Why venture debt, why not banks?
The target market for traditional lenders (banks) are businesses with 3 to 4 years of operational history. Typically, they have metrics that are achievable by profitable businesses.
Some of the deciding factors that traditional lenders look at are:
- Strength of cashflows, chargeable assets and guarantees
- Current ratio – 1.2x and above
- Gearing ratio – 1.2x and below
- DSCR – 1.2x and above
Generally, early stage startups are non-profitable with unfavorable ratios. This is because their focus is on generating top-line growth. For instance, software startups usually have low current assets, typically reflected by low cash in bank. On the flipside, they have high current liabilities, illustrated by long conversion date of convertible notes.
Venture debt takes a flexible and creative approach towards financing startups by looking at other metrics that traditional lenders disregard.
When should I consider venture debt?
Venture debt is ideal for startups that are generating revenue, usually pre-series A and beyond. Typically these startups are raising their growth round to accelerate growth or undergoing expansion. Besides, it is also suitable for startups launching new products, have achieved profitability and/or are looking to fund an acquisition.
Furthermore, venture debts are typically complementary to an equity round. Some utilize a revenue-based financing model whereby the lender obtains a portion of the revenue/profit generated over a pre-defined period. Usually lenders step in to fund the customer acquisition cost or general operational activities.
Generally, there are two scenarios where startups could consider venture debt:
- Firstly, as a bridge round. Startup has burn through their bank and is time to raise a Series B. However, KPIs have not been met to trigger favorable terms that the startup is looking for. Hence, startup decides to raise a small equity bridge round to lengthen runway by a few months. This ensures KPIs are met before moving on to Series B. To prevent dilution, the startup decides to raise a bridge round with a mixture of equity and debt.
- Secondly, as a normal round. Startup is now raising its Series B round and is required to raise a projected amount of capital to create a safe runway towards their next milestone. To avoid massive dilution to the founders, the startup decides to raise a part-equity-part-debt round. This minimizes dilution while achieving a sufficient runway towards their next milestone.
What are some of the things to expect?
Many have raised questions regarding venture debt to me in the last 24 months. Here are some of my key takeaways:
1. Pricing and Structure
- Most venture debt have a monthly repayment commitment with fixed interest and fee are through the loan tenor. Interest and fees vary from startups to startups, subjected to both macro and micro-economic factors.
- Duration of due diligence and contract negotiation depends on the speed both parties are moving at. It is important for startups to prepare the necessary documents accurately and promptly to ensure a smoother process. Besides, startups should plan their cash requirement ahead of time as the negotiation process often drags out longer than expected. Depending on the venture debt firm, disbursement of capital can occur within 2-3 days after the execution of legal agreements. However, there could be a delay of up to 2 weeks to raise capital.
3. Warranties or Equity-kicker
- A warrant is a stock option for the holder of the warrant. In this scenario, the venture debt can purchase equity from the startup under predetermined terms and conditions. For instance, the warrant permits the venture debt the right to purchase x number of stocks at $y for z years, and x is 100, y is 1 and z is 5. The venture debt can exercise the option to purchase 100 stocks at $1 in the next 5 years.
- Equity-kicker is a clause where if certain conditions are met, the venture debt will receive an amount of equity on the startups during loan maturity.
Usually, warranties and equity-kickers require an approval from the board of directors as most startups prohibit these through their company’s resolutions.
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