There are narrow and broad definitions of venture debt. The term “venture debt” or “venture lending” was originally used in the 1970’s to refer to equipment financing (venture loans and venture leasing) provided to early-stage companies. These startups needed to acquire physical assets, such as computer hardware or life sciences laboratory equipment, but lacked the cash flow for traditional debt financing.
In the early 1980’s, lenders such as Silicon Valley Bank (SVB) created a new type of venture debt financing. Generally, they did not require physical assets nor cash flow. However, they focused on providing loans to startups backed by well-known venture capital firms. The loans were structured to complement the equity provided by the venture capital firms, and were essentially secured by the enterprise value of the startup and the expectation that the venture capital investors would continue to fund the startup in subsequent equity rounds.
During the low-interest rate environment since the Great Recession of 2007-2009, institutional investors have been aggressively seeking out higher yield lending opportunities. Venture debt caught their attention, which has led to a tremendous increase in the number of lenders and types of loans in the market.
This expansion has been so broad that the term “venture debt” and its common definitions are much too narrow. As a result, some industry participants and observers have begun to use the term “growth debt” instead of “venture debt.”
At Find Venture Debt, we agree that “growth debt” has become a more appropriate term as the market has evolved. However, we continue to use “venture debt” as an umbrella term for a broad range of non-dilutive and minimally-dilutive funding since it’s more commonly recognized.
The complexity of the landscape reinforces our view that “venture debt” is an umbrella term for many types of debt available to startups and other fast-growing businesses. We have identified more than 20 types of venture loans. These range from working capital revolvers to synthetic royalty loans, with most venture lenders providing more than one type. We have distilled these into 10 types:
Determining the type of debt that is the best fit for a startup or other fast-growing business is case specific. The table below provides general guidance for pre-revenue, SaaS, life science, and other businesses that should serve as a starting point for consideration.
In the examples, we refer to “equity sponsor,” which means that the company has institutional shareholders such as a venture capital fund or private equity fund. Sponsored companies generally have access to more debt financing options.
Regardless of profitability or equity sponsorship, companies that have collateral can usually borrow money. Debt that is secured by specific assets will have the lowest cost. Therefore, if a business has accounts receivable or inventory, working capital financing should be considered. If they need to purchase fixed assets (e.g. computer hardware, lab equipment), an equipment loan or equipment leasing should be considered.
Pre-revenue: To obtain debt capital, pre-revenue startups need either collateral or venture capital sponsorship.
SaaS: Lenders like recurring revenue so SaaS companies can easily obtain debt financing. Sponsorship is not required. Profitability helps but is not required.
Life science: Working capital financing will usually be available. If a life sciences company receives recurring revenue from licensed IP or an approved drug or medical device, it can obtain royalty-based financing.
Other industries: In other industries, asset-based loans are always available. If a business has recurring revenue or reasonably predictable topline performance, it is a candidate for revenue-based financing. Other borrowing alternatives depend on profitability or equity sponsorship.
As a company progresses from early-stage to late-stage, and as its profitability improves, more financing options become available. The source for a particular type of financing may also change. For example, the only source of senior term loans for early-stage companies is likely to be traditional venture lending such as Square 1 Bank. As the company matures, debt funding from a broader array of sources becomes available.
The debt alternatives for each case are not mutually exclusive. To optimize the capital structure, it is common to utilize more than one, assuming the company has the financial capacity. The goal is not to maximize the total amount of debt but to minimize the weighted average cost of capital.
A company should not raise venture debt if management or the board does not believe the debt can be repaid. Seriously, venture debt is debt; the lender expects to be repaid. Venture debt should not be used when a business is on a downward trajectory, nor should it be used as a last resort source of capital. Debt provides leverage; it makes the upside better for equity holders but makes the downside worse. A company should also avoid venture capital loans if the terms offered by the lender(s) are not attractive; not doing a deal is usually better than doing a deal that is too expensive or restrictive.
It is beneficial to talk with several lenders, so you can compare pricing and terms. In addition, you have to consider whether the lender will be a good partner. Although a lender may not be as involved with your company as a venture capitalist, the good ones can be a great source of advice and introductions. Although it may not seem relevant when you are raising capital, it is very important to determine whether the lender has a good reputation for working with borrowers when a restructuring is necessary. Talking with companies and venture capitalists who have previous experience with the lender can provide valuable insights.
In some cases, capital can be obtained from two sources. Banks usually provide the least expensive capital, but their loan size is constrained due to regulatory requirements. Specialty finance firms and venture debt funds are less constrained but more expensive. Combining the two maximizes the amount raised while minimizing the weighted average cost of capital.
If a borrower cannot repay the debt using cash on its balance sheet or the proceeds from an equity financing, there are two alternatives:
If the business is on an upward trajectory, it can usually repay the loan using through an equity raise or a refinancing.
If the business is on a downward trajectory, restructuring may be the only alternative. Most, but not all lenders, will try to restructure the debt. One of the most important criteria in choosing a lender is whether they have a good reputation for working with borrowers when a restructuring is necessary. Of course, it is also important for the borrower to maintain open and frequent communication with the lender when times are good. This helps establish a relationship of trust and avoid negative surprises from the perspective of both the borrower and lender.
Lenders look at some of the same factors as equity investors: quality of management team, product-market fit, repeatable sales process. The primary difference is that lenders are far more focused on protecting their downside than hitting a home run. Therefore, market size and high growth potential are less relevant. Although other criteria vary widely by loan type and lender, below are a few guidelines.
If the borrower has multiple lenders, an intercreditor agreement is usually required. This is an agreement between the senior and subordinated lenders, which specifies how their relative rights and obligations are enforced in a distress or bankruptcy situation.
There are a half-dozen commercial banks with venture lending arms that are the best known providers. The venture banks include:
Banks are subject to significant regulatory constraints, which limit the amount they can lend to each company and subject the borrower to restrictive covenants. There are 15-25 non-bank lenders that specialize in traditional venture lending and venture leasing. They have a higher cost of funds but provide larger loan amounts and more flexible terms.
During the past ten years, new providers of venture debt have emerged which focus on a specific industry (e.g. SaaS, life sciences), loan product (e.g. MRR line, revenue-based financing), stage of development, or geographic region. In addition, many debt funds focused on the middle market have become more interested in expansion-stage and late-stage lending. Companies with recurring revenue business models have been the largest beneficiaries of this trend.
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