Founder’s Guide to Venture Debt

How Venture Debt Helps Founders Grow Their Businesses

Many founders of SaaS businesses I speak with look only to equity to finance the start-up and early growth of their businesses. They may not be aware of, or do not appreciate the value of, venture debt financing which is complimentary to venture financing.

In this guide to venture debt, I explain the basics of venture debt, the advantages, and the disadvantages so that you can determine if venture debt is right for your SaaS business.

What is Venture Debt?

Though referred to as venture debt, the terms and mechanics are similar to loans that businesses today use to fuel growth for many years: a term loan where the entire principal is drawn down at closing and repaid in regular installments of principal and interest, and/or a revolving line of credit where the principal is drawn from time-to-time with interest payable, usually monthly, on the principal that is outstanding. The principal may be repaid and drawn down again during the term.

Traditional term loans and lines of credit may be used for working capital and/or capital expenditures and are generally made available only to businesses generating free cash flow.

Venture debt, however, is tailored for businesses burning cash, but with rapidly increasing revenue and a plan to profitability. Rather than financing the business through capital raises, which dilute the founder’s share, venture debt provides a non-dilutive form of financing – or should I say a less dilutive form of financing.

Occasionally, venture debt will include a grant to the financier of warrants, a right to purchase equity (more about warrants later in this post). The purchase of the equity will result in some dilution but significantly less than a subsequent equity round.

Venture debt financing is a complement to equity financing and most valuable when used in conjunction and not as an exclusive alternative.

Brendan Brummer, VP of Operations at Arkose Labs, who has hands-on experience raising venture debt, points out that some venture debt providers require an “Investor Endorsement.” This endorsement requires the institutional investors that they know and trust to continue a relationship with the company during the term of the loan.

When to Use Venture Debt

Most successful early stage, fast-growth businesses employ both venture capital financing and venture debt financing. The venture debt permits the founders to delay raising equity while they work on increasing revenues and moving to profitability. The result is a higher valuation and, therefore, much less dilutive equity raises.

Venture debt is most beneficial when, for example, a SaaS business is burning cash to fund product development, to acquire new customers, and expand its subscription base. Commercial/retail lenders do not generally lend to businesses without free cash flow (profits), and when they do, the credit given for the base (revenue, receivables, subscriptions) against which the loan is calculated is very low, i.e. two or three times the monthly recurring revenue (MRR) of a SaaS business, rather than seven to ten times available from a venture debt lender.

Venture debt financing is attractive to a business which wants to forestall equity financing in order to increase its valuation and limit dilution of existing shareholders, and:

• Needs funding to reach an important milestone
• Fund an accretive acquisition
• Revenue is rapidly increasing, cash flow does not cover expenses, but break even is forecasted in twelve to eighteen months

When Not to Use Venture Debt

Venture debt is not always suitable SaaS businesses. You might not benefit from venture debt if:

• Your business is desperate for cash, but there is insufficient backing (equity investment) from existing shareholders which might lead the venture debt lender to question shareholder and management support
• It is merely to fund working capital
• There is no plan for the business to increase revenues to support the repayment of the venture debt and to be break even or cash flow positive with 12 to 18 months
• The business has predictable, stable/increasing revenue, and generates free cash flow (profits), in which case a revolving line of credit or term loan or both from a commercial/retail lender might be the better choice

Advantages of Venture Debt Over Equity

Okay, so you are thinking that you may be a candidate for venture debt. Let’s look at some the benefits that come with venture debt.

• No valuation is required. If, for example, market conditions have temporarily damaged sales and the business is under performing it will not negatively impact the businesses borrowing power.
• Venture debt will fill the gap between available equity financing and what is required by the business to reach its goals
• Forestalls dilution of existing shareholders interest in the business
• Allows founder to maintain control over strategy and operations
• Availability of funds is much sooner than through an equity financing
• A venture debt lender will not likely require board seats or observation rights
• Extends cash runway between equity rounds
• Enhances liquidity
• Reduces capital cost

Disadvantages of Venture Debt Over Equity

With positives, there are usually negatives. Let’s consider the downside of venture debt.

