The most frequently asked question we receive at Find Venture Debt is "Does my company qualify for venture debt?" Each lender has its own system for estimating the risk for borrower default and financial loss on a potential loan. However, most lenders rely on a core set of principles. These are commonly referred to as the five C's of credit analysis, which include character, capacity, capital, collateral and conditions. I've always found these terms a bit vague in isolation so here's how to think about them:
- Character is captured in your credit history, credit report, or credit rating.
- Capacity is captured in your debt to income or debt to EBITDA ratio.
- Capital is your down payment or equity contribution for an investment or acquisition.
- Collateral is your property or other asset that secures a loan.
- Conditions are the characteristics of the loan such as interest rate, terms, and intended use of proceeds, and external factors such as the outlook for the economy or industry.
At Find Venture Debt, most of the potential borrowers that contact us are technology and growth companies. They may be great opportunities for equity investors focused on upside potential, but can be challenging from the perspective of a lender focused on minimizing downside risk. Prior to a detailed credit analysis, we perform a quick assessment of creditworthiness based on five criteria:
- Assets: Does the company have assets that provide acceptable collateral for a loan? The most common assets used for asset-based lending are working capital (e.g. accounts receivable, inventory), property, and equipment. Although intangible assets such as intellectual property (IP) have collateral value, they are usually viewed as secondary rather than primary collateral for a loan.
- Cash flow: Is the company profitable? Is the company cash flow positive? The most common measures of profitability are earnings before interest, taxes, depreciation and amortization (EBITDA) and net income. Cash flow differs from net income due to non-cash items, and the working capital and capital expenditure requirements of each business. Cash flow is normally less than net income. However, businesses with substantial deferred revenue such as SaaS companies, may have cash flow that exceeds reported net income.
- Recurring revenue: Does the company have a subscription-based revenue model or other types of “sticky” revenue (e.g. SaaS or certain B2B services)? Venture debt lenders view recurring revenue as an asset that, in effect, can provide a collateral base for a loan. The company does not have to be profitable but should be at or near break-even. Lenders also prefer a low customer churn rate and high gross margins.
- Venture capital sponsorship: Is the company back by a well-known venture capital firm? In assessing creditworthiness, some venture debt lenders place substantial weight on VC-sponsorship. The lender is not relying on a guarantee (whether explicit or implicit) from the VC firm. Rather, the lender is relying on the VC firm's ability to identify and nurture the best startups, and to continue funding them at least until the lender is repaid. Since these companies often lack enough assets, cash flow, and/or recurring revenue to support the loan without future equity funding rounds, venture banks usually require the company to shift their deposit accounts and other banking service requirements to the venture bank. The bank accounts enable the bank to closely monitor the company's cash burn rate, provide a source of low-cost deposits, and function as a compensating balance to secure the loan. The banking services provide additional income to the bank.
- Personal guarantee or corporate guarantee: Are the owners or a third-party willing and able to guarantee the loan? Depending on the loan amount and the net worth of the guarantor, a guarantee can be an important factor in the credit analysis. However, unlike traditional bank loans and SBA loans, venture debt loans usually do not require a personal guarantee from the owner(s). In this context, the corporate guarantee does not include the borrower since it will always be required to guarantee its own debt.
In order to obtain venture debt, most companies must be able to respond "yes" to at least one of the above questions. If you need help determining whether your company qualifies for venture debt, please contact us at Find Venture Debt.
If you qualify for venture debt, we can help you obtain growth capital, while minimizing equity dilution and maintaining control of your business. Contact Find Venture Debt to get started!