Venture Debt For Startups
I always thought it was crazy for early stage companies to take on venture debt. Here’s a company that just raised $5MM of venture capital, is burning $300K per month and they think it’s smart to raise debt?!? I admit that my view is colored by my one experience raising venture debt in 1999 which did not end well (for anyone). So recently, I decided to take a look at venture debt and talked to about a dozen lenders, quite a few startups and some other industry experts. To my surprise, I found that in some cases, it does make sense.
First, a bit about venture lenders. Various estimates put the number of firms that have serious venture lending businesses at 20-30 in the US. My take is that there are three categories of lenders: (1) banks, (2) dedicated funds with "stable capital" and (3) dedicated funds without "stable capital." By stable capital, I mean a fund that raises capital from limited partners similar to a venture capital fund. The capital is committed for a specific period of time (like 5 or 7 years or more). Bank-backed venture lenders are regulated and tend to invest in less risky areas (like capital equipment or receivables financing). Dedicated funds tend to be more aggressive and invest in "growth capital" (more on this later). The permanency of capital is an important factor as this can have an impact on the borrowers stability of capital and the willingness of a lender to work with the borrower should the company hit a rough patch.
For startups, there are three main types of venture debt: (1) equipment financing, (2) receivables factoring and (3) growth capital. There are other types of borrowing (e.g. acquisition financing, but I’m focusing on these three categories for now). Equipment financing is borrowing tied to a specific capex purchase, e.g. building out a NOC. Receivables financing is useful for companies that have material A/R against which they can usually borrow as much as 80-85%. Growth capital (also referred to as "stretch equity") has availability tied to venture metrics and is useful when the startup can use the extra capital to reach specific business benchmarks beyond those achievable with equity financing alone and that will provide a material step up in valuation (or insurance that they meet those already committed to).
Some key terms/rules-of-thumb for venture debt include:
- Availability: A/R factoring – up to 85% of receivables; equipment financing – up to 100% of specific capex; and growth capital – up to the cumulative amount of capital invested by the lead investor (minus any other debt).
- Repayment: 3 to 12 month interest only period followed by up to 36 month interest plus amortized principal period (i.e. up to 48 months).
- Rates: For working capital financing, a good rate would be prime +1% and for growth capital, a good rate would be prime +3%.
- Warrants: Expect 6-12% warrant coverage on growth capital. That means take 6-12% of the loan principal and convert that into an at-the-money warrant to purchase an amount of shares at the price of the last equity round.
- Covenants: With growth capital, you can avoid them (including a "MAC" clause), however, most working capital loans will have them.
The process for raising venture debt is straight forward. The borrower will require some material (which you probably already have from raising your last equity round) including:
- Powerpoint pitch deck
- Financials since inception
- Current cap table
- Board approved forecast
- 1-hour meeting with the CEO to get the "pitch"
After reviewing the materials and the initial meeting above, a lender will issue / negotiate a term sheet. Once accepted, that will be followed by a half-day diligence meeting with the management team, legal documentation and closing. The whole process typically takes 4-6 weeks from term sheet to close.
So in terms of who to borrow from, my assessment is that banks will offer the best price but on the least favorable terms. The dedicated funds will offer the most flexibility, but will cost more. Consequently, I’d go to banks for equipment or receivables financing, but to the dedicated funds for growth capital. If you think you’ll need both (i.e. both equipment/receivables financing as well as growth capital), I’d go to the dedicated funds for growth capital first and then work w/ banks to get additional financing later.
With that, I’ll wrap this up with a few other comments in FAQ format:
- When should I raise venture debt? The best time to raise growth capital is in conjunction with or immediately after raising a round of equity, i.e. when there is the most capital in the company. It can be done at other times, but often with less favorable terms. More lenders will require a minimum of 9 months of liquidity in the company before investing and look to add an additional 4-6 months of runway.
- What is a "MAC" clause? It stands for Material Adverse Change and is a protection for the lender to call the loan principal in the event the company hits a rough patch. For growth capital, this should be avoided at all cost. Something as simple as the founder leaving the company could result in your loan being called.
- What collateral do I need to pledge? Many lenders will seek a blanket lien against all of the company’s assets (with the exception of equipment financing which may be secured against specific assets). This can be avoided with some non-bank lenders. Sometimes lenders will "split the baby" and take a lien on non-intellectual property assets.
- How many bids should I get? I recommend companies focus on 3 to 5 lenders maximum. Soliciting bids beyond that is time consuming and ends up sharing sensitive information too broadly.
- Is the recent market volatility/credit squeeze affecting venture lending? The short answer is yes. Less so with the dedicated funds, but some lenders leverage their investment by borrowing "wholesale" and lending "retail" and you have to imagine their liquidity is being squeezed along with everyone else. You should expect terms to tighten and prices to rise. If you think you will be in the market for venture lending in the next 6 to 12 months, consider borrowing now to get better rates/terms.
- What diligence should I perform on the lender? The most important question to ask is, "what were your three worst deals and who were the venture investors involved in them?" I would then use my existing venture investors to check out the lender with the equity investors who have experience working with them in a troubled situation. One third to half of every venture lenders portfolio will eventually have some sort of trouble, so learning how they behave in these situations is probably the best diligence you can do.
- How much equity does a venture lender end up with at an exit? Typically the lender ends up with less than 1% of the total equity. If they end up with more, it was probably a work-out situation.
- How much is too much debt? Most lenders will tell you that too much is when debt service exceeds 30% of monthly cash burn. You should target 10-20%.
- What about using brokers/advisers? I highly recommend using a "buyers rep" or adviser in the process. There are people who specialize in this and having the experience of someone who’s done 30 deals in the last 6 to 12 months is well worth it. The cost is minimal. If you’re interested, I know of a great adviser I’d be happy to recommend if you inquire.