Venture debt: A primer

With local tech star Oz Communication’s recent $10M venture debt deal happening, I thought it was a good time to walk through the good, the bad and the ugly about venture debt.

What?

As its name suggests, venture debt is a mix between debt and equity. It’s a loan that is secured by all the company assets (including intellectual property). Loan sizes vary from $1M – $5M typically and can go much higher. You can use the loan proceeds across your business.

Venture debt loans charge a premium interest rate (several points above prime). In addition, you have warrant coverage where you will give the lender warrants to buy shares in your company. If for example, you have a $3M loan with 10% coverage, you’re giving them options to buy $300K worth of shares.

If you cannot repay the loan, the lender can seize all the assets of the company and sell them to get paid back.

Where?

Venture debt is available from specialized debt funds. Here in Canada there are two main players:

MM Venture Partners: Do 3 year deals with monthly repayments

Wellington Financial: 3 year deals with one lump sum repayment at the end of the term

As you can imagine, the US market is vast, including players such as Lighthouse Partners, Sandhill, and many others. Even some of the commercial banks have been in on the action; though less so recently given the credit crunch hitting there.

When?

When to do a venture debt deal depends on whether it is offensive (adds value) or defensive (preserves value or stops value loss):

Offensive: Do these deals if you don’t have enough cash to get you to a significant milestone. i.e. If a year from now you will have significant revenue or partnerships in place, such that the value of your company will be much higher than it is today, then you should consider a debt deal to fund you through this milestone and raise equity at a higher value afterwards.

You also see these deals serving as a final mezzanine-type cash padding for late stage companies that need big cash reserves in order to go public. The beauty of these late stage debt deals is that you can pay the loan back from cash your business earns.

Defensive: when your business has not hit its momentum yet and you’ll have a tough time raising equity, consider venture debt to tide you over. Just beware; in some communities this will tarnish your company. You need to understand how your local VCs view venture debt.

Most lenders won’t touch you unless you have at least $1M or 6 months’ burn in your bank.

Why?

There are two reasons to do venture debt deals:

They are cheaper than equity: A VC’s target return is 35% per year. You’re not paying that to them, but you’re giving up enough of your company to make it possible. Target venture debt returns (interest and warrants) are 20%. If you repay the loan either from i.) Cash raised at a much higher valuation than you would have gotten today; or ideally ii.) From the cash your business generates, then you will have lined up relatively affordable financing.

You have no other option: This is the defensive scenario. You look at venture debt when raising equity is not an attractive option.

How?

The deal process is similar to a VCs, however it’s faster with much less due diligence. The lender has to like your team, technology and space just like a VC. And like their equity holding brethren, they are in this for the upside on the equity (warrants). So, if you come to them with a flatlining story that’s going nowhere they may do it, but what they’re really looking for are funding short term valleys that precede some good peaks.

If you have already have VCs, you need to coordinate with them before going down the venture debt path. Don’t surprise them.

That’s it. Venture debt definitely has a place in the capital structure of a startup. Used properly it provides real leverage to all stakeholders. If not used properly however, it can drag you down.

  • henric6116

    It’s great information about one of the vastly used form of funding. It is for sure one of the best method of getting money in current economic scenario. I have a 3 year old $ 30 million worth company and looking to expand. Can you please help me choose the right option for my company? ======================== Henric6116 Google

  • henric6116

    It’s great information about one of the vastly used form of funding. It is for sure one of the best method of getting money in current economic scenario. I have a 3 year old $ 30 million worth company and looking to expand. Can you please help me choose the right option for my company? ======================== Henric6116 Google