April 16, 2020

Founders, don't forget about venture debt

How it works, when to go for it and what to watch out for.

Believe it or not, receiving capital in exchange for equity is not the only way to finance your startup. 

Along with cash-for-equity, there’s also venture debt — an often-overlooked but attractive source of growth capital for startups. 

When approaching turbulent times, as we are now with the Covid-19 pandemic, wise companies build out war chests that will help see them through. Compared to equity, venture debt becomes an increasingly attractive source of capital, allowing businesses to diversify their sources of funding and provide additional liquidity, while minimising the implications for their cap tables. 


Who opts for venture debt?

Despite globalisation, the use of this handy tool varies by geography. 

In 2018, the US venture debt market experienced 4,000 transactions, totalling $15bn, which accounted for 15% of all venture financing that year. Meanwhile, in Europe, only 5% of all venture financing is in the form of venture debt with the market estimated to be close to $1bn. 

Traditionally, European debt lenders are mostly focused on the UK and western Europe. The extended central and eastern Europe (xCEE) market is estimated to account for just 3% of all venture debt deals, according to Deloitte. Instead, European founders tend to choose traditional equity or rarely, where available, bank financing — and are, most often, not even familiar with the specifics of alternative debt funding.

What makes venture debt appealing?

The main advantage of venture debt over traditional equity financing is that it is virtually non-dilutive. Since venture debt is essentially a term loan (with a usual term of three years) that works much like your mortgage, your cap table remains practically intact. 

The main advantage of venture debt over traditional equity financing is that it is virtually non-dilutive.

The only thing to keep in mind is that venture debt providers most often take warrants — these give them an option to subscribe to a predefined amount of a company’s new equity (usually equal to a fraction of the overall facility) at an exit event — i.e. when the company is sold, merged or listed on an exchange. The price at which options are exercised is agreed at the time of underwriting the facility and is usually linked to the most recent equity round — and if the company grows, venture debt providers partially participate in potential equity upside. However, the dilution from warrants is most often limited to 1-2%. 

Furthermore, unlike equity rounds, venture debt providers do not “price” the company — i.e. they do not establish a new valuation — eliminating one of the more painful discussions companies face when dealing with equity investors. This also makes the process of raising venture debt more streamlined as compared to other forms of financing.

When should my company take venture debt?

1) To extend the cash runway of your startup to get it to the next “value creation” milestone resulting in a higher valuation at the next equity round.

Venture debt can also be used as an “insurance policy” allowing you to extend your runway.

2) If you’re concerned that it might take longer than expected to hit your next milestone and you don’t want to raise equity under unfavourable conditions, venture debt can also be used as an “insurance policy”, allowing you to extend your runway. With the negative effect of Covid-19 looming over the capital markets, this becomes one of the main reasons to consider venture debt.

3) To improve the efficiency of an existing round, by raising part of it in debt and reducing dilution for the founders and existing investors.

4) To fund an acquisition to accelerate growth.

5) To act as a bridge to profitability. 

Additionally, as a venture debt round is “signal neutral”, it may be helpful in a situation where there may be a need to prevent a bridge round (a small round of funding to tide a startup over until its next larger round of funding) from existing investors to get the business to the next equity round without showing any alarming signs.

Who should I take venture debt funding from?

1) Look for a venture debt investor with a “light touch” approach to financing. It’s much easier to take money from those who don’t take board seats, take no financial covenants and have very limited governance requirements. Restrictive covenants (which sometimes include financial matters such as liquidity thresholds or limitations on burn) put excessive bounds to the startup’s freedom to run its business aligning with its own strategy and vision. For instance, covenants on burn levels can ultimately restrict the company from investing more into sales and marketing and growing at a faster pace.

A good sign is if a venture debt provider looks closely at who your VC backers are.

2) A good sign is if a venture debt provider looks closely at who your VC backers are and, even better, has a long-term working relationship with them. Include current investors in the process of selecting your venture debt lenders and negotiating fees. Ask for early repayment opportunities and flexible drawdowns — these would make the facility more flexible for you and tailored to your company’s financing needs.

3) Make sure your venture debt investor is someone who listens and understands your funding requirements and is creative and flexible enough in finding the most suitable loan structure for you. 

Most venture debt providers are happy to support cash flow negative companies.

4) Feel comfortable that your business is at the stage where it can sustainably service its debt. Most venture debt providers are happy to support cash flow negative companies; however they look for signs that the company has either a sufficient cash cushion to make debt repayments until it hits profitability or is in good shape to attract the next round of equity financing. A sound venture debt investor will advise on whether the company is mature and stable enough to take on debt financing or suggest the steps it needs to take to become venture debt ready. 

In summary, venture debt is an actively emerging form of venture funding that is targeted for VC-backed businesses looking for additional funds to fuel growth. Venture debt is also very much relationship driven — since it is a complement to equity capital, it is important that entrepreneurs and investors alike are aware of it and build relationships with venture debt providers early on. A smart infusion of debt financing might significantly boost a startup's growth potential and often makes the fundraising process much simpler and more transparent.