Most founders are familiar with venture capital — that is, equity financing. Mention venture debt and you might get a blank stare or two.
What Is Venture Debt?
Venture debt consists of loans made to venture-backed startups that have reached a growth or expansion stage. These loans are typically made three to nine months after a Series B through Series D capital raise to revenue-producing companies that can service debt payments, interest, fees and ultimate repayment of the loan principal.
In a previous article, I provided an overview of venture debt and how it supports diverse founders. This article explains how founders can prepare for a successful venture debt raise.
Who Uses Venture Debt?
Venture debt is provided to companies that have already received venture equity financing. Small business loans and loans made to companies not backed by venture capital firms have very different risk and return characteristics. These types of loans are not venture debt.
Like venture equity, venture debt provides growth capital for founders to develop new products, build their tech stack, enter new markets, expand their marketing, etc. Venture debt is suitable for growing revenue-generating companies that have successfully demonstrated product-market fit and raised multiple rounds of venture equity.
When to Use Venture Debt
Most venture debt is provided three to nine months after an equity raise to revenue-generating companies that can service debt. For example, A.R.I.’s Venture Debt Opportunities Fund typically seeks a minimum annual revenue of $10 million before making a loan, although relationships are usually formed well before this minimum revenue threshold is reached.
Venture debt complements equity and is typically used to raise 15 to 25 percent of a company’s capital in a given round. For instance, if a company wanted to raise $25 million at a pre-money valuation of $100 million in a Series B offering, $20 million could be raised by selling 20 percent of the company’s stock and then borrowing $5 million. Thus, the company preserves a significantly greater share of ownership and reduces its average cost of capital (debt financing is cheaper than equity financing) while achieving its overall fundraising target.
Founders must understand that most lenders require a minimum cash runway of 18 to 24 months. The best time to use debt is when you think you don’t need it: a company that needs capital to survive, as opposed to thrive, is no longer a viable candidate for traditional venture lenders. Founders should consider debt alongside their equity raise.
Here’s a horse racing analogy that founders should keep in mind. Equity VCs often place their bets before the horses are even on the track; lenders do so long after the race has begun. A.R.I.’s Venture Debt Opportunities Fund invests when we feel the race is already 80 percent run. We won’t always pick the winner, but it is extremely likely that we will consistently deliver strong returns because our selections have proven they are very likely to win, place or show.
Prepare to Raise Venture Debt
The key to a successful venture debt raise is preparation. As Ben Franklin said, “By failing to prepare, you are preparing to fail.” Because venture debt raises follow venture equity raises, much of the most difficult work has already been completed.
Venture lenders analyze the borrower carefully and consider similar factors to equity investors: business strategy, market opportunity, competitive landscape, the skills, experience and integrity of the management team, product-market fit, capital structure, financials and traction, including demonstrated success and positive momentum, among others.
While some factors might be similar, venture lenders view companies through a different lens than equity investors. We are primarily concerned with downside protection and limiting losses, deeply scrutinizing a company’s historical and near-term performance, with less emphasis on returns that may or may not materialize far off into the future. Lenders want to hit singles and doubles and never strike out; equity investors seek to hit homeruns, knowing that often they won’t get on base.
Start early and identify your company’s goals and needs. Develop a conservative business plan and operating model with forward-looking financial projections. Be able to articulate how the loan proceeds will be used.
Next, identify well-matched lenders by sector, company stage, loan size and geography. Reach out to them before you need financing to establish rapport. Positive references from existing venture equity investors are helpful but not critical.
A strong data room is essential. Lenders expect to find a marketing deck, audited financials, realistic financial projections and numerous supporting documents that reveal the borrower’s operations and finances.
Ultimately, the borrower must provide credible evidence that they will be able to make all loan payments and have assets that act as sufficient collateral for the lender in the event that a loan default occurs.
What’s the Right Amount of Venture Debt?
Venture lenders size loans based on a number of factors. While all have different underwriting standards and risk tolerances, they generally focus on enterprise value, revenue, cash-on-hand, cash burn (to determine runway), and the borrower’s collateral value.
A.R.I.’s loan underwriting guidelines include loan-to-enterprise value of less than 20 percent, loan-to-revenue of less than 50 percent, loan-to-cash of 25 percent or less, annual growth rate of more than 25 percent and collateral that could be monetized for at least two times the loan value. Most other top-tier venture lenders have similar standards.
Such transparent metrics, relatively stable across lending platforms, allow prospective borrowers to determine how much debt the market will provide. That said, more debt (leverage) isn’t always better: interest payments are due monthly, and the full debt needs to be repaid.
A Simple Tip for Debt-Raising Success
Raising capital of any kind isn’t easy, but a well-executed plan can make raising debt relatively painless.
In addition to the above, founders who successfully raise venture debt are organized, available, timely, transparent, humble and trustworthy. With the demise of crypto and the huge valuation hits that many startups have endured in the past year, intangibles are more important than ever. They are now a must-have rather than a nice-to-have.
From my vantage point, obtaining funding continues to get more difficult for startups and the demand for venture debt significantly outweighs the available supply. Founders who are able to earn a stamp of approval from lenders de-risk their businesses with improved liquidity and growth capital that will serve them well in a tough market.