Understanding venture debt financing

Silicon Valley Bank contributed a chapter on venture debt in the book, “Venture Deals: Be Smarter than Your Lawyer and Venture Capitalist,” 4th Edition, written by Brad Feld and Jason Mendelson. Following is an excerpt from Amazon's #1 Best Selling Book on Venture Capital.¹

If you are going to raise institutional venture capital to build and grow your business, it’s worthwhile to consider using venture debt to complement the equity you raise. Venture debt is a type of loan offered by banks and non-bank lenders that is designed specifically for early-stage, high-growth companies with venture capital backing. The vast majority ofMost venture-backed companies raise venture debt at some point in their lives from specialized banks such as Silicon Valley Bank. 

The first rule of venture debt

The first rule of venture debt is that it follows equity; it doesn’t replace it. Venture lenders use venture capital support as a source of validation and the primary yardstick for underwriting a loan. Raising debt for an early-stage company is more efficient when you can precisely describe the performance objectives associated with the last round of equity, the intended timing and strategy for raising the next round, and how the loan you are asking for will support or supplement those plans. 

Venture debt availability and terms are always contextual. Loan types and sizes vary significantly based on the scale of your business, the quality and quantity of equity raised to date, and the objective for which the debt is being raised. The amount of venture debt available is calibrated to the amount of equity the company has raised, with loan sizes varying between 25% to 35% of the amount raised in the most recent equity round. Early-stage loans to pre-revenue or product validation companies are much smaller than loans available to later-stage companies in expansion mode. And companies without VC investors face significant difficulties in attracting any venture debt. 

Read next: Learn more about the right amount of venture debt for your startup.  

The role of debt vs. equity

It’s critical to understand the fundamental differences between debt and equity. For equity, repayment is usually not contractually required. While some form of liquidity event is presumed within a time frame of less than a decade, and redemption rights can sneak into your financing if you aren’t vigilant, equity is long-term capital. The use of equity is supremely flexible – —it can fund almost any legitimate business purpose. However, it is difficult to reprice or restructure equity if execution doesn’t exactly match the business plan. 

In comparison, debt can provide short-term or long-term capital. The structure, pricing, and duration are closely tied to the purpose of the capital. Debt can be configured to include financial covenants, defined repayment terms, and other features to mitigate credit and other risks borne by the lender. These characteristics limit the utility of debt, from the borrower’s perspective, to a predefined set of business objectives, but they allow the lender to structure and price the loan to align with the borrower’s current circumstances. 

The entrepreneur’s perspective

If price were the only consideration, most entrepreneurs would fund their business exclusively with debt to avoid ownership dilution. This approach doesn’t work for high-growth businesses because of the first rule of venture debt: You can bootstrap your business by shunning venture capital, but then venture debt likely won’t be an option for your company. More traditional debt, such as cash-flow-based term loans or asset-based lines of credit may be an option, but they require you to generate positive cash flow. 

Since venture debt is designed for companies that prioritize growth over profitability, the venture lender wants to follow in the shoes of investors they know and trust, rather than risk lending to a company without venture backing. 

Venture debt isn’t usually available to seed-stage companies. Unlike most angels, most VCs (regardless of their natural entry point) typically invest in multiple equity rounds and maintain capital reserves for this purpose. Even if you can source a loan with an angel-backed profile, taking significant debt at the seed stage probably isn’t optimal if substantial additional equity capital is required to fund the company. Institutional VC investors typically don’t want to see a large portion of their fresh equity used to repay old debt. 

And don’t forget the main rule of debt:. You do actually havehave to pay it back someday and that day may turn out to be an inconvenient day in ways you can’t forecast ahead of time. 

Read next: When is venture debt right for your business? 

The players

Silicon Valley Bank was the first bank to create loan products for startups. It happened because SVB is based in Silicon Valley and evolved from the ground up to serve the innovation economy that surrounds it. That’s an important distinction as you explore loan options to fund your company. There are few banks that truly understand venture debt and many that don’t. Many players come and go in the venture debt market, so make sure that whomever you are talking to is a long-term player. When a bank decides one day that it is no longer interested in lending venture debt, it can wreak havoc on your business. 

