Financing Options: Venture Debt

It’s Monday, time for MBA Mondays and the next post in the Startup Financing Options series. Today we will talk about Venture Debt.

If there were two words less likely to be found together, it would be venture and debt. Startups are not credit worthy enterprises. They have little to no assets and no cash flow. Equity is the appropriate way to finance startups.

However, there is a large, growing, and vibrant market for something called Venture Debt. It is indeed debt, largely provided by a number of banks and finance companies who specialize in this market. The terms are usually three years, interest only, balloon payment, with warrants for the equity kicker. Now that I’ve just thrown out a bunch of buzzwords, I’ll explain each of them.

The term is how long you have to pay back the loan. Three years is the typical term for Venture Debt.

Interest only means you pay the interest on the loan each month but you don’t pay the loan down each month.

Balloon payment means you pay the loan amount in full when the term expires.

Warrants are like options, you get the right to buy equity at a fixed price for a period of time, usually five or ten years.

Equity kicker means an equity component to the deal to goose the returns.

So who can get Venture Debt? Venture Debt is available largely to companies that have secured at least one round of venture capital financing by a recognized venture capital firm or syndicate of venture capital firms. It is also available to more developed startups that are credit worthy by virtue of significant assets or cash flow.

So why do banks loan to startups when they have raised VC but not when they have not? The answer lies in the key understanding about Venture Debt. The banks are not loaning against the credit worthiness of the startups, they are loaning against the creditworthiness of the venture capital firm or syndicate. Basically the banks are betting the VCs will keep funding the company well past the term of the veture debt loan.

I’m not a fan of venture debt for early stage companies. If the startup is getting the money because of the credit worthiness of my firm and the other firms in the deal, then I’d rather be putting more equity in instead and getting paid for my capital at risk. I’ve told this to every venture debt lender who has come to see me so it’s not a secret how I feel about this kind of funding.

I am a big fan of venture debt late in the life of the startup. It can be a bridge to a sale or a bridge to an IPO or can be used to fund an acquisition or some other value enhancing transaction. I encourage our portfolio companies to tap the Venture Debt markets all the time once they have become credit worthy on their own. It is smart to use debt vs equity when you can absolutely pay the debt back.

But financing companies with debt when the company has no obvious means other than their VC investors to pay the loan back is bad financial management in my opinion and I am not a fan of it in the least.

 

From the comments

zackmansfield added:

as someone who works for one of the banks that lends to VC-backed companies, I can say that Fred is spot on in his description and can attest that he has indeed explained this view in person re: venture debt in early stage companies.

It should be noted that there is an obvious counter to Fred’s view from the other side of the table (i.e. the entrepreneur).  If a company needs cash and Fred believes in the company, he obviously wants to put more $ in to own more of it.  Yet an entrepreneur may want to look into venture debt to avoid that dilution at that time, especially if there are meaningful milestones that will be achieved over the period of time that the debt affords, which would thereby increase overall value and minimize dilution.

Regardless of how this plays out, it’s imperative that everyone’s on the same page – VC, entrepreneur, and lender – given the fact that the underwriting *is* very much predicated on relational and non-quantitative dynamics, especially for early stage companies.

fredwilson replied:

A threesome sounds good but usually causes problems

 

This article was originally written by Fred Wilson on July 25, 2011 here.