We’ve covered a bunch of dynamics relating to raising capital thus far, all of which was focused on raising equity.  The second type of capital a company can raise is in the form of debt.  Like with equity, I’ll attempt to break this down, starting with some of the basic tenants of debt in this intro blog, and move into the more nuanced components of venture debt going forward (disclaimer: I have worked at NXT Capital Venture Finance for the past two years making venture debt investments.  We are no longer making new investments, but do maintain a portfolio of active loans.).

How does it work?

We all are familiar with debt, and likely understand a decent amount about it.  Home mortgages, car loans, credit cards, student loans, etc. are all forms of debt, typically where we as consumers borrow money from a bank in order to buy things.  There are two basic things we need to know about a loan, the interest rate and the length of the loan.  Most debt is structured in this way, with various tools and methods to help match borrowers needs to their ability to pay the loan back.

Looking at a mortgage as an example, the standard mortgage is 30 years with the current national average of 4.23% annual interest.  With monthly payments, your mortgage would cost you $2,453.85 a month for the next 30 years (there is some cool math that helps us calculate this number, but like most people these days, I use a calculator or excel to find that payment value).  At the end of the 30 years, the house is all yours with no mortgage.  To really understand why we pay $2,453.85 a month, we need to know the various parts of the loan: interest and principal payments.

Thinking through how the math works is important.  Each month, the bank will calculate the interest that you owe for that month, and the rest of the payment will go towards paying down the amount you owe (known as the principal of the loan).  In the first month of our mortgage, we will owe 4.23% divided by 12 (we only owe one twelfth of the interest, because we pay it twelve times in a year) multiplied by the current balance of $500,000.  That comes to $1,762.50 of interest in the first month.  We know that the monthly payment is $2,453.85, so in the first month we would pay $691.35 ($2,453.85 minus $1,762.50) towards the principal balance.

In month two, we don’t start with $500,000, because last month we paid $691.35 towards the principal.  Rather, we start with $499,308.65, meaning we multiple that number by 4.23%/12.  If you continue this for 360 months (30 years x 12 months), you will end up with a principal balance of $0 at the end.

This is an example of a standard amortizing loan (amortizing means you are paying one amount every period that includes both the interest and the principal until there is no outstanding principal balance).  Another type of loan is known as a bullet loan.  A bullet loan pays only the interest throughout the entire term of the loan, and repays the full principal balance only upon maturity (maturity is the date the loan is due, using our mortgage example, this would be 30 years after we started the loan).  Most bonds you can buy in the public market are bullet loans, with the full amount of the loan repaid on the maturity date and interest payments made ever quarter.

There are all different structures that can go into the loans as well, but if you are really interested in learning more about loans, I suggest buying a book or taking a class – sorry.  There is just too much to cover in my blog, so I will try to keep the concepts at a high level, with enough understanding to see how venture debt works.

With this basic review done, we’ll be able to dig in to the debt stack at a venture backed company. We’ll explore when and how to best use venture debt to maximize the value of a business and the ultimate return for the founders, venture capitalists, and the venture debt lenders!