Capital Chaos

As referenced in the latest round of financing for Cooking.com, I thought it would be valuable to explain the concept of venture debt and some of the distinguishing characteristics.

Some things to consider about venture debt as opposed to venture capital:

Venture Debt:

Typically repayable within 24-36 months

Usually only given to high growth companies because of timing of point #1

Doesn’t require company to give up equity

Depending on life-stage of a company, usually comes in the form of a senior note - meaning in the event of a default by the company, all other debt/equity will become subordinate to the venture debt

Typically convertible with terms that are senior to other forms of convertible notes

Carries an annual interest payment, paid monthly with significant penalties for non-payment

Venture Capital:

Receiver gives up equity for capital

Typically invovles some form of board representation (depending on stage of company and amount position of investor)

Usually enters into deal with exit strategy (although never set in stone)

VC can be invested at any stage of a company lifecycle

So now the obvious question is, why would a company take venture debt as opposed to a typical bank loan?  Well for one, there is no strategic value in a bank loan.  It’s just cash.  Venture debt is usually strategic in nature - the lender has other assets it can strategically tie in with the loan to protect its loan.  Venture debt  is traditionally used for the purchase of hardware and infrastructure equipment, enabling emerging companies to reserve the venture capital investments for business critical activities such as research and development, marketing practices, and hiring. Additionally, venture debt can be used to finance accounts receivables, inventory, demonstration equipment and can be purely offered as growth capital.

Bank Loan vs. Venture Loan:

A more careful look at the difference between a bank loan and a venture loan was explained very well by David Hornik where he points out that established companies leverage their balance sheet assets through typical asset based debt products offered by commercial banks. Venture lending is territory that most banks are wary to enter because early-stage companies just represent too much risk for traditional banks because such companies have no tangible assets. Typical bank financing is tied to receivables. You must have sales revenue and probably meaningful sales revenue to attract bank financing. Even then, an established company with a steady, predictable revenue stream can use accounts receivable financing at best to smooth out cash needs, not leverage its enterprise value to extend runway. For a company that is cash-flow negative or just starting to achieve revenue, it’s worse because it’s tough to rely at all on a formula based A/R line for expansion and growth. If you miss a monthly or quarterly revenue projection, chances are you’ll have less in receivables than anticipated and may have to pay down your outstanding on your accounts receivable line of credit.

Having said that, there are banks that offer venture loans to early-stage companies. But be careful. At smaller dollar amounts bankers can convince their credit committees and the federal regulators that monitor their bank to make aggressive venture loans, but it is with the understanding that the goal is to grow the lender into a traditional commercial credit, replete with financial covenants and asset-based borrowing, which box in a company. Either it’s the proverbial banks are only willing to lend you money when you don’t need it or it’s that the typical slippage in a startup’s projections necessitates a talk with the banker about waiving a covenant violation. Banks also typically require young companies to maintain their deposits with them and require a right of offset in the loan agreement. This right of offset can be used by the bank at its discretion to pay down the loan in an event of default.

Independent venture lending providers, particularly ones that are private companies, have the ability to structure flexible deals that give you true runway extension. And, the better funded ones can support their companies with these structures at higher dollar amounts and through a startup’s maturation process. The established venture lenders also know how to evaluate and manage the risks involved in dealing with early-stage companies. They are willing to take a lien on a company’s assets when no real assets exist in anticipation of success.

Perhaps the greatest benefit of venture lending is that it injects money into a business without heavily diluting the equity stake of the entrepreneur or venture capital investors. While equity dollars are necessary in financing a company’s development and a typical prerequisite to obtaining venture loans, they come at the high price of sharing significant ownership. Venture loans can be a real aid that can enable an early-stage company to have access to low-cost capital and minimize entrepreneurs and VC dilution. An added benefit for VC’s is that they can improve their ROI on a given deal by encouraging their portfolio companies to take on a responsible mix of debt along with their equity dollars.

Consider this example. A communications startup determined that they needed a round of financing totaling $47 million, of which $8 million would be needed for equipment. They evaluated whether it was in the company’s best interest to finance the equipment using debt or equity. In other words, they were weighing whether they should raise $47 million from VC’s, or $39 million from VC’s with the expectation of financing the additional $8 million of equipment through a venture lease. After taking a careful look at options, they concluded that the larger equity sum would cause significant dilution that would be costly to company employees at time of liquidity; meanwhile the venture lending route would preserve more of the employees stake in the company and simultaneously create a stronger balance sheet.