A founder's cheatsheet to raising Venture Debt
Historically, debt has been a financing tool available predominantly to cash-flow positive companies. Today, “venture” debt providers are willing to take on some of the early-stage financing risk, for an upside. It is worth noting upfront that venture debt is a complement to equity, not a substitute. Equity, with its risk-sharing characteristics, remains the main source of capital for the startup world, especially in the early stages.
How are venture debt providers willing to underwrite such risk? Instead of trusting that their loan will be paid off by cash generated by the business, venture debt providers partly rely on the ability of the company to raise further rounds of financing. The debt providers’ model extends to the next rounds of financing, providing more capital along the way.
While debt is an equity-free instrument, venture debt comes with equity warrants. These equity warrants give the holder the right to purchase equity at a predefined price for a specific period of time, providing debt providers with the extra upside to compensate for the earlier-stage risk. They are typically not very dilutive to founders and other shareholders, representing usually 1-2% of the company. The exact amount of shares in a warrant is a function of the loan amount. For example, for a $2 million loan, the coverage could be around $200k. This figure divided by the share price results in the corresponding number of shares.
When is debt relevant to your business?
Positive EBITDA is not a prerequisite to raising venture debt. For some sectors, when raising large amounts of equity pre-revenue is common, it is also possible to raise venture debt pre-revenue.
Typically, to pursue venture debt, you should be at the stage where your unit economics are able to tell a growth story with strong margins (e.g., CAC, LTV, payback period, etc).
Why explore venture debt as a financing option for your startup?
You can add debt to a large equity round to account for your “low” scenario, or to grow faster, or to finance acquisitions, etc.
Debt is relevant to your company when you have a growing (typically revenue-generating) business, with strong unit economics and a healthy runway which you wish to extend without extra dilution.
What is the typical size of the deal?
To be able to tap the debt market, you need to have recently raised / be raising at least a $10m round from reputable equity investors, or be generating significant revenue, either way resulting in a healthy runway.
The minimum debt ticket ranges depending on round size from a minimum of $2-5m (no upper ceiling).
How does the process of fundraising for debt work?
The process of raising debt is usually coupled with an equity round. This way, you can use the same pitch and due diligence materials. While debt providers do their own due diligence, they still heavily rely on the lead investors’ work.
But, it is not necessary to couple the debt raising process with an equity round. For as long as you have a good runway, you can explore adding debt to your capital structure.
What happens if things go wrong?
In terms of repayment and security, venture debt behaves like traditional debt and should not be confused with convertible debt or safe notes. Venture debt needs to be repaid.
Typical repayment spans 4 years with a 12-month interest-only period. During this time, the company pays back the loan amount plus interest in monthly installments. This schedule could add significant pressure to the company's economics, highlighting the importance of robust financial planning.
In case a repayment is missed, the venture debt provider has a number of options in getting their money back, often including direct access to the bank account and priority in a liquidation of the company against investors, founders or any other shareholders.
In this context, it is evident that raising venture debt is an instrument that fits companies with predictability in revenue and cash reserves, that founders should put to work with caution.
What are the basic terms to look out for?
Example: A company raising a $12 million round, could add $2-5 million in venture debt with 11% interest, 2% warrant, $250k fees, 4 years repayment with 12 month interest-only period.
Interest rates: Vary (10-12%), correlating to risk. In the current environment, you can count on the upper part of the range. It also becomes increasingly important to look at fixed vs. floating rates, and the corresponding premium for fixing the rate.
Equity warrants: Warrants (typically 10-20% of the loan amount) provide an upside to debt providers, giving them the right to acquire a 1-2% equity stake in your company.
Fees: There are fees to booking the deal which range between 1-2% of the loan amount.
Typical repayment period is 3-4 years with a 6-12 month interest-only period. It is important to note that there is a fee in case of early repayment of the loan (e.g. 3% of net book value in the first year, 2% in the second and 1% in the third).
Security type: The loans are senior to investors, founders and all other shareholders in terms of repayment and secured against the assets of the company.
Other terms: Financial covenants are unusual at the startup stage. Monthly reporting is usually expected. Of course, no board seat or similar.
Recently, we had the chance to interview two of the leading providers of venture debt in Europe, as part of the Tech Finance Network Startup Financing Series. In this video, Aris Konstantinides, General Partner at Kreos Capital, and Ben Tickler, Managing Director at Silicon Valley Bank, answer all our questions on venture debt financing for startups.