There’s been a lot of digital ink spilled around the various types of capital available to startups today. At NextView, for instance, one of our more popular posts centers on atypical seed rounds to know. Today, we wanted to share some basics of another source of capital: venture debt. What is it, and how should founders think about it?
As a startup grows, venture debt becomes a viable option to continue that growth. It can be lower cost and can either buy more time or accelerate growth. Below, we talk to Glen Mello, Managing Director of Silicon Valley Bank’s accelerator team in Boston. Glen is an active contributor to the local tech ecosystem and well-versed in how and when startups can use venture debt to their advantage.
NextView Ventures: What is venture debt, and how should startups approach it as a source of capital? What are some pros and cons?
Glen Mello: Venture debt is a good complement to equity. It’s generally got a lower cost compared to equity capital and can help support growth. You’ll also see some startups use it as an additional cushion. From a company milestones perspective, entrepreneurs who take on venture debt are almost always thinking about raising that next round of capital from other institutions.
One con is that it is debt, so it needs to be repaid. In a scenario where you have missed the milestones or you’re out raising at the same point where it’s amortizing and you’re starting to pay it back, it can be a challenge.
[Ed. note: We’d like to be extra clear that founders should not take on venture debt if they don’t have 100% visibility into repaying the loan, as banks that need to recoup their loan my force the company or you as the guarantor into liquidation or bankruptcy. Use good judgment, talk to your co-founders/investors/lawyers, and partner with a bank that values transparency and relationships such as SVB.]
NVV: How does venture debt differ from other types of traditional loans?
GM: The model is more about the relationship with the entrepreneurs, the investors, and us as the bank, as opposed to cash flow or fixed assets to lend on. The structure itself is very similar to traditional debt, as it has interest rates, it needs to be repaid, etc., but the underwriting of it is much different.
NVV: What stage of growth is appropriate for a company to have achieved prior to taking on venture debt?
GM: It becomes more useful as the company is continuing to grow — probably at a point after they’ve raised some institutional capital. Reason being, there’s more of a defined strategy for the company. In many instances, you raise an institutional round to either fulfill a product strategy or go-to-market strategy or you’re increasing sales and marketing hires, so you have better visibility into what needs to happen in the next six, 12, 18 months. Prior to that, there’s a lot that’s unknown, and so when you layer in debt that eventually needs to be repaid, it can complicate the process.
Especially in the early stages, so much about the company may change in how they think about product or go-to-market — and change multiple times — before raising an institutional round. So it makes it a lot more challenging when you have debt on the books that isn’t as longer term as equity. (Equity doesnt need to be repaid, so it’s a more “permanent” capital source.)
NVV: These investments seem to happen between institutional rounds. Why?
GM: There’s a fair amount that happens in parallel to VC rounds, but yes, it often happens when a company is fresh off of an equity raise, usually within three or four months. The reason it happens this way is that, again, there’s a buy-in from all the parties I mentioned. For the investors, there’s a plan they just invested in. For the founding team, there’s a strategy in place. And then the question becomes, “How do I complement the capital I just raised, either to buy more time in case I slip or to accelerate my spending if t?” Venture debt gives you those options, and particularly for companies that wind up doing well, then on your same cash-out date, you’d likely have achieved a better milestone thanks to fueling your spend, which would translate into a better valuation.
NVV: Let’s talk about the seed stage specifically. With venture debt as a source of low-cost capital to fuel growth or buy time during later stages, should a founder approach their fundraising from VCs any differently today?
GM: No. After you raise a seed round or other early rounds, I think that entrepreneurs should consider this a complement to institutional equity. There’s a perception in the market that they can just raise debt instead because it’s easier, and that’s a perception that’s probably not accurate.
Looking at current trends, companies are taking on debt sooner than they ordinarily would have before, in addition to taking on more of it in dollar amount. It’s not often a seed-stage company — usually it’s later — but the trends are going earlier and larger.
NVV: Walk me through the typical process once a startup approaches you.
GM: The first thing is really about spending some time with the entrepreneurs and walking through the model, their go-to-market strategy, etc.
