This post is not about the pro’s and con’s of raising venture debt for startups, it is about how to go through the process of deciding whether to take venture debt at all – and how to do it.
Each company is unique and I have seen venture debt extend a company’s runway enabling them to get to cash flow b/e without founders taking any more dilution; and I have seen companies not hit their plans and the ramifications this means when the note is then called. But it is a pretty common instrument and even Facebook took venture debt early on before the cloud existed when they needed to buy servers. And in my experiences with the lenders that we have worked with, they are always much more flexible when covenants are close to being breached or when there is a workout situation than your typical risk averse banker. They also tend to work quickly and will be ready to give you a termsheet in under two weeks after your first meeting.
Venture debt is typically only for companies that are already generating revenue (though there are exceptions for biotech and semiconductor companies where there are assets that can be used as collateral). It is typically only available to startups that have raised money from reputable VC’s because in the worst case scenario, the venture lender will want to know that the VC firm will invest more equity in order to pay off the loan.
There are numerous reasons to explore taking a venture loan, but one of the best is to extend your runway enough to enable you to hit key milestones. One of my portfolio company’s recently took a c$3m loan on the back of a successful equity fundraise for working capital purposes – it’s enabling them to scale up their operations faster and extend their runway ahead of the next round which meant that they didn’t have to take the extra dilution that $3m would have bought new investors.
So how do you begin to compare which provider and deal to go with. Here is a 4 step process I would advise you to go through:
1. Figure out whether or not it is worth taking a loan. If you are fortunate enough to raise a large enough round of equity on terms that you and your board are happy with, then don’t consider venture debt. If you still have some room to fill and have exhausted equity resources, consider taking venture debt. Have your FD/CFO or even an associate from one of your VC investors build a model to see the impact it could have on your runway and cash flow forecast. Again, if it buys you enough extra time to reach one or two significant milestones that will enable you to raise your next round at a much higher valuation than a smaller equity round, this is a good thing for the company.
2. Get introductions to lenders from your VC. We have active dialogues with multiple venture lenders in all major geographies. They will help you to negotiate the best terms as we know what the market rates and the latest terms are on deals. We may even have preferred lenders who we have worked with in the past who we know to be reasonable, can work quickly and in some cases add value to our portfolio companies. This should also help to fast track the negotiation and diligence process (typically they will want to see an updated deck and plan with a pitch from the founder(s), historic and forecast P&L/balance sheet and have a call with the VC to understand more on why they invested into the company). They are really assessing the likelihood that the company will not hit their plan, not raise their next round of VC, and jeopardize not getting their money back.
3. If you’re in an ultra-competitive market for loans (SF, Boston, London, Tel Aviv) and don’t get the terms you were hoping for from your first lender, have your VC reach out to another one or two firms to get competitive offers before moving onto the last step.
4. Finally, and most importantly, compare each loan side by side to see the true cost of capital. There is a very simple way of doing this. Ask the lender for a repayment schedule so you can compare like for like, the true cost of each loan. Assuming that each lender is offering to loan the same amount, you need to compare their commitment fee or transaction fee rate (is this going to be paid at drawdown?), whether there is an end of loan payment, whether it is all drawn-down at once or whether this can be tranched, any interest-only terms, the interest rate, warrants, and the schedule (although it’s typically 36 months). What may have seemed like the most cost effective loan (typically the one with the lowest interest rate and warrants) could have been the most expensive once you take into account the transaction fee or an end of loan payment.
Once you’ve taken the time to model each loan side by side it will be very apparent which lender has given you the most attractive rates for your company.