• Venture debt must be repaid and with interest, and if you are in default or failing, the lender’s recourse may be as drastic as the sale of all the business’s assets
• However, venture capital allows the holder (the venture capital firm) to claw back the founder’s equity and eventually reduce the other existing shareholders’ interest in the business to an insignificant amount if the business is not meeting financial and other targets.
• May be less expensive than giving up equity in terms of ownership but venture debt is not inexpensive per se.

What to Look for in a Venture Debt Partner

• Past handling of borrowers in distress, attempting to restructure, or with unique needs for capital. Call past clients as references
• Priority required by the lender: only senior debt with funding up to 6x MRR or only junior debt with funding of up to an additional 18x MRR, or a unitranche loan combining senior and junior debt
• Willing to subordinate to the senior lender to help optimize your total cost of borrowing
• Offers capital efficiency by allowing funds to be drawn when needed instead of all up front
• Interest only monthly installments with the entire principal due at maturity

• Flexible prepayment with reasonable prepayment fees. In addition to interest, there are often setup fees, administration fees, standby fees, early prepayment fees, warrants, and a fee each time funds are disbursed under loan facility – an advance Fee
• Lender’s reputation
• Reasonable financial covenants and/or negative covenants

Does the Venture Debt Contain Warrant Provisions?

A warrant is an option, granting the holder a right but not an obligation to buy shares in the capital of the borrower at a set price and quantity until a future termination date. A warrant is sometimes included to compensate for the higher risk associated with venture debt.

If your venture debt contains a warrant provision, pay attention to:

• The formula for calculating the number of warrants and the strike (purchase) price for each share acquired
• How long the warrants will remain outstanding
• Is there a cashless exercise. For example, upon exercising the right, if the shares are worth more than the strike price, the borrower will simply pay the difference to the lender without the shares having been issued
• Is the lender upon purchase of the shares able to require the borrower to redeem or repurchase the shares (a put option)
• The anti-dilution clauses associated with the warrants or underlying shares

Warrants are usually exercised when the borrower is acquired or goes public or if the value of the shares has significantly increased, yielding an ‘equity kicker’ return to the lender.

What does the Venture Debt Process Look Like?

Step 1: Screening

• Introductory call between the borrower and lender.
• Review of financial information including historical financial information, forecasts, and unit economics.

Mr. Brummer says be prepared to present the following information in the process: P&L, cash flow statement, balance heet, Board approved operating model, most recent pitch deck, SaaS metrics (usually in their format), and legal/incorporation documents.

Step 2: Term sheet

• Review, negotiate, and sign the term sheet which will set out the substantive business terms.
• Ask for the term sheet early in the process.

Step 3: Diligence and Approval

• The lender’s sales lead will pitch the proposed loan to its credit committee. The committee will consider the advice of its diligence team who has reviewed the borrower’s business, finances and operations.

Step 4: Legal and Funding

• Legal and funding documentation is prepared. The borrower will be responsible for all legal fees, its own and the lenders. Immediately following execution of documentation and registration of security funds will be released.

Mr. Brummer highly recommends hiring an experienced lawyer to be your advisor in these engagements.

Step 5: Portfolio Management

• The lender will require monthly and fiscal year-end financial and operations reports including relevant metrics. The borrower wants a lender who takes the time to understand the borrower’s business and provide guidance when necessary.

Step 6: Exit

• The borrower, repays the loan in full, perhaps by way of a refinancing, capital raise, or a sale.

Conclusion

Venture debt financing, on its own or as a complement to venture capital, is possibly an attractive, non or less dilutive, and relatively quick source of funding (compared with a capital equity raise) for SaaS businesses who are burning cash to fuel their rapid growth.

Many thanks to Brendan Brummer of Arkose Labs and Espresso Capital for the technical review of this guide to venture debt.

If you want to learn more about venture debt, Espresso Capital is hosting a webinar on September 19th. You can register at this link (FYI, I receive no compensation for offering this link).