Venture Debt 101

Venture debt lenders expect returns of 12–25% on their capital but achieve this through a combination of loan interest and capital returns. The lender is compensated for the higher rate of perceived level of risk on these loans by earning incremental returns from its equity holding in companies that are successful and achieve a trade sale or IPO. SVB shares best practices and insights to help you understand how venture debt works. Too many entrepreneurs focus their loan selection strictly on price and loan size.

There’s often not enough work for a seasoned SaaS CFO to come onboard full-time until the business has achieved economies of scale and there’s a certain level of predictable growth. A CFO looks towards the future, and supports the business with planning and strategic decision-making for growth and value creation going forward. In 2012, I joined one of our clients, Ares Capital, to help provide debt for acquisition of established public software companies taking private. Efficient liquidity management and robust liquidity position signify financial prudence. In all predictable use cases, replacing equity capital with debt is more efficient . We encourage companies to get the best terms they can, but more importantly, to choose the best partner. We also recommend viewing each financing option as a single solution, even if comprised of multiple financing vehicles, and comparing holistically with other financing alternatives.

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Yes, but availability depends largely on the type of investors backing the company. The typical venture debt borrower is a fast-growth company that has raised money from venture capital firms, or similar institutional sources, and has a defined strategy for continuing to raise capital. Many seed-stage companies will not align with this profile because of the composition of their investor base. Venture debt lenders focus their underwriting on the probability and the capacity of the existing “inside” investors to independently close one or more follow-on rounds, should the company prove unable to attract a new “outside” investors. Most seed investors fail to meet this standard either because they lack a committed a capital base or because they don’t intend to participate in follow-on rounds.

There are many instances where venture lenders have complained that companies were not forthcoming about their circumstances and did not provide relevant information such as their cash burn, or the loss of a significant lost contract. It does not help a company to hide from its lenders – the worst possible way to treat your lender is to make them think that everything is going according to plan, and then drop a bombshell on them when it’s too late to course-correct. Because there may be ways to restructure debt, it inures to a company’s benefit to treat its lenders fairly. Second, after understanding the basics, founders should consider evaluating multiple venture debt lenders in order to make the process competitive.

Overview Of Venture Debtfor Technology And Growth Companies

Venture debt can extend the cash runway of a startup company to achieve the next milestone achievement prior to their next equity raise, resulting in a higher valuation and less equity dilution. The best time to raise venture debt is concurrent with or immediately following an equity raise. Momentum is strong, diligence materials are in-hand, and cash is in the bank. Venture debt can augment a portion of the equity need and minimize equity dilution. In addition to minimizing equity dilution, the process was easier and materially less complicated than equity financings I have experienced in the past. There are important differences in the voting rights and liquidation treatment of preferred and common stock. However, it is important to understand that the vast majority of venture debt lenders have no interest in exercising their warrants prior to a defined liquidation event.

• Hedge funds liked the uncorrelated nature of venture debt’s returns, traditional leasing companies saw growth potential, new banks saw value in securing client relationships with high growth businesses.
• Thus, venture debt for later-stage companies typically has more stringent revenue or performance covenants and loan availability is tranched to performance or fundraising milestones.
• In other words, investors commit their capital in exchange for an equity interest in a company.
• Many seed-stage companies will not align with this profile because of the composition of their investor base.
• While many founders long for that multibillion-dollar windfall, they ignore the costly downside of giving away equity too much, too early on in exchange for growth that may not yet be fully proven.
• At the early stage when the business is working on its product market fit and is yet to establish its revenue model, equity capital must be the primary external source of capital.
• Although it may not seem relevant when you are raising capital, it is very important to determine whether the lender has a good reputation for working with borrowers when a restructuring is necessary.

However, venture debt differs from equity financing in many ways, and some companies may opt for venture debt to delay or avoid raising another VC round. Many of these investors, however, do not have the sourcing and screening prowess that venture capitalists possess and hence, are faced with the challenge of hunting for the right deals. Additionally, VC funds have an average lock-in period of eight to 10 years. This can deter new investors, who may shy away from the irrevocable and binding commitment.

Insights From Svb Industry Experts

Money is essential for companies to grow, and venture debt can be helpful. It can provide a bridge so that a founder can delay raising an equity round, grow the company and attract higher valuations. Venture debt interest rates often are based off of WSJ Prime (currently at an all-time low percentage), and venture debt may protect a founder’s ownership by allowing a founder to retain a higher percentage ownership of his/her company. While venture debt can help a founder by protecting ownership, it also carries risks and founders should understand the pros and cons before accepting venture debt. As new venture models evolve in the coming years, venture debt will continue to represent a way for entrepreneurs and investors to support the success of their companies. Only limited statistics are available on the annual volume of venture loans, as most providers are private funds or divisions of larger businesses that do not report separately on their venture debt activities.

