When Does Venture Debt Make Sense For Your Startup?

Piggy BankStartup blogger and venture capitalist extraordinaire Fred Wilson recently published a great article on Venture Debt, which I strongly suggest you review HERE. Go ahead, I will wait…

…welcome back. As Fred points out, many entrepreneurs hear the word “debt” and promptly run the other direction. In the past, venture debt was often viewed as a funding vehicle of last resort. When the current investors were tapped out and a bigger fool could not be brought into a venture, all eyes turn towards debt. However, when deployed judiciously, venture debt can mitigate investors’ and founders’ dilution.

At Rincon Venture Partners, we are in the midst of negotiating a term sheet with a cash-positive startup that is growing aggressively. The nature of the company’s business model requires it to fund certain costs before it is paid by its customers. Thus, even though the company is cash flow positive, its growth is constrained by the amount of payables it can fund. Enter venture debt.

By combining our equity investment with a tranche of venture debt, the company has avoided a larger equity round, which would have significantly diluted the Founders’ ownership share.

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Venture Debt Tips And Tricks

Strategic Tranches – Many venture debt providers will allow you to draw down the money you borrow in multiple allocations. Seek maximum flexibility by expanding the length of time you have access to the funds and minimizing the amount of money you must accept upfront.

Death By A Thousand Fees– The more you need the money, the more expensive it will be. The true cost of debt is often obfuscated by the inclusion of numerous, arcane fees. Rather than trying to negotiate each individual fee, consolidate them and negotiate the percentage that the fees represent of the loan’s size.

No Early Payback Penalties – Many venture debt lenders attempt to discourage early payment of their loans with onerous penalties. Although an early payment fee of 1% of the entire loan amount is common, refuse to accept such a provision.

Dollar Blend – Many venture debt lenders require that their funds be accompanied by an equity investment, generally from legitimate venture capitalists. Although this might be advantageous to you (as it might spur your equity investors to invest new funds), give yourself greater flexibility by not agreeing to debt that is contingent on raising new equity dollars.

Investor Threshold – If possible, avoid accepting more venture debt than your investors can reasonably payoff with an equity infusion. In this way, you are assured you can retire your debt if your adVenture hits an economic bump in the road.

Multiple Proposals – Venture debt terms are notoriously non-standard. Thus, garther several term sheets and combine them into an ideal agreement. Then take your “greatest hits” term sheet and communicate to each debtor, “I like this rate, that fee, this covenant, this drawdown schedule and that interest-only period. Do we have a deal?” As with most negotiations, competition is the only way you will obtain an optimal result.

Brand Names Matter – If you violate a debt covenant or otherwise have difficulty servicing the debt, a venture debt lender can destroy your adVenture. Thus, avoid one-man-band lenders, anyone new to your market or a firm that is lending outside of its core market segment. Do your research and identify lenders which care about their reputations and have a track record of lending to venture-backed startups.

Minimize Covenants – Negotiate terms which mitigate the impact of violating any particular covenant. The less time you have to spend managing your covenant compliance, the more time you will have to deliver a compelling value proposition to your customers.

No Guarantees – Avoid personally guaranteeing the debt’s repayment. Instead, collateralize it with your company’s assets. You have enough stress, without risking the loss of your house and other personal assets, in the event of default.

Mr. Mojo Rising – Real-world Example

During the summer of 2006, I joined RedMojo as an Advisor. Consistent with the advice I outline in Free Advice Worth Half The Price, I was paid solely in equity. I also participated in a small convertible debt round. The terms of the deal offered creditors the opportunity to earn a healthy interest rate, and a decent multiple on their principal, in the event the company was sold within a specified time period. The investors also had the ability to convert their debt into equity at a discount to the value established in a subsequent venture round; otherwise known as convertible debt.

A convertible debt structure is often deployed when the debt is a bridge to either an equity investment or a liquidity event. Ideally, the option to convert the debt should be at your discretion and not that of the debt holders. It is also common to provide convertible debt holders with a discount off the valuation applied to equity investors. For instance, in an equity round with a $5 million pre-money valuation, a convertible debt holder with a 20% discount could convert their debt into equity at a $4 million valuation.

