What Kind Of Startups Should Look At Venture Debt?
As we covered so far, venture debt is the perfect tool for raising growth capital while avoiding dilution and maximising equity returns for startups. It is also a very timely tool to finance acquisitions or bolster balance sheet before an IPO, strategic partnership or an M&A possibility.
While VC’s are comfortable taking concept bets, venture debt providers invest in the company’s ability to execute. In developed markets like the US and Europe, the Innovation Economy has accessed debt for more than 35 years. However, it is important to use venture debt in the right situations and for the right kinds of startups.
Key questions therefore are:
- What kind of startups should raise venture debt?
- How much debt should they raise?
- When is the right time for these startups to raise debt financing? and
- How should they go about raising debt?
What kind of startups should look at venture debt?
Venture Debt is better suited for startups having a high degree of visibility into revenue forecasts and a proven product-market fit. Such companies usually have positive unit economics and a clear path to breaking even. Startups having recurring or subscription-based revenue model (e.g. SaaS companies) and Enterprise consumer base with high lifetime value are more attractive to lenders.
On the other hand, Venture Debt is not ideal for startups having highly variable revenue stream or consumer base with high churn, like certain marketplaces. It should not be used by companies having low cash balance or as a financing of last resort. As a thumb rule, startups should take Venture Debt based on their own market opportunity and creditworthiness not based on their VC’s pedigree.
How much Debt should a startup raise?
Raising too little may not be worth the cost of having additional conversations and juggling another investor relationship. Raising too much can cause a company to become over-leveraged. Startups must, therefore, balance the amount of debt required with their business plan. Typically, companies raise 20% to 30% of last equity round as Venture Debt. As a thumb rule, monthly debt payments shouldn’t exceed 25% of a company’s total operating expenses.
Also, the amount of Debt should be less than 10% of the company’s Enterprise Value. Crossing these limits can cause a startup to become over-leveraged which discourages future equity investors.
When is the right time to raise debt financing?
The best time to raise venture debt is in conjunction with or just following an equity round when it is most accessible, all diligence materials are fresh, and the business has momentum. It enables Venture debt lender to leverage due diligence done by equity investor which reduces processing time.
Increasingly, startups are raising Venture Debt as a part of equity round rather than waiting few months to raise separate debt round. By raising 20-30% of the financing round as debt, founders can conserve equity and have more flexibility in building their business.
For example, a company raising $10 Mn in Series A can raise additional $3 Mn in Debt for a $13 Mn total raise. The startup can then capitalise on PR value of this bigger round to boost its marketing and hiring. It is important to draw the loan when you actually need it. Drawing debt too early can lead to a situation where the startup is making debt repayments at a time when it needs that money the most.
On the other hand, waiting too long to draw the money carries a risk of Venture Debt lender recalling the loan if a significant negative event occurs in the business.
How should a startup raise debt?
Venture Debt lenders work closely with VCs. A lot of times the company’s VC sponsor will introduce the founder to a Venture Debt provider. In other cases, intermediaries like lawyers and bankers can help make introductions. Startups can also reach out to venture Debt lenders directly.
A great way to get the attention of a Venture Debt lender is to use a reference from one of the lender’s portfolio companies. Since Debt lenders have a close relationship with their investee startups, getting a reference from a portfolio company is an excellent way to start the conversation.
Startups need debt several times in their lifecycle. While a company’s first loan might be for growth capital, the same company after few years might need debt for an acquisition. Venture Debt lenders love working with repeat customers who have impressed them with their track record and on-time payments.
Since lenders understand the company’s business and have an existing relationship with the company’s founders, they are more comfortable writing bigger checks for subsequent Venture Debt rounds to the same company. Thus, it makes sense to raise debt early in the lifecycle and establish relationships which makes it easier to raise successive bigger rounds.
Finally, startups should consider Venture Debt lenders not only as Capital providers but as strategic partners and use them for growing their business.
In conclusion, Venture Debt is a great alternative for startups to raise affordable capital, get more time to build their business and balance their capital structure. However, it should be used under the right set of circumstances and not as a financing of last resort. By raising debt at the right time, startups can have an extra cash reserve in their armour to tackle any business challenges.
[This article is part of 4 article series on Venture debt funding. You can read more articles here.]