One of the great values of the web is the democratization of information – anyone can look up anything at anytime and likely find an answer. Within the entrepreneurial world, and more specifically the world of venture capital, this has led to a surge of transparency in an industry which has historically had a bit of a black-box or club mentality.
Today there are a ton of fantastic resources out there for entrepreneurs looking at the inner workings of raising venture capital. Some of the best ones are created and maintained by venture capitalists themselves – Mark Suster, Fred Wilson and Brad Feld come to mind. Mark Davis has created an invaluable resource in his “Get Venture” blog. And sites like Venture Hacks can help people navigate all kinds of aspects about the start-up process.
With all the resources out there, I’ve been surprised about how little information is available regarding the small subset of the VC world that I’m most familiar with: venture debt. Sarah Tavel of Bessemer wrote two posts about venture debt a year ago, and if you do a Google Search for “venture debt”, you’ll see she’s prominently displayed on the first page of results.
As a lender for a Square 1 Bank, I spend parts of everyday explaining to entrepreneurs and those involved in our industry some of the intricacies of debt financing to venture-backed companies. Based on the above-mentioned facts, I thought it would make sense to run through a series of posts about venture debt: what it is, how the process works, the in’s and out’s of terms, etc. I’m not yet sure how many posts will be in the series, but I’m hopeful it will allow those involved in the entrepreneurial world to have a better understanding of the part venture debt plays in VC-backed companies.
Understanding Venture Debt – Part I: What is Venture Debt?
There are several different forms of venture debt and stepping back and viewing the issue at a high level makes sense in helping to understand the whole. Venture debt ostensibly refers to debt financing which is offered to companies who have a professional investor as a significant equity-holder in the company.
The reason the venture investor is important is because most often, companies in the market from venture debt do not have the underlying levels of financial performance (namely a history of profitable performance) that a traditional lender (read: regular commercial banks) looks to when underwriting a loan. Venture-backed companies tend to be cash rich after raising a round of funding, but often have plans to burn through a portion or all of the round of equity financing in order to rapidly grow product development or (hopefully!) sales.
In general, “normal” commercial lenders are scared silly by the idea of a company planning on burning through their cash. Over the last 25 years or so, a variety of institutions have popped up who understand the dynamics of the venture world and have gone out of their way to establish carefully cultivated relationships with the venture capitalists and entrepreneurs who are part of the ecosystem (in my next post I will provide an overview of the players in the space). By leveraging the relationships and understanding of the dynamics which are at play with venture-backed companies, venture-lenders can effectively provide loans to companies who are burning cash while minimizing loan losses, leading to a workable business model. Thus, an alternative form of capital is available for entrepreneurs called venture debt.
Within the broad umbrella of venture debt, there are a few different types of loans which are available and appropriate for different stages of VC-backed companies.
- Accounts Receivable-based Line of Credit – this type of debt is useful for companies that are generating revenue and assets in the form of Accounts Receivable. Many times, companies will see a working capital gap caused by the time it takes for them to collect accounts receivable and the terms under which they must pay their vendors. It is possible to leverage the billed accounts receivable, often at a discounted rate of 80% of the AR base. There are many types of lenders who will finance AR, and I will touch on the various aspects in a later post to get into the details. This is often the cheapest and least risky form of venture debt as the loan is tied to a quick asset. Other names for this type of loan facility include AR Line, Formula Line, and Receivables Line.
- Equipment Term Loan – If a company has the need to purchase a significant amount of capital equipment, it’s possible to finance the purchase. This allows the company to use the proceeds of the equity round for the purpose of funding growth in sales and marketing. Lenders sometime require the advances on the loan to be supported by invoices for equipment to specifically tie the loan to equipment, though not always. If the company’s plan shows continued cash burn, it’s likely any long term debt such as this will include covenants related to minimum liquidity or a requirement to raise additional equity (a discussion around covenants is certainly an issue I will address in future posts).
- “Venture Debt” Term Loan / Non-Formula Line of Credit – Often this is what people think about when they hear the phrase venture debt. This type of capital looks and feels in many ways like equity in the short term, with the obvious caveat that it’s debt and will have repayment terms associated with the note. Term loans typically have multi-year terms (3 years is the norm, though some are longer) while Non-Formula lines of credit (i.e. not tied to AR) typically have a 1 year term.
That’s a good overview for now of venture debt. In my next post, I’ll look further into the types of institutions which provide these various types of financing: venture banks, debt funds and the like. Feel free to provide feedback in the comments section about particular aspects of the venture debt landscape which you’d like to know more about.