Erin Platts, head of commercial banking with Silicon Valley Bank’s UK Branch, explores the circumstances under which venture debt could be right for your startup or scaleup.
The advantages of utilising debt financing alongside equity rounds have been recognised by many fast-growing VC-backed businesses in the US for decades. With an increasing number of UK banks and venture debt funds now offering a wider choice in terms of the type and source of debt financing available, at what point does venture debt become the preferable choice for your business’s strategy and needs? There are a number of scenarios where it can serve as a powerful financial tool.
Benefits of venture debt
The primary benefit of venture debt is to minimise dilution. A mix of equity and debt enables you to retain a larger percentage ownership of your business. Venture debt emphasises the borrower’s ability to raise additional capital to fund growth and repay the debt, as opposed to historical cash flow or working capital – vital for pre-product companies or revenue-stage businesses maximising growth over profitability.
By leveraging equity raised from venture capital firms or similar institutional sources, the average cost of the capital required to fund operations when a company is “burning” more cash than it generates is reduced. Naturally, the additional funds extend your cash runway to the next equity round and the flexibility of venture debt terms also allows for tranching and extended draw periods.
Importantly, the additional runway should also allow a fast-growing business to raise their next round of equity at a higher valuation than they would have been able to without the extension of runway that comes from the venture debt.
Venture investors generally appreciate the role venture debt plays in reducing the cost of capitalising their portfolio companies and it can be seen as a way of signalling expanded liquidity and increasing momentum, or as a useful insurance to hedge against performance blips or valuation hurdles. And while the cost of equity can fluctuate significantly, one fact remains firm: debt is cheaper than equity.
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Timing is key
As a rule of thumb, venture debt is used to supplement an equity round, not to replace it. Creditworthiness and bargaining leverage are highest immediately after closing on new equity and often the debt can be structured with an extended “draw period” so that the loan need not be funded right away.
The cost of venture debt is usually between a seven and 12% interest rate, so not wildly expensive, especially when considered alongside the equity- and cost-saving benefits that venture debt delivers. As with other areas of financing, venture debt pricing will vary based on the lender’s assessment of the risk. Venture debt does not include financial covenants, another flexible advantage. Most venture debt loans are offered with a three-to-five-year timetable with monthly or quarterly repayments. The use of warrants is common as well and should be factored into the cost of capital.
Seeking an expert provider
Most high-street banks will not lend to loss-making businesses as the risk carried is clearly higher. This is where specialist expertise and a deep understanding of the sector are crucial.
Partnering with a specialist innovation lender who understands the space and has relationships with venture capitalists will help ensure thorough due diligence on the suitability of such financing is performed thus vastly reducing the risk of businesses becoming overstretched. As it is the market standard for companies to pay lenders’ legal fees, instructing a lawyer experienced in negotiating such deals is useful.
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If you secure debt from a fund as opposed to a bank, ask for a carve-out for working capital products. This allows you to access less expensive and more scalable debt further down the road. It is worth reiterating the importance of avoiding overstretching the business, though.
At Silicon Valley Bank, we encourage our entrepreneurs to be thoughtful and prudent about the amount of debt they bring into their businesses. When debt service payments begin, they can delay cash flow breakeven being achieved or even attracting a new lead investor if you have too much debt on your balance sheet too early. However, experienced investors understand that debt comes with trade-offs that need to be evaluated.
The amount of venture debt is generally calibrated to the size of the equity round, and the company’s current and projected cash-burn rate. Businesses with high burn rates are many times considered risker venture debt candidates because they are even more dependent on external capital to ‘fuel the burn’, however this is sub-sector specific.
Venture debt can deliver a variety of advantages and solutions when conventional loans are simply not an option. By securing specialist expertise from a lender that knows venture capitalists and understands the startup space, venture debt offers a flexible way to support rapid growth and expansion plans, extend your cash runway, minimise dilution, and provide a bridge to profitability, amongst other wider benefits.