Venture Debt: Suspension Bridge or a Pier to Nowhere?

As capital availability tightens up, we’ve seen more companies consider using some form of venture debt instead of equity financing. The concept was pioneered by Silicon Valley Bank and started to take off in the 90s as more lenders entered the market. Today, there are many venture debt options available to entrepreneurs. The difference between venture debt lenders and conventional lenders is that instead of looking toward hard assets or positive cash flow to secure their loans, venture lenders look at the enterprise value in a distress sale or to the equity players to back them up. This may seem backward, but the theory is that the venture lenders do so much business with the portfolio companies of the VC clients that, if necessary, they can pressure the VC firms to make them whole to preserve the relationship.

The appeal of venture debt is that investors can avoid setting a price at a sensitive time and it may carry the company to profitability or a value inflection point at which time equity will be less expensive. Venture debt players are typically looking for an all-in return of 18-20%, including interest, fees, and any warrant coverage. That’s not cheap, but it’s a lot less than a VC would be looking for. They’ll typically lend up to about 25-30% of their estimate of the enterprise value in a distress sale.

Venture debt can be a valuable tool in two very specific situations:

1. The company is in high growth mode, near profitability, and the venture debt will very likely take it to cash flow positive.
2. The venture debt will carry the company to a very specific, highly likely-to-occur milestone, such as a next round already underway.

Scenario 1 is the best use. If the business model is proven and the company needs a little more cash to hit cash flow positive, using less-expensive money is appealing and sensible. Scenario 2 makes sense only if the next financing is highly likely. If the VCs are using venture debt as a bridge instead of offering it themselves, it’s likely that they’re worried about the company’s viability or the syndicate is tapped out. If it’s a Hail Mary for a company without proven scalability, it’s likely to end in tears. In the event more money is needed and not available, the lender is going to be focused on getting their money back and unconcerned about any value that might go back to the equity holders. Lenders vary in their aggressiveness, but if the equity investors don’t step up, that’s the basic tradeoff.

If you’re considering debt financing, we’d keep these thoughts in mind:

• What will the company look like when the debt is due and how sure am I about that?
• What am I financing? If hard assets, debt can make a lot of sense. If increased sales and marketing spend, the model better be well proven.
• Venture debt will be a lot more expensive than a traditional bank but likely to have far fewer covenants. How important is that to you?

In a down market, venture debt can be a way to avoid a down round, if you’re confident in your business model. The bottom line is that venture debt is a powerful tool. Like any power tool, you can build something great with it, or you can cut your fingers off. Be sure you know how to use it.