- Venture debt is intended for early-stage businesses who have typically raised $5M+ in a single round and is typically made available alongside an equity raise or within a few months of a round closing.
- Enabling companies to take on additional capital, venture debt can be used without the same level of dilution as from pure equity.
- Lenders structure venture debt in different ways so it is important to fully understand any dilutive components of warrants and the impact they will have on the business if converted.
Venture debt can provide valuable options for early stage businesses, helping to minimize dilution and enabling them to scale. In our recent webinar on demystifying venture debt, SVB’s Andrew Parker and Dominic Honmong discussed the factors businesses should consider when deciding if this financing option is right for them, including criteria for eligibility, when to use it, the benefits, and what to look out for.
Here we outline five key points from the session.
Who should consider venture debt
Venture debt is intended for earlier-stage businesses, generally Series A onwards, who have typically raised $5M+ in a single round. They are generally fast-growth and cashflow-negative, with the financing usually provided to businesses that will be going on to complete further rounds before realizing an exit. It is intended to be as equity-like as possible but without the dilution that occurs when external investors are brought in. The trade-off is that it comes at the higher end of the cost of capital.
Venture debt providers look closely at a company’s investors, as they naturally work with investors they have built relationships with over time. These are typically well-known, top-tier VCs from the US, Europe or Asia with an LP/GP type structure, who hold reserves for follow-on investment. Lenders then know that if it takes longer to raise an additional equity round or there is a bump in the road, investors and the bank can work together to get the company through to the next external round.
When to take on venture debt
Venture debt is typically made available alongside an equity raise or within a few months of a round closing. It can be made available between rounds, but companies should have around 9-12 months of cash runway. The amount of financing targeted, equity or debt, should enable you to execute your business plan and get you through to the next stage. This can be done using pure equity with venture debt as a safety net or buffer, or the debt financing can be used to minimize the dilution of a round.
At early stages, venture debt is complimentary to equity, it does not replace it. Venture debt should be as equity-like as possible, but it is a loan that needs to be repaid over a period of time or refinanced in later equity rounds. The exception is for later-stage companies looking at an exit or an IPO.
How venture debt is used
Venture debt enables companies to take on additional capital without the same level of dilution as from pure equity. It can be used to extend cash runways, as a safety net in case it takes longer than expected to reach the next round, or as an insurance policy in case any bumps in the road are hit. Companies also use it to double down on plans, such as fueling sales and marketing, and to get further down the line in terms of enterprise value so the next round can be raised at a higher valuation. Some companies at Series B or C stages also use venture debt as a bridge to profitability if they don’t intend to raise further equity rounds.
When deployed, venture debt is often used to fund engineering, sales and marketing or to expand further geographically. Over the past year, there has been an increase in use of venture debt to help with bolt-on acquisitions, where companies are cementing their position in the market or expanding offerings to their client base.
Venture debt is a term loan typically structured over a 4-5 year amortization period, usually with flexibility or a period of time to draw the loan down such as 9-12 months. Interest-only periods of 3-12 months are common. Lenders will typically provide 25-35% of an equity round and are keen not to overburden businesses with large debt overhangs when they raise again in the future.
There are four key cost components. An upfront fee to arrange the facility, interest rates of 7-12% with repayment flexibility, a back-end or final payment fee, and a warrant component. Warrants set venture debt providers apart from high street banks, giving them the option to buy shares in the business at the point of exit. As other financial institutions are coming into the market offering their own version of venture debt, they often include financial covenants. This removes flexibility and is not really venture debt.
What to expect and watch out for
The entire process can be expected to last between 6-8 weeks. Due diligence is undergone, followed by clarification of any questions that arise. Ordinarily, a credit approved term sheet will then be shared within around ten days and the debt provider will join investor calls to understand their investment thesis and strategic goals. The legal process then covers the wording of the loan agreement, the security agreement and the warrant instrument.
Be sure to assess the full cost of the debt as lenders structure in different ways, and fully understand any dilutive components of warrants and the impact they will have on the business if converted. Lenders normally expect full charge over all business assets, including IP, so there should be no personal guarantees. It is also key to use a law firm that is familiar with these types of facilities, to get the best deal from the negotiation process.
You can watch the full replay of the Venture Debt webinar here.