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Venture debt: Timing is everything
Venture debt can accelerate growth, but it’s important to choose the right time to take debt on. Here are some key questions to ask if you’re considering debt.
Even though we live in a world of big data, knowing when to accelerate your growth plans remains an art that is as much based on information as it is intuition. While there are certainly milestones that can help you to pick the right moment, the truth is no two businesses are alike – so there’s no blueprint for scaling at speed.
This is particularly true when it comes to taking on venture debt. Given its comparative affordability, and the fact that it minimises your dilution, you would think the most obvious answer to the question “When should I consider venture debt?” is as soon as possible – but that’s not always true.
Thinking about adding venture debt to your cap stack? Ask yourself these questions to help decide if it might be the right time.
Do I have a plan for deploying the debt?
In the simplest terms, lenders ask two simple questions: “How will you use the debt?”, and “When will you be able to pay it back?”.
To answer confidently, you need to understand the relationship and differences between debt and equity.
Equity is a pre-requisite for venture debt: you need to have raised some form of capital to qualify. While equity has an expectation of return on investment, the funds are highly flexible, often with little to no requirements on how they are deployed. Although you’ll still need to defend performance at your Board meetings, you can use the funds as needed to fuel your growth.
Venture debt can be a powerful tool to accelerate growth, but only when taken under the right conditions. Understanding what it takes to be eligible, and the implications of taking on debt, is essential for those considering an alternative to venture capital.
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On the other hand, venture debt is a loan. That means it needs to be repaid via a future equity raise, an exit, or a shift to profitability. Lenders will expect to discuss and agree upfront a defined use case for the funds that drives towards one or more of those outcomes. Those use cases can vary from upfront runway extension (which gives you more time to scale revenues, grow users, or hit key development milestones) to funding customer acquisition costs or R&D spend.
Think through the amount of debt you are taking on and if it will help you take your business to the next level. If there isn’t a clear roadmap in the next three to five years, debt may not be the right solution for you right now.
How might the costs compare to raising equity?
The fixed nature of venture debt, insofar as it must be used for an agreed purpose and repaid within a fixed timeframe, stands in stark opposition to the flexibility of equity – and that’s true when it comes to cost.
Venture debt often involves a facility fee paid upfront, monthly interest on the funds you’ve drawn, and in some cases a maturity fee. Repayments typically take place over a set period, meaning you can clearly forecast the cash flow benefit to your business.
In short, debt is a cost you can account for.
With equity, although not contractually required, there is an expectation that an investment will lead to a liquidity event – and the terms are agreed well in advance. This means founders are driving performance to increase valuation for the next round and ultimately an exit. Each equity round will involve giving up some ownership of the business, but presents an opportunity to create a larger business.
Be aware that most venture debt will involve a small warrant. This gives the lender the right to buy shares in the future at a price established when the warrant was issued. Comparably, the dilution from a warrant is typically much lower than equity and often serves as a trade-off for the flexible structure of the debt.
How can I get the Board on board?
Debt is still misunderstood, particularly given the familiarity of the fundraising process, and you may face questions from your Board. Here are some common questions you may expect.
The business plan seems achievable, why take on the cost of debt now? | It’s better to raise debt from a position of strength when you are in the driver’s seat and thus able to negotiate terms at a reasonable cost. In the last few years, we’ve seen macro events impact the time businesses need to achieve their plans and the equity markets impacting timelines to raise. Knowing you have the runway to achieve growth, but also an ability to navigate any unforeseen delays, will give you a better chance of long-term success. |
What type of control / security do I need to give the lender? | Although this will depend where your business is headquartered and jurisdictions you operate in, you will usually need to provide some level of security over IP as well as charges over bank accounts. |
Are there any covenants you need to comply with? | Venture debt typically does not involve any covenants (remember, this is the trade-off for having warrants included in the pricing). |
What are milestones and what happens if you miss them? | While venture debt does not have covenants, you will sometimes see “milestones”. This typically unlocks more debt for your business. The thought process is that as you achieve key inflection points, you take on more debt, but if you are underperforming, you do not want to over-lever your business with debt. |
What happens when you raise more equity? | The debt can either remain in place, you could choose to repay it early (although that may involve some fees), or in most cases, you will refinance the debt and secure a new interest only period plus potentially enhanced terms or more debt. |
The golden rules of taking on venture debt
Debt isn’t right for every business, but when used correctly it can be a powerful tool to help fuel growth while retaining ownership for yourself and early shareholders.
Here are 3 guiding principles to remember.
- Be mindful of when you take debt on: You’re more likely to negotiate favourable terms at a low cost by raising debt when you still have significant runway.
- Have a plan for your debt: Whether you want to spend more to grow your customer base faster or have a few quarters of additional runway to weather any potential storms.
- Work with a lender you trust: Your business is scaling at speed, and you need a lender who can match the pace of your business in the good times and collaborate with you on solutions when things aren’t going to plan. Leverage your network, ask for recommendations, and do your diligence while they do theirs.
