Venture Debt –What You Should Know About It before Using It
Investors who have successfully pitched to receive venture capital funding are often surprised when they are offered another way of getting funds in the form of venture debt. While the concept of venture debt is not new, it has remained rather obscure and not even monitored by the National Venture Capital Association, which tracks and publishes data and statistics relating to venture capital. A quick look at what venture capital is all about and what the merits and hazards of this investment route are.
Venture Debt – What Is It and How Does It Work
The concept of venture debt is actually quite simple. It is an offer for additional funding in the form of debt to a company whose equity capital has already been diluted by the founders in their earlier attempts to raise enough money. For example, a startup may have raised seed capital of $500,000 with the valuation being done at $2 million and may have again raised a further $8 million via a “Series A” issue with the valuation being done at $20 million. While to get this money in, the promoters have already parted with a certain percentage of the equity, it is quite likely that the company has a further need for more funds to pay for equipment or marketing expenses. However, instead of diluting the equity further, the founders can choose to raise the money through debt and reserve the dilution for another Series B round in the future.
Venture funding usually assumes the contours of a certain amount of debt being offered by the venture capital fund that is a specified percentage of the last round of funding, typically 30%. The mechanics of the venture debt is somewhat more complex than that of a simple loan. In the case of venture debt, there are costs involved at every stage; when taking the loan, during the tenor, and while exiting the loan. Usually, there is a short period during which, only the interest is payable; typically, this is around six months while the repayment of the principal and the interest can be done over a period of two to three years. According to a counselor at https://www.nationaldebtrelief.com/, venture debt tends to be quite expensive; typically, you can expect the debt to cost around 20% of the principal over a couple of years. However, the venture capital fund is also entitled to a number of warrants to protect its investment if the company is sold off. These warrants are structured in such a way that instead of a return of 20%, the return can easily be 200% or even more.
The Ideal Time to opt for Venture Debt
Given the high cost of venture debt, it can be assumed that most startups would be very tentative about taking up venture debt; however, there is definitely a place in the capital structure for venture debt for some companies who are in a growth phase that demands more deployment of funds. Venture debt is especially useful for companies that have progressed beyond the concept phase that is typically riskier and has found a fit in the market for its products and needs to purchase capital assets while being unwilling to dilute its equity capital further. According to entrepreneurs with experience of taking on venture debt, not diluting equity is not necessarily only about maximizing payouts in the future but more importantly maintaining control of the operations and strategy of the company. It needs to be appreciated that equity is extremely valuable and it does not always make good sense to part with it to make use of funds required for a short-term opportunity, especially when it can be met through the use of debt just as easily.
When Not to Take Venture Debt
Venture debt should never be taken on without considering its downsides, especially as the disadvantages can be devastating. It is quite possible, if not likely, that the venture debt company can call on the loan if the borrowing company defaults or is unable to adhere to the terms and condition of the venture debt agreement. If the company is not able to pay up, it can even force it into liquidation or a distress sale. Also, if the borrowing company is in financial distress, the venture capital fund that has a board representation will typically, assist in the negotiation of new terms that can prove to be extremely costly and disadvantageous of the founders. Any financial bump, if it is severe enough, can result in the disappearance of the equity capital of the founders as the venture capital fund goes about raising additional funds or even attempts to sell off the company to realize the debt. While any of the proceeds that are left over will be distributed between the VC firm and angel investors, typically, the founders of the company will get nothing at all. Not for nothing, https://www.forbes.com quotes a VC, Fred Wilson, as commenting on his blog that “financing companies with debt when the company has no obvious means other than their VC investors to pay the loan back is bad financial management.”
The presence of venture capital can also create problems when the company plans to raise additional equity capital. The new investors will either have to approve of their funds being used to pay off the debt or agree to take a position of lesser preference that the debt. This situation acts to discourage new investors. Experts also caution against the use of venture debt when the revenue stream is not stable, the repayments would be more than a quarter of the operating expenses when the actual use of the debt is not clear. After all, the intention of taking the debt is to make the company more profitable not to get it into trouble.
While venture debt may be very attractive as it can prevent dilution of equity and can be accessed relatively quickly, it should be used with a lot of circumspection. It is not only an expense that is quite high but may bring down the company if its cash flow is insufficient to cover the repayments.