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April 1, 2012

Raise More Debt Before You Raise More Venture Capital

Did you have to re-read that headline a few times? I admit, it might seem a bit confusing coming from a venture capitalist.

But here’s the truth: there are plenty of expansion stage
financing alternatives to VC money. In fact, there are myriad sources
of capital that — depending on time, how it’s used, and the company’s
needs — are better options than venture capital.

As most startup and expansion stage company founders know, debt needs to be a big part of your overall financing strategy.

But not just any debt. The key is to study the various forms of
financing available to you and understand when, how, or if you should
use each one.

In this post (as the headline indicated) I want to discuss Venture Debt, a concept that’s excellently explained and broken down in this document from Leader Ventures, a California-based Venture Debt firm (for the record, I don’t know Leader Ventures and can’t qualify them as a company).

Let’s start with a quick definition of Venture Debt.

To summarize Leader Ventures’ document, it’s a form of financing
that, when utilized properly, can reduce dilution, extend a business’s
runway, or accelerate its growth. All with limited cost to the company
itself.

In short, it offers a balance between flexibility and dilution for
venture equity-backed companies that lack the assets or cash flow for
traditional debt financing. Venture Debt is often structured as a term
loan that amortizes over time and is complementary to equity financing.

Here are a few other Venture Debt basics:

  • The typical term rate for financing is three years.
  • It’s mostly available to late stage startups with significant assets or cash flow, or expansion stage businesses that have already secured one round of venture capital.

It’s important to note that Venture Debt is different from another
common form of debt financing — Convertible Debt — because it can be
used like equity, includes warrants, and generally is paid back by
monthly payments on principal and interest over the life of the loan. On
the downside, interest rates for Venture Debt tend to be higher than
Convertible Debt. (10% ore more, compared to 3-5%)

When does Venture Debt make sense?

Again, it largely depends on your company. But as Leader Ventures points out, it’s generally a viable option in these scenarios:

  • When a company wants incremental capital to accelerate growth without taking equity.
  • In conjunction with, or following, an equity round to provide additional capital without increasing dilution.
  • To add runway and enable the company to reach additional milestones,
    allowing it to raise its next equity round at a higher valuation.

On the flip side, it’s a very bad idea to take on Venture Debt when
you’re cash balance is low and the business is in a weak financial
position. The terms will likely be unfavorable and debt payments may
amount to more than a quarter of operating expenses.

As Leader Ventures also mentions, if your company has stable revenue
streams and accounts receivable then you might be better off looking
into A/R financing — which is generally cheaper and less burdensome.

Is Venture Debt really a good idea?

It depends on who you ask. One opinion comes from Fred Wilson, who tried to answer that question on his blog, A VC, in July.

Venture Debt, Wilson writes, is a perfectly acceptable source
of financing if it’s a bridge to a sale or an IPO, or if it’s used to
fund an acquisition or some other value-enhancing transaction.

Quite simply, Wilson writes, Venture Debt is only a good idea if the
company — rather than the investors backing it — possess the
creditworthiness for the loan and can absolutely pay it back.

In my opinion, Convertible and Venture Debts are two additional tools
in the overall toolbox of funding options. They should only be used
once your company has reached operational stability. That means your
distribution model needs to be pretty baked. It means that you have
budgeting and forecasting processes that are accurate and reliably
predict the future performance of the company. It means that you have to
have an experienced CFO who knows how to evaluate debt proposals, knows
how to pick the right option, and knows how to manage debt on the
balance sheet.  It means that you have the full support of your
investors to fund you if your cash balance drops. It means that you
should see a clear path to another funding event,whether the next VC
round or an IPO (an exit is never predictable, so don’t count on it).

Check out the full document from Leader Ventures, which includes
definitions of specific Venture Debt terms, some of examples of when
it’s best used, and an opinion on its purpose from another respected VC.

Have you had any experience using Venture Debt as a source of
financing in the past? What was your experience? And why — if at all —
was it helpful in accelerating your company’s growth? Go ahead and
comment…

Firas Raouf is a Venture Partner with OpenView Venture Partners.  You may find this post, as well as additional content on OpenView's blog located here.  You can also follow Firas on Twitter (@fraouf) by clicking here