown out a bunch of buzzwords, I'll explain each of them.
The term is how long you have to pay back the loan. Three years is the typical term for Venture Debt.
Interest only means you pay the interest on the loan each month but you don't pay the loan down each month.
Balloon payment means you pay the loan amount in full when the term expires.
Warrants are like options, you get the right to buy equity at a fixed price for a period of time, usually five or ten years.
Equity kicker means an equity component to the deal to goose the returns.
So who can get Venture Debt? Venture Debt is available largely to companies that have secured at least one round of venture capital financing by a recognized venture capital firm or syndicate of venture capital firms. It is also available to more developed startups that are credit worthy by virtue of significant assets or cash flow.
So why do banks loan to startups when they have raised VC but not when they have not? The answer lies in the key understanding about Venture Debt. The banks are not loaning against the credit worthiness of the startups, they are loaning against the creditworthiness of the venture capital firm or syndicate. Basically the banks are betting the VCs will keep funding the company well past the term of the veture debt loan.
I'm not a fan of venture debt for early stage companies. If the startup is getting the money because of the credit worthiness of my firm and the other firms in the deal, then I'd rather be putting more equity in instead and getting paid for my capital at risk. I've told this to every venture debt lender who has come to see me so it's not a secret how I feel about this kind of funding.
I am a big fan of venture debt late in the life of the startup. It can be a bridge to a sale or a bridge to an IPO or can be used to fund an acquisition or some other value enhancing transaction. I encourage our portfolio companies to tap the Venture Debt markets all the time once they have become credit worthy on their own. It is smart to use debt vs equity when you can absolutely pay the debt back.
But 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 in my opinion and I am not a fan of it in the least.
Are there real examples you can think of that might help illustrate this further?
illustrate which aspect of the post?
Fred,As a background I am a C-level executive at a mature software firm and considering using venture debt to buyout the co-founders (who are majority owners).This is a great post and what would help are additional details. What interest rate do you currently use? How much in warrants do you give? Does there need to be collateral?Any examples you can provide would be much appreciated. Thank you.
We took on venture debt at my last company Majestic Research. We had 5 termsheets to raise a series B round and turned profitable sooner than expected. . .We put in place a debt facility instead which turned out to be a useful tool for growth capital and created a nice defensive cash cushion when the market melted down in 2008 and many of our clients cancelled.
“The banks are not loaning against the credit worthiness of the startups, they are loaning against the creditworthiness of the venture capital firm or syndicate. Basically the banks are betting the VCs will keep funding the company well past the term of the veture debt loan.”Great reason to have one or multiple VCs with a overall positive track record behind you..P.S. Have to leave now again for the day to yoga teacher training so can’t reply.. 4 days left! Party on Friday!!
Have fun, teach somewhere where I can take a class when you get back…
Maybe I can teach a yoga class in a park next time I visit NYC. Donation-based class for some local food charity or other. 🙂
I would totally do that!!!
Either in terms of recency of transaction, stage-agnostic, if it’s a great example. Or in the later case, where it was used as a bridge to a follow-on transaction.Assuming this was publicly disclosed, obviously.
Sorry if I overlooked this in your post: What happens if the startup goes under and VCs don’t invest more capital? Are the founders themselves (or investors for that matter) on the hook for repayment of the debt? Are interest rates much different than say personal or business loans?If not on both questions, then wouldn’t these kinds of loans act as free leverage on an investment? You (the VC) put in X, and then the company immediately secures more cash from the bank without dilution (well, I guess warrants count as dilution…) or risk of penalties for nonpayment?
Nobody is on the hook. The bank looses money
That is true, but not necessarily complete. In practice, the banks rarely let companies get to this point. As the senior money in the capital structure, they have a strong incentive to not let the company run down to zero. In my experience, these lenders typically include covenants in the debt that allow them to call the loans when the companies start to run into the earliest signs of trouble. In a lot of cases, these covenants create a situation where the company is in technical default even when they are, at least by the measures of most early stage companies, in fine shape. This can lead to emergency (read: expensive) financings from the equity investors, premature sales processes or other undesirable outcomes, even when cash remains in the bank. This is a real, if difficult to quantify, cost of taking debt.
