What is Venture Debt It is a debt instrument to a rapidly growing company that would not otherwise qualify for traditional loans. The debt has a reasonably high interest rate (10 to 15%) and has a small warrants package attached which provides the debt provider the option to purchase equity at a pre-agreed valuation […]
What is Venture Debt
It is a debt instrument to a rapidly growing company that would not otherwise qualify for traditional loans. The debt has a reasonably high interest rate (10 to 15%) and has a small warrants package attached which provides the debt provider the option to purchase equity at a pre-agreed valuation (sometimes nil).
Why would a company consider Venture Debt?
The main reason is to minimise dilution associated with an equity raise. Not all shareholders have equal capacity to support an equity raise. Typically, this split is between Founders on one side and the institutional investors (Venture Capital/ Family Office) on the other side. Founders do not typically have the millions of dollars available to support follow on investment rounds. This results in dilution generally at a point in time where valuations are on a steeply upward trajectory. Venture Debt enables the company to support a portion of the capital raise with a debt instrument that significantly reduces the dilution to the Founders.
Who is eligible for Venture Debt?
Venture Debt providers generally look for the following attributes in a business:
-High growth. Companies need to be established and on a steep growth trajectory for this instrument to be suitable. Stable and profitable companies are eligible for cheaper forms of debt funding like bank funding. This instrument is for companies that can deploy further funds to accelerate growth but want to minimise dilution.
-Pathway to profitability. Lenders will want to understand whether there is a profitable core to the business if growth initiatives and product development were stripped back. When presenting the financials to a prospective lender, care should be taken to clearly identify the discretionary expenditures that are being used to drive growth versus those expenses that are required to support existing revenue streams. This is a good discipline as a manger anyway as it will ensure that you are getting an adequate return on this additional investment
-Institutional shareholders. Venture Debt providers will be looking at the performance of the company, but they will also be looking closely at the shareholder register and determining their capacity to put more money in if something goes wrong. Generally Venture Debt providers do not back companies that are 100% Founder held and will be looking for companies that have completed at least a couple rounds of fundraising that include institutions like family offices or venture capital firms. (as opposed to a group of wealthy individuals).
-Equity participation. Debt providers will look for evidence that the institutional shareholders are continuing to support the business. The best way to do this is to have a portion of equity raised at the same time as the Venture Debt raise. For example, if your funding requirement is $10m you could raise $5m from a family office or venture capital firm and a further $5m from a Venture Debt fund
What should I do if I want to access Venture Debt?
The core of the process is similar to most capital raises however; Venture Debt providers are credit providers who dabble in equity which gives them a slightly different approach to normal equity investors. The simplest explanation is, equity investors look up to your blue sky potential whilst credit analysts look down for an umbrella in case it rains. In practice this means a deeper understanding of:
-Assets and their value in a downturn scenario. For Venture Debt there is rarely tangible assets (like property and equipment) to lend against, but lenders thinking is still the same. They will look at elements like your customer list, customer contracts and your tech stack/ IP and form a view on their ability to realise value on these soft assets if there is a downturn.
-Cost Structure. Specifically, the ability to restructure and reduce costs to achieve profitability. A clear identification of discretionary expenditure that can be removed if they are no longer pulling their weight (geographies, services, product lines etc) is helpful in this regard.
-Institutional investors’ available funds. If the investment in your business has come from a fund that has already closed and been fully deployed, then this will adversely impact that investors ability to follow on invest in a downturn. This is because the fund has a fiduciary duty to act in the interests of members of each individual fund. In a downside scenario this gets awkward as it can have the appearance of investors in Fund 2 subsidising/ protecting the investment of investors in Fund 1.
-Exit pathway. This is a debt instrument with a maturity date. Therefore, a plan needs to be in place to repay this loan at maturity. The two main ways to demonstrate this are:
– A public listing that would see this debt position repaid.
– Improved performance over the forecast period such that more traditional forms of lending like bank debt become available.
Therefore, before you take a Venture debt position to investors you need to adjust the messaging and run some specific financial scenarios in order to minimise the perception of risk in the mind of the incoming lender.
Who is Providing Venture Debt?
The Venture Debt market is mature in places like the US ($9bn market), UK and Germany. However, the concept of small high growth companies, who are usually loss making, being able to access debt is relatively new in most countries. In markets like Australia and New Zealand there are a growing number of funds providing Venture Debt ranging from large US funds to local family offices. It’s important these funds are put into a competitive process so you can get the funding that is right for your company. This is where we can help.
How much Venture Debt can I raise?
There is no hard limit, we have seen Venture Debt cheques be as large as $20m in Australia. In the US, with EV’s of privately backed companies in the billions, the size of debt positions can go well north of US$100m. The larger the transaction the greater likelihood of being able to attract offshore providers to the process. Smaller raises will be limited to a few local players.
Most of the variables that affect the eligibility of Venture Debt are the same that determine the facility size offered to you. However, there are a couple metrics that provide useful guidelines:
– Implied Enterprise value based on recent equity raise. Generally, debt tranches can be sized off a conservative % of this value (generally around 10% or less).
– Financial forecasts. Venture Debt providers will be looking at the financial metrics at maturity to determine debt size today. It is significantly easier if the debt bridges the company to profitability and a traditional lender refinance (such as a bank loan) as opposed to further equity raises.
In short Venture Debt can a great instrument to reduce your dilution while you continue your growth. However, at the end of the day it is a debt instrument and you need to carefully assess if it’s the right funding source for your business.
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