If we don’t have a prior relationship, we’ll really want to try to develop that because it’s such a relationship play. And it’s that important because all companies will go through good times and tough times, and we’ll want to make sure we’ve got the right partner on the other side.
We’ll also dig into the model, dig into the product, dig into their go-to-market, and really try to understand and evaluate the milestones associated with getting to their next round of funding. These are value-creation milestones. We’re essentially looking to understand the probability of a company attracting more outside capital. If they can’t, then we want to know more about the existing investor syndicate, so we’re not the only ones at the table.
We’d then put together a proposal that would spell out all the mechanics, including the pricing. It includes the amount we’d be willing to do, maybe with some available up front and some available based on milestones so we’re funding their growth. We also spell out the interest-only period, the amortization period, the warrants, the interest rate, and then some high level legal terms we would include in the documents and highlight in the term sheet — similar to a VC term sheet.
In terms of negotiation, there are always hot buttons. It could be with the entrepreneur or the investors. But overall, it’s a really efficient process. Investors have typically seen our term sheets and documents before, and the startup’s lawyers have seen these too, so everyone knows the standard and what to expect. The fact that the process can be much smoother and quicker can actually be a benefit.
NVV: What do debt providers look for in a company’s track record? Traction and revenue? Business model? Previous capital raised?
GM: We look at things very much like a VC investor. We’d look at the team — if they’re a repeat entrepreneur, have a good track record, have built a quality team, and so on. We also look at whether we’ve had a prior relationship with them, whether good or bad. Then we look at our relationships with the company’s current investors.
We also consider the market opportunity. Are they way ahead of the market? Are they entering one of maybe many raises down the road, or are they late to the game? Maybe there are many players in the market where some have already been acquired and prices looked good. Or maybe there aren’t enough chairs left in the market for latecomers.
SVB also has an analytics group to use for industry stats, company statistics on a global basis, and so forth, so we collect a lot of data that we try to leverage internally.
NVV: How important is the accuracy or confidence in a startup’s cash flow prior to taking on venture debt? With equity, for instance, it’s likely the investment won’t be repaid when you look at the numbers of startups who fail.
GM: Cash is actually a big piece of the analysis. Among the elements we look at are the burn, the cost to hit certain milestones or inflection points and whether or not there’s a buffer built in, whether we’re providing the buffer or the equity investors are providing it, and so on. So although the startup’s plans may change, understanding product and go-to-market milestones is pretty important. As an aside, it’s probably more important if there’s a significant hardware component to the product. Typically, the gross margins aren’t there compared to software, so revenue isn’t quite as important in the early stages of getting to market. But the costs are definitely there. If you’re way off on the cost of manufacturing or shipping, it can really impair a company at the point in time where it’s going to be raising more capital.
NVV: What are some stereotypical terms? What percent of the fair market value of a company’s assets is typically lent?
GM: It’s less about lending on the assets and more about those relationships. We’d look at a company and the relationship we have with investors, management team, founders, etc. first and foremost.
There used to be a rule of thumb that debt was around 25% of the fresh equity raised. That ratio is now getting skewed to much bigger percentages now, which goes to what I was saying earlier that there’s a lot of liquidity in the market and people are doing larger deals than they normally would have done.
NVV: Is there any dilution? Any equity the venture debt lender gets?
GM: There are warrants attached to these loans, but it’s a pretty nominal dilution and pretty low cost of capital for an entrepreneur, which is usually part of the appeal.
NVV: How long is the typical term? What interest rate is typical?
GM: The rate can fluctuate based on the prime rate, so there’s a chance it could go up. The chances of it going down are nonexistent today. The typical term is four years, which would include some period of interest only, and then it would start to amortize.
NVV: Any other terminology a founder should know in order to better understand venture debt?
GM: I think venture debt is used as a generalization. The way to characterize it simply and appropriately is that venture debt is term-oriented debt, which is different than something based on working capital. It’s really to help facilitate growth and complement some equity that’s raised. That’s the best way founders should think about it.