There are a number of potential benefits when you identify the right banking partner. Banks with a focus on the innovation economy can provide startup-centric financial advice, investment and payments solutions, sector insights, and networking assistance to complement the support provided by your investors. The most experienced banks can also provide institutional resources to startups and in some cases your financial partner may become an active advocate for your business. 

Banks have historically emphasized financial covenants and structure over yield, placing more limitations on maximum loan size. Venture debt is typically secured by the business pledging its assets as collateral to the lender, and lenders have a robust set of legal remedies they may apply when a borrower violates the loan agreement. Regardless of the venture debt option you pursue, a loan is rarely just a one-time transaction, but the beginning of a relationship. 

Venture debt can be used as performance insurance, a lower-cost runway extension, funding for acquisitions or capital expenses and inventory, or a short-term bridge to the next round of equity. Before raising venture debt, you should discuss various options with your board, especially your VCs, since they will have a broad perspective on the use of venture debt and can provide introductions to the players. 

Venture debt can be used as performance insurance, a lower-cost runway extension, funding for acquisitions or capital expenses and inventory, or a short-term bridge to the next round of equity. 

How lenders think about loan types

Venture debt is a different type of loan that was created shortly after the birth of the venture capital industry. Venture debt relies on a company’s access to venture capital as the primary repayment source for the loan (PSOR). Instead of focusing on historical cash flow or working capital assets, venture debt emphasizes the borrower’s ability to raise additional equity to fund the company’s growth and repay the debt. 

Most venture debt takes the form of a growth capital term loan. These loans usually have to be repaid within three to four years, but they often start out with a 6- to 12-month interest-only (I/O) period. During the I/O period, the company pays accrued interest, but not principal. When the I/O period is complete, the company begins paying down the principal balance of the loan. The duration of the I/O period and terms under which the loan can be drawn are key points in the negotiation process. 

Venture lenders are keenly aware that dilution is a powerful incentive as the core value proposition of venture debt is reducing dilution for founders and management. Because access to capital is the PSOR, venture lenders evaluate your company through a similar lens as your investors, such as: 

• Will additional equity be needed? 
• Which metrics will influence the next-round valuation? 
• What level of performance correlates to nondilutive access to capital? 

Lenders closely monitor a company’s burn rate and liquidity to determine the resulting number of months of capital available (often referred to as runway). Companies with enough momentum and liquidity to achieve milestones for the next financing are more likely to attract non-dilutive, 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. 

"Transparency and predictability are the most important criteria to seek in a venture debt lender."

Putting these pieces together will help you see your company the way a venture debt lender does: They care about who your investors are, what metrics your investors use to gauge the company’s progress, how much progress is required to increase the probability of non-dilutive access to capital, and when your company will run low on liquidity in relation to those performance milestones. 

Negotiation tactics

The value of reputation is paramount. The venture capital industry is relationship-driven, which applies equally to debt and equity. Most VC-backed companies progress through a series of equity and debt financings and, as a result, are multiturn games. In negotiating each round of venture debt, as with equity, a tension exists between getting the best deal terms and getting the best relationship partner. The desire to optimize every term in every loan should be balanced against the benefit of partnering with a lender who may provide greater strategic or performance flexibility over a long period of time. 

Occasionally, there are cues that hint at which trait is more likely. For example, you should be particularly wary of lenders who change critical deal terms as the negotiation migrates from term sheet to final loan documents. Deal term drift is a good indication that a winner-take-all, contract-centric mindset is that lender’s standard operating procedure. 

Conversely, in the example of a relationship-focused decision process, you may not get the most advantageous position on every deal term. Instead, you are counting on the lender’s willingness to roll with the ups and downs that inevitably will impact your financial performance and strategy over time. This doesn’t mean that deal terms don’t matter, since the size and structure of the loan needs to be aligned with the needs and strategy of the business. However, the partnership-focused lender values being flexible and playing a long-term game, both with your company and your investors. 

As the adage goes: you’re only as good as the company you keep. In the venture industry, where risks lurk around every corner, this truism is apt. Given the dynamic environment and the high mortality rate of startups, predictability is one of the primary characteristics every entrepreneur should seek in key business partners. It’s a rare startup that executes on the precise strategy and capital plan contained in their early-stage business plans, which means that transparency and predictability are the most important criteria to seek in a venture debt lender.