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One of the biggest concerns founders and CEOs have is raising capital to maintain runway until profitability is reached. Over the years, founders have often focused on venture capital and funding rounds. This means that venture debt could be overlooked as a way of boosting a company’s finances. Simply put, when you raise capital you are essentially buying money with equity whereas, with venture debt, you’re buying money with interest. What’s more, acquiring venture debt is fast, efficient, and allows founders to hold onto more of their company’s ownership longer than with other sources of capital.
Because equity funding is so time-consuming and less accessible these days, if you’re a startup with a short cash runway, you might not have the luxury of spending months chasing VCs or pitching to angel investors. That’s when the speed of venture debt really comes in handy.
What is venture debt?
Venture debt is a type of non-dilutive debt financing for early and growth-stage companies. Simply put, venture debt adds capital to the company as a term loan or a line of credit to fund growth or extend cash runway. Since many startups have few physical assets to use as collateral, it would not qualify for a traditional bank loan. With venture debt, other forms of assets, such as tax credits, recurring revenue, and purchase orders can be leveraged for a credit facility.
Why Choose Venture Debt?
Many startups try to raise equity right away when they need to raise funds for their business. But an early-stage startup equity raise can have quite a few repercussions, including:
- Time: Raising money through equity is often a long and difficult process.
- Dilution: Diluting too early can lead to a loss of control over the direction of the business.
- Loss of board seats: This means you’ll need to get your equity investors’ approval on everything from staffing decisions to the strategic direction of the startup.
- Forced valuation: While this isn’t bad per se, it could be a problem in some cases. For example, if the company is growing quickly or hitting key milestones where it would be better to defer valuation until the company will be worth more.
With significant downsides to seeking equity too early in a startup’s lifecycle, many savvy founders look into other avenues to acquire the funding needed to ensure their young business has enough runway to succeed. One of those avenues is venture debt.
Why Venture Debt?
- Venture debt is generally less expensive than equity.
- The process for venture debt is straightforward and much faster than an equity round which takes months.
- Adding debt allows you to grow your business and have a higher valuation when it’s time to raise equity.
- When you get venture debt, you get to maintain control over your business.
- It’s also flexible, meaning you can combine venture debt with senior debt from a bank to reduce your overall debt capital costs.
- Venture debt is non-dilutive which allows companies to create greater economic value for founders, employees and early supporters.
What can you do with your loan?
How you put the cash from your loan to use is up to you, usually with a few limitations that we will discuss later on.
Borrowers usually choose to invest the money in growth activities such as:
- Sales and marketing initiatives.
- Product development acceleration and efficiency improvements.
- Payroll in a cash crunch.
- Increasing working capital to keep operations going.
- Business scaling.
- Strategic hires.
These aren’t the only reasons venture debt is attractive. Since it has a relatively quick turnaround (between seeking debt and getting money in the bank), venture debt allows companies to:
- Extend their runway to give them time to hit their next goal.
- Build their valuations ahead of equity rounds.
- Finance big-ticket, one-time acquisitions.
- Conserve cash before an economic downturn.
- Purchase materials for manufacturing
- Avoid another equity round (and therefore more dilution).
- Fund a dividend recap.
- If a company is eligible for a grant or a tax credit (such as SR&ED) venture debt also can act as a bridge loan to help the company continue operations while they await their cash.
What can you not do with your venture loan?
What you can’t do with your venture debt is typically outlined in your covenants. Covenants can sometimes be negotiated, depending on your position, the type of loan and the nature of the venture debt provider you are in conversation with.
Keep in mind that if your lender is including an excessive amount of covenants in your agreement, it could be a sign that they are risk-averse. This means they may not be as supportive should your startup hit a few bumps in the road.
There are two types of covenants:
- Financial. These may cover provisions such as hitting a certain revenue target or ensuring your startup has a specific amount of cash on hand. Financial covenants typically are reserved for more established companies that may have a more stable income. Startups, which traditionally have more volatile cash flow may be able to avoid at least a few financial covenants.