Absolutely true with some lenders which is why, if you decide to pursue venture debt, it is important to go with a lender that doesn’t limit your operating flexibility and that doesn’t restrict how you use *your* capital once a loan is funded. It is also important to understand that there are three types of venture debt lenders: banks, private funds and publicly-traded specialty finance companies. The structure of private funds enables them to be highly risk tolerant, flexible and closely aligned with all equity holders.Disclaimer: I work for a venture debt fund.
Last year, my brother in law was pursuing this type of debt deal for a manufacturing start up. After much back and forth the bank tossed in that they would like the founders to pledge their homes as part of the deal. Needless to say they passed.
in the interest of clarity, was your bro-in-law’s company venture backed? It would surprise me if so, as most of the bank lenders who do venture debt deals don’t require personal guarantees or wrap up personal assets of the founder.
They were operational with cash flow but no VC round.
the bank is on the hook. i worked in the venture debt world at one point and its interesting to note that the loan losses for venture debt are typically around 1% of assets (similar to loan losses of normal commercial debt).
Why is that – does it have to do with the waiting to lend until close to the time the company goes public in general cases? So most of the risks have already been outlines?
It has to do with a few things:1. It typically takes 3-4 years to figure out if a venture-backed company is going to be successful or shutdown. by that time most if not all of the loan will have been paid down2. the lender tries to stay in close touch with the company and its investors and can react if it looks like the company is going to shut down.3. investors usually continue to fund the company to some sort of outcome where the bank typically gets paid back (asset sale, etc.)
Thanks, but it makes VC as an idea not such a brilliant one – despite therisk, why shouldn’t more people go for the debt (no dilution, so in a sense,cheaper capital)
Because the venture debt guys are really underwriting the reputation of the VC’s and loan a small amount on top of what equity investors put in. . . .
The loan becomes a senior obligation of the company, not of the founder/s, investors or any other party. If the company fails, the lender loses money; the lender is taking risk which is not too dissimilar from equity. As we learned in this last economic cycle, debt can cut both ways, so, while it is a very cost-effective complement to equity, venture debt needs to be used in an amount which is appropriate for the stage and commercial trajectory of the company. Venture debt is typically complementary to equity, but sometimes, particularly in the case of capital efficient business models, the equation is different for founders/management/employees than it is for equity investors.No capital is ever free. But it may be “free”. There is a shockingly wide range of behavior among lenders when start-ups go through the common “fits and spurts” of growth businesses, which is why it’s important to thoroughly reference your lender and chose one which has a long history of being flexible and risk tolerant.Disclaimer: I work for a venture debt fund. But I’ve been on the equity side and have used venture debt very successfully with early stage pre-revenue/pre-product companies to reserve additional capital for my investments while helping the teams I backed minimize dilution.
I can imagine that, apart of the hope of the VC putting in more money if necessary, banks consider being backed by a top VC as a sign of viability.That type of analysis where you follow someone just because you trust his judgement is dangerous because your interests may not be aligned and you may not understand the full picture. But, having the chance to follow a top VC in their investments blindly, I bet many of us would consider it, so I can’t blame the banks for trying.
I think you hit it on the head here – I believe VC backing is necessary because the lender wants some deep pockets if the investment goes sideways (similar to the buyout world, where some lenders only finance the top buyout firms’ deals). But in my experience, the venture lenders aren’t necessarily “blindly” following a top tier firm’s investments. Some lenders I have spoken to only lend to companies backed by who they perceive to be the top partners at the top firms, in their focus sectors, so there is some selectivity.
+1. Once you can afford to pay back the debt, it’s an amazing deal if you have a recurring revenue model, as the cost of capital (5-6% – wow) is going to almost always be cheaper than the ROI on deploying it. It was terrific for us. But it can’t on its own build a company or get you to lift-off. It only helps when you get to the stage you don’t actually need it.
as someone who works for one of the banks that lends to VC-backed companies, I can say that Fred is spot on in his description and can attest that he has indeed explained this view in person re: venture debt in early stage companies. It should be noted that there is an obvious counter to Fred’s view from the other side of the table (i.e. the entrepreneur). If a company needs cash and Fred believes in the company, he obviously wants to put more $ in to own more of it. Yet an entrepreneur may want to look into venture debt to avoid that dilution at that time, especially if there are meaningful milestones that will be achieved over the period of time that the debt affords, which would thereby increase overall value and minimize dilution. Regardless of how this plays out, it’s imperative that everyone’s on the same page – VC, entrepreneur, and lender – given the fact that the underwriting *is* very much predicated on relational and non-quantitative dynamics, especially for early stage companies.
