Venture Debt

Time for my take

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If you’ve been following my blog for a bit, you get how the money can flow, valuations are set, terms are decided, etc.  I tried to remain as impartial as possible.  Well, the table is turning and I am going to start putting my thoughts out there.  I’ll start by digging in to the venture debt market.

Raising capital from a lender is just inherently risky.  There is a reason huge venture backed companies that raise massive rounds never touch it.  Why risk the huge valuation of a company over a couple million dollars of debt?  It just doesn’t make sense.

That ISN’T to say that there aren’t significantly more opportunities to raise and use venture debt effectively.  First, getting a bank line from one of the venture banks is almost a no brainer.  Money is really cheap right now, they don’t put many restrictive covenants in place, and the warrant dilution is less that the options for a new college grad.  It is just a good way to provide a sensible amount of stretch capital for the unplanned, unknowns of the world.

Beyond that I think venture debt becomes segmented very quickly – every situation is truly case by case.  Using debt to fund topline growth is where I believe venture debt is best suited.  This means an established business, generating a reasonable amount of predictable revenue, with an end goal in mind.  If there isn’t a path to being cash flow positive, at which point you can repay the loan without impacting growth, venture debt just becomes a replacement for equity with a lot more risk.

It is easy to make those statements when you can always raise more equity are fair valuations.  Clearly that isn’t always the case, which is why each situation is unique.  If you are in the middle of a massive technical inflection point and pushing out the date of an equity raise by 6 months increases the valuation by an order of magnitude, do it!  Just do it with the full understanding that the equity will come in and refinance out the debt.

I’ve found the most common issue with debt is when companies are using debt as a short term band aide, and something doesn’t go exactly to plan.  Which is ALWAYS.  It just never is perfect in the real world.  Being caught with a pile of debt on your business, insufficient cash flows to support it, and a valuation that you are not prepared to sell for is a recipe for disaster.

There are many situations where it is a fantastic solution that fits all the needs of all parties involved.  The few rotten apples spoil the bunch for everyone else.

Where to use Venture Debt

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There are varying opinions and views on this topic, and I will not claim to have all the answers.  I have spent the last few years covering the competitive landscape of venture debt lenders on behalf of my firm, and I was making investment in the space.  In that time, I developed a strong view of how this unique investment product can be best used.

The way I see it, venture backed companies can be divided into three groups (kind of):

  • The top third of high flyers that are just amazing companies – generating tons of value for everyone who was fortunate enough to get some ownership in through any means necessary.  These companies are the reason people continue to dump truckloads of money into the venture asset class, the hope that you might invest in the next WhatsApp and make $19B.
  • The bottom third of companies that are bound to fail, or at the very best be rolled into another company with little fanfare.  These are the businesses that just never make it, for a multitude of reasons including poor capitalization, mismanagement, or just a lack of market acceptance.
  • That leaves the elusive middle.  These are the companies that are just somewhere between raging success and relative failure.  They probably are a good business, (i.e. they do make money) but they just aren’t ever going to make a lot of money.  Which isn’t bad, but it doesn’t justify the large risks nor generate the outsized returns, which are required of the venture asset class.

In my opinion, the top third of companies have no need and no business wasting time taking on venture debt.  Revolving lines of credit, bank lines, equipment financing and all of the other great credit vehicles can be used, but there is no real value of venture debt over equity.  Equity can be raised at very non-disruptive valuations with minimal impact to management, and in sufficient quantities to support the rapid growth.

Venture debt gets to pick from the bottom third and the middle third.  The best venture debt investors can tell the difference between the two.  Good companies in the middle third that are generating money and value in the market can raise venture debt in order to capitalize growth at a level that is attractive to management, while helping to juice the growth rates and increasing value to equity investors.

Companies in the bottom third of the market are the ones that can be harmed substantially by raising debt, and can harm venture lenders returns.  They are unable to repay the loan, forcing the lender to try and sell the business at a likely inopportune time, degrading the value of the equity for all of the holders.  This is just bad for everyone involved.

It is not simple to tell the difference between the middle and bottom third.  Lots, actually, all management teams believe their business in not the in bottom third, and there is ALWAYS a reason it is ‘just about to turn the corner’.  Sometimes they do, sometimes they don’t.

Venture debt investors that are able to pick the companies in the middle third while avoiding the bottom third, make money.  The top third just don’t need money in the traditional venture debt model, and usually would price a deal so competitively that it isn’t always worth the work to generate the return – just put equity in and get the associated upside.

Notice, NONE of this is predicated on revenue, or growth, or patients, or magic beans.  It is primarily business analysis.  There are some governors that most lenders have in place to try and avoid issues (they may require $10mm in revenue, or a plan showing positive EBITDA in 12 months, or something), but typically those are focused on avoiding the bottom third.  Metrics drive value, and financials are indicators of strength.  The combo is the special sauce which represents success.

