My SVB colleague (Samir Kaji) and I are putting together a venture debt primer for some of the venture funds we work with, and are looking for feedback. Samir did a great job of organizing and synthesizing the information I’d gathered over the years on the topic, but I’d be interested in getting your feedback on the content below.
What is Venture debt?
- A form of debt financing provided primarily by Banks and Venture debt firms for Venture backed companies that typically don’t meet the traditional asset or performance requirements of traditional forms of debt financing.
When is it appropriate to explore Venture Debt?
- For early stage companies, BOD is able to clearly define the milestones they would like to meet prior to the next equity fundraising, and has a reasonable amount of visibility on when they expect to hit them. In addition to the aforemtnioned, later stage companies should also have demonstrated some sustainable revenue traction and have some customer diversity.
- Company is backed by a strong syndicate of Venture partners that has the ability to further support the Company financially with or without the introduction of a new lead.
- Company has a management team that, preferably has worked with secured creditors in the past.
What type of situations do Lenders often find challenging to provide Venture Debt?
- Companies that are just entering commercialization with marginal visibility into timing and significance of near term sales opportunities.
- Companies that have recently restarted or have recently gone through a significant business model reorganization.
- Companies that have incomplete executive management teams (i.e. searching for a CEO).
- Companies that have had significant amounts of capital with little progress.
- Companies that are reliant on bringing in an external investor or a liquidity event for repayment of loan.
What are some of the benefits?
- Used appropriately, venture debt can provide incremental runway between equity rounds for early stage companies, allowing for additional time to meet critical milestones.
- For later stage companies, and in conjunction with a working capital line, can alleviate and smooth out liquidity needs.
- Results in nominal dilution to shareholders and can greatly impact shareholder returns even with small amounts of debt.
What are the risks?
- Overleveraging is common and can impact fundraising efforts if Company is not performing well.
- Venture debt should not be more than 50% of last insititutional raise and in most cases should not exceed 25% of last raise.
- Monthly P&I payments should not exceed 15% of monthly cash burn. Under 10% is considered ideal.
- Not using a reputable partner can put the Company’s shareholders in a very precarious position if the lender is uncooperative or decides to exercise debt acceleration or foreclosure remedies.
- Planning around debt as a “hail mary” is dangerous as lenders often have the right to withhold advances if the business significantly deteriorates and investors no longer find the Company attractive as an ongoing investment. Venture debt should not be viewed as a pre-agreed bridge loan.
- Preference of secured debt holders may reduce or eliminate investor / management economics during a liquidation/distressed asset sale.
What are the key terms to be aware of?
- What is the all-in IRR? This should include all fees, backend payments, etc. IRR’s can range from 7% to 15%+ depending on risk profile of transaction and other economics of deal (warrants).
- Is there any requirement to maintain deposits in a lower yielding or non-interest bearing account? This should be included in the cost analysis.
- Are there any MAC clauses after debt is funded? What are the lender’s rights to withhold advances?
- How are the warrants being calculated? Is there any unique provisions (i.e. put option).
- What is collateral? Blanket lien on all assets is standard; IP may be included if risk level is considered higher. Equipment financing collateral sometimes relegated to financed equipment.
- Are there any financial covenants? Typically not in early stage lending.
- What is the real runway provided by the debt?
- Is the lender requiring draw far in advance of cash-out? If so, how amortization will there be prior to projected cash out?
- Are there any covenants that require certain level of cash
- What is the lenders reputation in working through difficult situations?