A threesome sounds good but usually causes problems
touche – well played fred
Saucy! It must be the heatwave….
On Sunday voice texting discussion turned into casual sex, and on Monday venture debt into a threesome… can’t wait for Tuesday thread 🙂
i will do my best to continue the run
Can you hear the drums Fernando?Probably not, ever since turntable booted us 😉
Yeah, those were a few good sessions! btw, I’ve been in the US after the lock out and managed to make a list of the songs in my queue to recover some of the great weird ones. As soon as I get the time and put some order in the list I’ll send you an email with the names.
LOL – hard to align interests in a triangle!
Which is why it’s important to choose the right partners.
Absulateyl.. You can not do anything without a right partner.
I like this series.What I think it points out is that each type of financing has its sweet spot, and when you try and mix one for the other no matter how hard you try it doesn’t work.Debt is great when you are borrowing money to purchase an asset or leveraging a proven model and you want money to grow ahead of the curve.Preferred is great when you need money for a great idea that is going to grow very quickly, but you don’t have the assets/proven value for an investor to buy common shares.Friends and Family and Vendor/Customer financing are for when you have to do what you have to do and have relationships where people trust your word, more than they worry about getting paid back.All the other permutations, try to get one form to work as another. Disqus editing has serious issues today.
Venture debt…does sound like oxymoron.
Was wondering if you could perhaps write something about business plans and what one should think of etc. And also what to think of when having a possible investor who want to give you a soft loan if there is anything special to think about when it comes to soft loans. I’m wondering because we might have an investor from Saudi Arabia who might be interested in giving us a soft loan.
Seems to me that if a startup is lucky enough to get venture debt at an early stage – it may be seen as a poisoned apple for future investors
The killer here for an early stage companies are those warrants. Anyone willing to lend to a company on shaky financial ground is going to have quite a kicker and generally a mechanism to up the equity (i.e. lower the price) if certain milestones or payments aren’t being met. This can turn into a really ugly death spiral.Incentives can get disentangled very easily.
Agreed on early vs late credit integrity. Early stage cos with little or no current prospect to service debt should not borrow such debt. Many an entrpreneur and newly minted CEO (as well as co directors) have failed to oblige that a promissory note is a “promise to repay”. The banks that play in this space make money on deposits and ancillary bank services; without that it’s a money losing business. The Fincos and other entities that play in the early stage space must typically have an anomaly in the portfolio from a warrant (much like a fund maker in a venture fund), otherwise, they won’t generate alternative asset return expectations and won’t stay in business — I’ve seen players come and go over the last 15 years. As well, when a company has become credit worthy (market acceptance occurring, execution risk vs technology risk is omniprensent and FCF on the horizon, etc) it should look for a financing partner that has a long-term view with a stable capital base.
Here is a similar storyVenture Debt Tips And TricksStrategic Tranches – Many venture debt providers will allow you to draw down the money you borrow in multiple allocations. Seek maximum flexibility by expanding the length of time you have access to the funds and minimizing the amount of money you must accept upfront.Death By A Thousand Fees – The more you need the money, the more expensive it will be. The true cost of debt is often obfuscated by the inclusion of numerous, arcane fees. Rather than trying to negotiate each individual fee, consolidate them and negotiate the percentage that the fees represent of the loan’s size.No Early Payback Penalties – Many venture debt lenders attempt to discourage early payment off their loans with onerous penalties. Although an early payment fee of 1% of the entire loan amount is common, refuse to accept such a provision.Read more: http://www.businessinsider….
In The Netherlands I see a surprising number of straight loans being made to seed and early stage startups by the big banks. Large principal. Low interest. No warrants or whatever. However, backed by a partial government guarantee. Fred, will you post something about that type of financing?