The Debt Stack

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There are multiple types of debt and there are multiple ways to use that debt.  From the perspective of a venture backed businesses – debt can become very dangerous if used incorrectly, but can also be a very helpful low cost source of capital.  Different lenders will take a different type of lien.  A lien is a form of security interest in a business, meaning if you can’t pay back the loan the lender can take the assets it has a lien against.  A bank takes a lien against your house in a mortgage or against your car in an auto loan.  Your house or car is the collateral, against which the bank will loan you money.

Working Capital Debt – Revolvers

The easiest, lowest cost and often the first type of bank financing many businesses can access.  This is known as Asset Backed Lending (ABL), where the bank will take a lien against various forms of working capital.  Working capital financing is typically secured by the accounts receivable (A/R) of a business (A/R is the payments from customers for products and services previously delivered).  Another form of working capital that you can borrow against is inventory.

Typically venture backed businesses can borrow up to 80% or 85% (the amount you can borrow is known as the advance rate) of the total value of A/R from qualified customers, that is not older than 90 days.  This means customers with quality credit, who are current on all outstanding bills.  Inventory typically has a 50% advance rate, but is often slightly more difficult and complicated than A/R financing.

Rates for working capital financing are usually the lowest, and are based on the amount the borrower has outstanding every month. In addition to the balance monthly, there is an unused line fee or commitment fee, where the bank will charge the borrower a percentage of the total revolver amount that is not drawn.  Additionally, there is a very small warrant associated as well (a warrant is a right to a number of shares of equity, that doesn’t cost the bank anything, until the day it exercised – at which point the bank would only exercise the warrant if it were to generate more money than they cost).

Interest rates are typically set at LIBOR + 2% – 4%, with a LIBOR floor of 1.00%, unused line fees are typically 0.5% and warrant coverage is between 0.25% and 5% (warrant coverage is calculated as the value of the equity if a warrant is executed as a percentage of the full debt amount – i.e. 5% warrant coverage on a $1mm revolver would represent $50k of equity value).

Working capital facilities typically have no amortization but are simply due in full upon maturity.  Almost always, the facility will be extended, meaning it is never due.  Revolvers will have a specific lien against the assets, but they often require a blanket lien against the entire business as well.

Senior Term Debt

After working capital facilities, companies can often also raise a small senior term loan.  This is structured as a lien against the business, with no specific liens.  Often, a bank will extend a term loan in conjunction with a working capital facility.  Meaning a company can borrow an additional amount, beyond the working capital facility.  This is only known as senior debt, if it is from the same lender as the working capital facility.  The costs are similar to a working capital facility, but obviously a little higher as the risk is higher.  The term becomes a consideration, and can include an interest only period.  An interest only period is a set amount of time, during which a borrower will pay only the amount of interest due each month, with no principal amortization.  In the event the facility comes from a second lender, it is considered a subordinated loan.

Subordinated Term Debt

A subordinated loan means nothing more than it is subordinated.  It still will have a lien on a business, but the banks lien will be second in line after the senior lender.  Subordinated debt will cost the most, and will require the most consideration for a borrower.  I will cover these considerations and costs in a future blog, going into to more detail.

Other Debt

There are obviously other forms of debt as well, most common are equipment financing and vendor financing.  Equipment financing is borrowing for specific equipment (such as server racks for software companies), where the collateral is specifically defined and does not have a lien against the business.  Vendor financing is the same as equipment financing, but not from bank, rather the actual supplier of the business.  This is like getting a car loan from the dealership.

Bueller…  Bueller…  Bueller?  Anyone still reading?  Sorry.  It got dense quick.  I promise, this is interesting and fun, but there is a basic understanding of how various types of debt work, and how they interact.  We got some terms (advance rate, collateral, revolver, sub-debt, LIBOR, liens), and now have the basis for debt.

Basics of Debt and the Venture Market

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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!

Who? What? Why?

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Who?

I’m Kevin Holub, a 25 year old associate at a firm in a niche area of of the venture community you’ve probably never heard of – venture debt (don’t worry, we’ll get to the what later).  I graduated from Northeastern with a degree in International Business, focusing on finance and entrepreneurship. I am heading to Harvard Business School in the fall for my MBA.  I am also blond haired, blue eyed and enjoy long walks on the beach…

What?

As I said, I work in niche corner of the venture capital landscape – venture debt.  From 10,000 feet, venture capital is the way most leading private companies raise money.  Companies seek large sums of money in exchange for a portion of their equity.  Venture debt provides large sums of capital as well, but rather than take a stake in the company, venture debt providers issue a loan to the business .  But let’s not get too deep into this yet, otherwise there is no need for the blog.

Why?

Because I’m bored. Because no one knows that venture debt is.  And even worse, many companies raising capital have no clue how any of it works.  I’ll touch on all aspects, both high level and detailed, of the venture debt market.  I’ll try my best to explain things clearly, and provide a layman explanation of the various topics along with links where I think they are helpful.  I look forward to your input, and will do my best to respond to you question/inquiries.