The standard discount associated with convertible debt ranges from 20% - 30%, depending on:

  • Length of time before the equity round is estimated to close - the longer the time, the higher the discount
  • Relative probability of closing an equity round - the higher the probability, the lower the discount
  • Overall risk profile of the company - the higher the risk profile, the higher the discount

Be aware that if you grant debt holders a discount above 30%, you may be forced to renegotiate the rate, if subsequent equity investors find it too generous.

RedMojo’s CEO orchestrated the venture debt round masterfully. Equity funding would have diluted the Founders while simultaneously complicating the company’s equity structure, thus making a potential sale of the company more cumbersome. In addition, if venture capital funding were secured, the company’s ability to control the scope, nature and timing of its exit would have been greatly reduced.

As I point out in Who Wants To Be A Millionaire?, institutional investors generally do not invest in quick flips. Thus, if a venture capitalist had invested in RedMojo, it is likely they would have encouraged the CEO to grow the company in order to enhance the return on their investment. Conversely, they may have discouraged and possibly even blocked the sale of the company until such time that they felt their return was maximized. Institutional investors generally seek deals with a potential to return 6x – 10x of their initial investment, not the 1x – 3x return they would have gotten from a quick sale of RedMojo.

Accepting equity funding and growing RedMojo might have proven to be a sound strategy, but it would have forced the CEO and the rest of the Core Team to increase the overall value of the company considerably, just to recoup the impact of the dilution that would have resulted from the equity investment. For instance, if the Founders relinquished 33% of the company’s capitalization to equity investors, they would have had to increase the company’s overall value by one third, just to recoup their prior equity ownership positions.

Although equity funding was seriously contemplated, the CEO ultimately sustained RedMojo’s operations solely via debt, which proved to be highly advantageous , as the company was eventually sold to Novell for $9.72 million. The sale resulted in a nice return for the Founders, employees and creditors.

Equity Is Forever

Some investors erroneously believe that the relationship between an investor and an entrepreneur is akin to a marriage. Such investors are mistaken. Equity investors are more analogous to blood relatives – love them or hate them, you cannot divorce them.

In contrast, debt is similar to friendship. Although it can be emotionally painful, friends can terminate their relationship without calling a lawyer. The degree to which debt offers you greater flexibility than equity is based upon your wherewithal to pay the ongoing interest and ultimately repay the debt. If you leverage debt as a last resort, then expect it to greatly limit your flexibility. However, if you can accurately predict your cash flows and structure a loan with minimal covenants, debt can afford you more flexibility than equity.

Factor The Math

If your startup has contracts with large corporations or government agencies that have solid credit ratings but pay their bills at a glacial pace, factoring your receivables might make economic sense. Unfortunately, like venture debt, factoring is too often erroneously associated with struggling companies that have no other funding options.

Factoring involves selling your accounts receivables for upfront cash, effectively accelerating the collection of your receivables. For instance, if you have high-quality accounts receivables totaling $100,000, you can generate $80,000 - $85,000 of near-term cash. The primary issue which dictates the discount factor is the probability that the receivables will be collected. Thus, the payee’s credit rating and the number of days the receivables have been outstanding both impact the discount factor. Distressed receivables which have a low likelihood of collection are difficult to factor and will result in a much higher discount (as high as 90%, depending on the expected collection rate) and thus will net you significantly less near-term cash.

Forcing Your Investors’ Hands

Much like Corporate Venturing, venture debt can act as a catalyst to spur your current or prospective investors to act. Current investors will often prefer to commit additional funds, rather than see their investment subordinated and the company’s assets secured by debt. As such, the equity investors may opt to stay at the front of the line with respect to receiving any proceeds from an exit by putting forth their own funds and thus averting the company’s need for debt.

Debt Downside

The obvious downside of debt is that, unlike equity, you actually HAVE to pay the money back. Thus, never enter any debt transactions lightly. Even though venture debt offers you more flexibility than an asset-backed loan granted by a traditional lending institution, such as a bank, you must still pledge the company’s assets to collateralize venture debt, including your intellectual property, accounts receivable and even, in some instances, control over your bank account (in such cases, the lender has the right to unilaterally transfer cash out of your bank accounts upon a covenant violation).

Despite its potential downsides, the next time you contemplate an equity round, give venture debt its due consideration. If you are judicious, you might be able to leverage venture debt to jumpstart your fundraising process, while retaining the lion’s share of your equity ownership.

By the way, if you still have not read Fred Wilson’s Venture Debt post, you can check it out HERE.

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John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara's Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.

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