When you say “I’m not a fan of venture debt for early stage companies” how would you define “early stage”?Pre …Series A? …$Xm revenue? …$Ym profit? …Positive net cash flow?Nice piece, as always, now I am officially buzzword compliant on venture debt 🙂
The Venture Debt providers I have worked with also seek as much cash or liquid collateral as possible (CDs, DDs or LCs), often asking to be “over” collateralized. They are well protected. Agree with Fred, this is not a great structure for a startup, but it does have its place for companies that are earning cash flow.
Fred, perhaps you’ll write on the cousin of VC debt, royalty based financing schemes, sometimes, also called venture lending. I used it in my 1st fund, royalty structures, to overcome limitations in Michigan & with the VC model, how finance medium growth companies that would not get big enough, fast enough for liquidity, family held businesses that don’t want outside shareholders and the inability to predict if a company will in fact, create a liquidity event. Later I used it in emerging markets, countries with no or inefficient capital markets; how get them the $ for growth & development. I wrote an article on this technique of the European VC Journal, a bit old now, but fyi for you and your readers. http://www.ivipe.com/ivi/pa…
Well thought out post as always. I wish I would have hadaccess to a resource like this back in my entrepreneurial days.We far too often see companies that haven’t thought throughcapital implications and instead are looking for fast and cheap capital. That’s obviously a downwards spiral.Capital ought to be ‘matched’ to the activity, lifecycle phaseand risk in order to best be deployed and utilized properly. Just as you wouldn’t purchase naked optionson a credit card (or at least the vast majority of us shouldn’t!), companies shouldn’ttake on debt when starting a company, pre-revenues, launching a beta product,etc. That’s not good matching and that activitywould be better suited for an equity investment, where there is a longer timehorizon.Debt should be the investment vehicle around the time thatthe market and tech risks have largely been solved and an execution opportunityis present. Debt capital is appropriateat this point when there is good revenue visibility, they are at the bottom ofthe J curve, there is a value added acquisition prospect, etc., and when a latestage dilutive round isn’t going to benefit either the founders or earlyventure investors. What metrics do you look to when helping a company evaluatetheir options as far as leverage?Keep the MBA Mondays coming – Your ‘school’ would certainlybe ranked in the Top 10 MBAs given that cost to value is such a huge componentof the rankings! Thanks.
“The banks are not loaning against the credit worthiness of the startups, they are loaning against the creditworthiness of the venture capital firm or syndicate. Basically the banks are betting the VCs will keep funding the company well past the term of the veture debt loan” This is the most clear explanation of venture debt I’ve seen. Thanks Fred.So when building that financial cushion to bridge your company from early state to maturuty, how can you best leverage venture debt to continue raising capital, especially when your startup does not have a fee-for-service model?
“I’m not a fan of venture debt for early stage companies. If the startup is getting the money because of the credit worthiness of my firm and the other firms in the deal, then I’d rather be putting more equity in instead and getting paid for my capital at risk”i think i’ve seen this firsthand. a startup i worked with took venture debt before they had uncorked revenue and turned profitable. as the company worked to dial in the right model, the monthly debt service became a drag on their burn rate diverting precious cash away from efforts to grow. unfortunately the company was never able to completely turn the corner. It certainly wasn’t entirely the fault of the venture debt deal, but it didn’t help at that stage.Ironically, when the company was eventually acquired, for an amount less than it had taken in, the venture debt that was least helpful was the investor who made out best – all their money back and then some.
There’s another debt alternative for early stage businesses (venture-backed or not) in the form of A/R finance. For companies which have revenues, particularly advertising-derived ones which are saddled with lengthy payment terms, A/R finance can provide substantial leverage without equity dilution inuring benefit to the founders and VC’s alike. Obviously this strategy doesn’t work in all instances, but it’s definitely an option that is often overlooked and avoids many of the objectionable components of traditional venture debt.
Not sure I agree that venture debt is not appropriate for early stage companies. Two reasons: 1) VCs want returns on their capital. Thus, let’s say a VC puts in $5 million to a young company. Does the VC want that company using that equity capital to purchase office furniture and equipment or to rent additional space? Not going to get a return from those purchases. Or, would the VC prefer that the company use those funds to commercialize their products, develop new markets or attract new customers? That is where the returns come from.2) Even the SBA has been working with VC companies to provide venture debt through their SBIC and New Market programs – which lends a little credibility to the benefits.