- Non-financial. These covenants prevent the business owner from engaging in specific acts such as selling the company.
Should you decide to go ahead with a decision clearly prohibited in your loan agreement, you would be in breach of the agreement and it would cause your company to default on the loan.
Expect to have at least a few covenants on your loan. These covenants may include stipulations such as:
- Approval of payment of any existing debt or taking on new debt with your loan
- Approval of any merger or acquisition
- Approval before purchasing or selling long-term assets
- Prohibition of adding additional liens to collateral promised to the original lender (should the loan default)
- Approval before issuing dividends
- Agreement to send audited financial statements to the lender
- Agreement to stay current with taxes
- Agreement that any subsequent loans are secondary to the lender’s original loan unless stated otherwise
At Venbridge, we keep our covenants limited so startups can invest in the areas they think are best.
Is Venture Debt The Right Choice For You?
While venture debt has a lot of upsides, it’s not right for every business or for every stage. There are several circumstances in which venture debt would not be your startup’s best option, including:
- There is no clear use for the capital
It’s extremely important that any funds borrowed are used in areas of the business that create value. If your company has excess debt capital on your balance sheet, it simply shows an added cost with no discernible benefit. The same is true of raising excess equity, as it would cause unnecessary dilution.
- If your business is not achieving Product-Market Fit
If your company hasn’t found its fit in the market, it would be too early for the large majority of venture capital firms. Venture debt could be the answer if you’re on your way to achieving product-market fit as some debt providers such as Venbridge specialize in empowering up-and-coming startups. However, if you’re not confident your business can make its monthly fixed interest payment as well as the principal paid at the end of the term, then venture debt is not the right choice for you.
- If your business has declining Revenue/Margin/Profit with no plan for improvement
Venture debt is designed for fast-growing companies for which the value created via capital investment exceeds the cost of capital. For example, if you are only growing by 5%, it doesn’t make sense to borrow at 15% interest unless it’s to bridge a gap or to get over a temporary dip in your finances. Similarly, if your customer acquisition costs are getting higher, or your churn rate is increasing and you don’t have a plan for improving these metrics, a loan isn’t going to make sense.
What To Look For In Venture Debt
There are various lenders that provide venture debt in Canada, but not all work in the same way. As a business, it’s important to do your own due diligence on any venture debt organization to understand the structure and terms involved with the debt financing. Make sure the solutions on offer will ultimately work with your long-term raise strategy.
Look for a partner that:
- Believes in your business
Pick a funder that takes the time to understand your business model, concept, and long-term goals and then finds the best way to help you achieve them. Your funder can look for ways to combine different assets to give you a bigger loan, negotiate repayment, and introduce you to key people to kick off your business.
- Is flexible
You may want to increase funding as your startup grows or prepay your loan without penalties. A lender that is rigid or has significant early-payment penalties could stifle your startup and risk your organization’s ability to execute on its ability to raise additional capital in the future.
- Has an all-in cost structure
Seek out venture debt that offers transparent and simple pricing.
- Offers capital efficiency
If the debt requires a startup to draw down on the entire amount of the loan upfront, it can mean the company is paying interest on excess capital. As an alternative, look for loan structures that allow your startup to draw multiple disbursements as necessary.
- Is comfortable with the risk
Look for debt providers that have a proven track record of being founder-friendly, and a reputation for being able to support when things don’t go exactly as planned. A seasoned lender will work with your company to overcome challenges and find the optimal outcome for all stakeholders – not just themselves.
- Doesn’t have restrictive or excessive covenants
As venture debt is meant to work as growth capital and bear more risk, it should have fewer covenants than traditional working capital loans. Of course, because of this, it is priced accordingly. However, the covenants that are included in the agreement should be appropriate for startups using the capital to fund growth and may have no operating cash flow. Be mindful to avoid organizations that mask senior loans as venture debt. These deals may have excessive covenants which end up increasing the risk of default or reduce the capital that’s available to be drawn down.