The role that venture debt plays in a startup’s lifetime is often misunderstood, yet this financial tool is many times vital in a founder’s journey and should be considered by every founder as a potential part of their strategy.
In fact, if you had to visit us at F2, you would see the SVB office right across the hallway. SVB is the most renowned venture debt bank in the world, and their proximity to us both physically and personally could be thought of as a representation of the relationship between venture capital funding, and venture debt: two important and complementary tools, both deserving of space.
To that end, the first chapter of our F2 Finance Playbook is all about Venture Debt. It features a Q&A between Jonathan Saacks, the Managing Partner at F2, and David Cohen, General Manager at SVB, where they discuss the burning questions about this form of financing.
In this blog, I will summarize and highlight those core points regarding venture debt.
First things first- what is venture debt and what role does it play in a tech company?
Venture debt is a term for loans that are tailored toward investor-backed startups. It can be thought of as a financial instrument for creating value or reaching business milestones without further dilution of a company’s existing investors, including its employees.
Venture debt does not replace VC funding for equity, rather it compliments it. This debt can be used as a lower-cost runway extension, a short-term bridge to the next round of VC funding, or as performance assurance. In essence, venture debt is a way for startups to inject capital into a healthy and growing business without dilution.
At what point should a founder consider venture debt?
From the very beginning of their journey, founders should familiarize themselves with the basic concept and terminology of venture debt, much like founders should understand all aspects of potential future financing.
Strategically, startups should consider venture debt together with, or immediately following anew equity financing round because they are likely to have more leverage and appear more attractive to the lender at such a time. Additionally, a company is best positioned to take on venture debt when it is confident in its ability to repay its loan as this eliminates the risks associated with venture debt.
Besides debt being paid back with interest, and VC taking sizable equity, what else differentiates debt and VC financing?
There are many other factors that distinguish debt and equity financing, including:
- VC investors often receive a board seat, they also often add more ‘value’ to a startup other than funding, including strategic advice, networking, and more. In contrast,typically there are no board seat requirements for venture debt, and the value add often starts and ends with the loan.
- When it comes to venture debt, a startup’s valuation is not required, while with equity investments, a company valuation is always required.
- The due diligence process for VC investors tends to be a longer, more thorough process than that of a venture debt bank- this is mostly due to Venture Debt coming after a VC investment, and hence relying on those investors to have done a sizable portion of the DD beforehand.
- When opting for venture debt, companies are required to pledge assets to the lender as collateral, while equity financing carries no such obligation.
What parameters must a founder be mindful of before assuming venture debt?
Like all forms of financing, founders must consider a few elements before deciding a) whether to take venture debt and b) if a venture debt bank is the right one for them.
In our playbook Q&A, David Cohen breaks it down into 4 factors.
1) Size of the debt. In the case of venture debt, more does not equal better. Rather, a founder must ensure the right balance between their last equity round, and their venture debt. A rule of thumb is that venture debt should be one-third of one-fourth the size of your equity round.
2) Circumstantial factors. This includes the interest, warrants, and specific terms. These factors are all important, and usually, they are all negotiable.
3) Length of return time. It goes without saying but the more time a startup is given to payback the loan, the better.
4) Arguably the most important and often overlooked factor when it comes to venture debt is the relationship between the founder and the venture debt bank. As a founder, it is essential to choose all your business partners with thought and consideration as the road to success is long and always difficult. As such, you should ensure that the venture debt partner you chose is understanding and supportive and that there is mutual respect.
Does assuming venture debt affect the way VCs look at a company?
While debt financing can buy runway with less dilution for founders and existing investors, a lack of visibility of a company’s performance may raise a question regarding the company’s ability to repay the debt.
However, debt financing is not intended to replace venture capital, but rather to complement it, and experienced VC investors tend to agree that, at the appropriate level, balancing between debt and equity is the right and healthy way to finance a company.
As David expresses in the Q&A with Jonny, in all his years at SVB in the Venture Debt business, he has never seen a new VC investor re-consider investing in a startup due to assuming venture debt.
Surely there are many other factors surroundings venture debt. But when it comes down to it, a responsible founder understands the basics of this financing tool from the beginning, recognizes the relationship between equity financing and debt financing, and feels confident to use this financing tool in the most strategic way possible.