When it comes to venture debt, it’s not just about how much you’ve raised, but how strategically you’ve raised it.
Debt may not look like a good thing on a balance sheet, but interest in funding startups through venture debt has been on a slow upturn. Founders are increasingly looking to debt financing to fund their startup vision, and investors are happy to provide.
The last few years have been especially good to the venture debt sector. In 2019, the U.S. venture debt market reached US$10 billion, nearly twice its value in 2016. In frontier markets too, venture debt is catching up. Debt funding in India reached a five-year high in 2020, both in terms of funding amount and the number of deals. Investors are optimistic about the prospects for venture debt in Southeast Asia.
But raising venture debt is not so much about the transaction alone. Oftentimes, there is a long-term funding strategy behind choosing to take on such debt. Where there is none, the liability quickly becomes apparent.
And so to be able to employ venture debt as a means of startup funding, it’s important to get the basics right.
As its name suggests, venture debt is a form of non-equity venture funding where founders rely on using loans to fund their startup needs.
These debts typically come from banks, such as Silicon Valley Bank in the U.S. or DBS in Singapore, or venture debt funds such as Trifecta Capital, which recently closed a $140 million debt fund. In line with the basic premise of a bank loan, venture debt is also paid off through a series of installments, with interest.
Here’s an example of how this works in practice. Lighter Capital is keen on lending to companies from high-growth, high-margin markets, such as SaaS. They lend up to $3 million in debt funding to tech companies based in the U.S., Australia, or Canada. These companies don’t need to be profitable, but should have an average monthly recurring revenue of at least $15,000 for the three months preceding their loan application, gross margins of at least 50%, and a minimum of five clients.
In return, the lender takes up to 10% of monthly revenues until the total repayment cap (the total amount the startup repays upon which the loan is terminated) is reached. Companies typically pay back the loan over 3-5 years.
As an example, say Lighter Capital lends $1 million to a startup at 8% with a repayment cap of 1.5x the principal. In this case, the startup will pay Lighter Capital 8% of their revenues every month until 1.5x of $1 million, or $1.5 million is reached.
The terms of the loan differ for each debt provider. DBS, for instance, provides venture debt funding to growth-stage tech startups that are already backed by a DBS partner venture capitalist, such as Vertex Ventures or Monk’s Hill Ventures. Moreover, they expect applying startups to at least have SG$3 million in equity funding raised from institutional investors, in addition to a business model that is proven to be commercially viable.
Three things you should know about venture debt
Unlike equity-based funding avenues, debt funding can have little to no effect on the cap table. Sometimes, however, such deals come with ‘warrant coverage’. Warrants give lenders the right to claim some equity in the company (expressed as a percentage of the loan amount) at a pre-determined price until a certain period. Should the lender choose to exercise this right, founders will see some of their ownership walk away (not as much as a VC would take, however). Not all venture debt investors may ask for warrant coverage, preferring to be non-dilutive instead.
Covenants and collateral are two other terms of note in venture debt. Not all venture debt providers will ask for collateral – startups are less likely to have such collateral in the first place. However, some lenders may require collateral in the form of cash or company assets, such as inventory or intellectual property.
Venture debt can also come with loan covenants, or contractual obligations that borrowing parties must adhere to. For instance, they may set time-time-bound performance benchmarks, or expect that founders maintain certain financial ratios.
Like collateral, covenants may be somewhat flexible, depending on the policies followed by the debt provider, and the applicant’s relationship with them. For both however, founders will want to evaluate if the capital is worth the obligations, or if they simply have a bad deal on their hands.
Why take on debt when you have VC instead
Venture debt is not as much a competing alternative to venture capital, as it is a complementary fundraising tool. While VC funding is more suited for the long term growth prospects of the startup, venture debt can provide a leg up in the interim.
Its primary benefit lies in being able to provide startups with liquidity in the short term without forcing the founders to give up more ownership. It’s a less intensive way of raising follow-on capital as well, and can help startups achieve certain short term benchmarks to make them more attractive in their next VC round.
Founders may raise venture debt for a number of reasons, such as extending the company’s runway, making their capital more efficient, or funding big ticket hires or acquisitions in the short term. In the more developed U.S. debt market, 91% of respondents in a study raised venture debt to increase runway, aiming for a better valuation in the next VC round.
Notably, the best time for them to raise venture debt is not when the company is running low on cash, but immediately after they’ve raised a venture round.
Debt providers typically lend based on how much VC dollars applying companies have at the time. For startups that raise venture debt when their available capital is diminished, the chances of defaulting are higher – debt, after all, must be paid back. The lender may choose to declare default on the company even as they wait out delays in their next VC round. Applying soon after a VC fundraise gives founders a shot at securing better deal terms for the loan.
So while venture debt is not something that companies want to take on in times of desperation, it can offer advantages to founders looking to strategically deploy additional capital at a lower cost to increase the company’s long term prospects. Venture debt is one of the moving pieces in the fundraising landscape that can help them do that, provided that they read the fine print.
Header image by Daniel Thomas on Unsplash