Previously, he was Chief Financial Officer and Vice President of Business Development for ShoppingList.com, a venture-backed startup. Patrick holds an MBA from Stanford Business School, where he was an Arjay Miller scholar, and an A.B.

Venture Debt

With an investor mindset, and an experienced team with a track record of success, Hercules continually strives to be highly responsive, creative and flexible in addressing each portfolio company’s unique capital requirements. Recognized as the industry leader, Hercules understands the flexibility entrepreneurial companies need, and has the experience to work closely with them, especially through challenging times, to help them reach critical milestones. Hercules’ deep sector expertise, and strong capital base have made Hercules the lender of choice for more than 380 innovative companies.

Far too often, Y Combinator founders tell me that they met a venture debt lender, got a term sheet and quickly signed and agreed to terms. A founder would never speak to only one equity investor when raising a Series A round, but in my experience, it is common for founders to speak to only one venture debt investor. Fortunately, there are more lenders and new entrants offering venture debt, and founders now have additional options .

The Genesis Of Venture Debt

This could include building out sales teams, marketing, investments in R&D, and much more. In addition, in venture debt financing, the lenders receive warrants on the company’s common equity as a part of the compensation for the high default risk. The total value of the distributed warrants generally represents 5% to 20% of the principal amount of the loan.

In exchange for access to this relatively cheap source of funds, banks are heavily regulated in terms of the types of lending and the amount of risk they can take. Debt funds, like venture capital firms, use equity invested by their shareholders or limited partners to fund lending activity. This source of capital is subject to much less regulation, but the cost is much higher.

Another consideration for startups is factoring in how to pay back venture debt over time while also investing in growth — unlike venture capital, which doesn’t have to be paid back directly. In some cases, a company with hefty venture debt repayments risks facing a more difficult time raising from VCs as investors may balk at funding debt repayments as opposed to growth opportunities. Please note that while venture debt investors need to protect their investment, they also deserve to be treated fairly.

Raising debt when the company is flush with cash may seem counterintuitive, but in many cases the debt can be structured with an extended “draw period” so that the loan need not be funded right away. Regardless of when you want to actually fund the loan, your creditworthiness and bargaining leverage are highest immediately after closing on new equity. Conversely, in the example of a relationship-focused decision process, you may not get the most advantageous position on every deal term.

Choosing A Venture Lender

In Europe, the big ones are Kreos, Columbia Lake Partners, Harbert, and Bootstrap. They all work closely with the VCs because that’s an important part of their due diligence and underwriting process.

In this article, I explain how venture debt arose, explore its value for the entrepreneur and investor, and describe how it can be used. Hercules has achieved its vision, now with over $12.8 billion of capital commitments made to over 540 emerging growth companies since inception.

Early-stage investments are often based on the promise of a disruptive idea or new technology and the investors understand that there are significant execution risks involved in realizing that vision. As a result, early-stage investors are slightly more accustomed to supporting their portfolio companies through “inside rounds” when execution does not occur exactly as planned, or key milestones require more time than anticipated. Later-stage investments are premised more on the growth and product development record of the company. When execution falters, it can adversely impact the company’s ability to attract new investors, and the existing syndicate may struggle to adapt to the valuation pressure or increased need for capital that results from the loss of momentum. Thus, venture debt for later-stage companies typically has more stringent revenue or performance covenants and loan availability is tranched to performance or fundraising milestones. It can also be used to finance the purchase of equipment and make investments in infrastructure.

There are several situations where venture debt is a smart financing option for entrepreneurs and their venture capital investors. Lenders closely monitor a company’s burn rate and liquidity to determine the resulting number of months of capital available . Companies with enough momentum and liquidity to achieve milestones for the next financing are more likely to attract nondilutive next-round term sheets from outside investors. Companies with a shortfall in either category are likely to struggle to attract a new lead investor and may have to resort to an inside-led, possibly dilutive round, to continue funding the company.

Important Venture Debt Terms

In this context, the advantages in voting rights enjoyed by preferred stock holders are largely irrelevant. By leveraging equity raised by a startup, venture debt can reduce the cost of capital needed to fund operations and can be used as insurance against operational hiccups and unforeseen capital needs. Typically, the total value of the business’s distributed warrants amounts to anywhere between 5% and 20% of the principal loan amount. Many participants segment today’s venture debt providers into three groups, based on how they are funded.