Capital Raise Blog Series - Vol 10 - What Is Venture Debt?
As investment bankers, RKJ Partners possesses a breadth of knowledge and experience in advising clients that seek growth capital. In our latest blog installment, we define and outline the key elements involved in the process of raising capital.
There is no question that in today's fundraising environment, capital efficiency is paramount. Making equity dollars last is particularly important since they come at a high price. Although the price is high, these precious equity dollars are often a critical factor in an emerging company's success. Yet, taking this equity investment means accepting painful ownership dilution due to the low valuations given to companies at this early stage. So, what's the alternative?
Overview – Venture Lending
Venture lending offers a low-cost method for venture-backed companies to leverage fixed assets and their enterprise value to get more “runway” out of their equity dollars. These types of loans can give a young company the extra time and resources needed to reach major product or customer milestones. And, being able to achieve important milestones such as shipped product or securing a first customer, can provide real uplift in valuation and significantly reduce ownership dilution at the next VC financing round.
Venture lending is usually offered in two forms: "growth capital" and equipment financing. Growth capital provides operating capital that can assist in product development, product or geographic expansion, acquisition of complementary technologies, or just about any key operational imperative. Typically the cost of such capital is interest, along with principal, paid over a fixed period of time (generally 24-48 months, depending on the company's risk profile) and a small pledge of stock warrants. There may also be a "final payment," which helps the lender earn the appropriate risk adjusted yield, but pushes off the cash outlay by the borrower to a future date so it doesn't have to part with precious (and typically more expensive) dollars in its early years. Some flexible providers are even willing to structure deals that provide companies with a period of interest-only payments to help preserve cash at critical junctures for a company. Meanwhile, equipment financing allows a company to borrow against the equipment it purchases, such as computers, manufacturing equipment or other assets, and frees up the equity dollars that would have otherwise been spent to obtain such items for higher value add use, namely research and development or sales and marketing. Like growth capital loans, the lender receives monthly payment of principal and interest plus warrants and possibly a final payment.
Both forms of venture lending are available to promising early-stage startups backed by top-tier venture capitalists, usually when they are still cash flow negative. From a financial planning point of view, venture loans can be an attractive insurance policy. If there's risk that critical milestones may slip, having the ability to borrow and extend runway so those milestones can be safely achieved insures a trip to the equity fundraising market with a better valuation. If the milestones are not in jeopardy and you ending up not borrowing, your worst case is to have given away warrants that typically amount to less than one or two percent of dilution.
Venture Debt is less expensive than equity … in the long run
Perhaps the greatest benefit of venture lending is that it injects money into a business without heavily diluting the equity stake of the entrepreneur or venture capital investors. While equity dollars are necessary in financing a company's development and a typical prerequisite to obtaining venture loans, they come at the high price of sharing significant ownership. Venture loans can be a real aid that can enable an early-stage company to have access to low-cost capital and minimize entrepreneurs' and venture capitalists’ (“VC’s”) dilution. An added benefit for VC's is that they can improve their return on investment (“ROI”) on a given deal by encouraging their portfolio companies to take on a responsible mix of debt along with their equity dollars.
Key Tips When Considering Venture Debt
When considering venture loans, keep in mind the following tips:
- Minimize Covenants – Negotiate terms which mitigate the impact of violating any particular covenant. The less time you have to spend managing your covenant compliance, the more time you will have to deliver a compelling value proposition to your customers.
- No Early Payback Penalties – Many venture debt lenders attempt to discourage early payment of their loans with onerous pre-payment penalties - 1% of the entire loan amount is common.
- Milestone 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.
- Fees overload – The true cost of debt is often increased by the inclusion of numerous fees. Rather than trying to negotiate each individual fee, consolidate them and negotiate the percentage that the fees represent of the loan’s size.
- Blending – Many venture debt lenders require that their funds be accompanied by an equity investment, generally from legitimate venture capitalists. Although this might be advantageous to you, give yourself greater flexibility by not agreeing to debt that is contingent on raising new equity dollars.
- Competitive Proposals – Venture debt terms are notoriously non-standard. Thus, gather several term sheets and combine them into an ideal agreement. Then take your “greatest hits” term sheet and communicate to each debtor.
- Reputation Matters – If you violate a debt covenant or otherwise have difficulty servicing the debt, a venture debt lender can destroy your company. Identify lenders which care about their reputations and have a track record of lending to venture-backed startups.
- No Personal Guarantees – If possible, avoid personally guaranteeing the debt’s repayment. Instead, collateralize it with your company’s assets.