Venture Debt – The Better Option?

This article appeared on PE Hub Canada on February 28, 2018.

Consider this…

Company X is out of startup territory, with annualized revenue north of $2 million and growing fast. Company X needs to fund its growth, but it’s not quite at break-even yet, and has no significant tangible assets to pledge as collateral.

Bank debt isn’t available, and government programs are cumbersome to entertain and are not nearly sufficient. Company X is then left with a couple of financing options: venture capital or venture debt.

What’s the difference?

Venture capital, as the readers of this article already know, is a form of private equity that is invested in earlier-stage, high-growth companies. Venture debt, however, as Bloomberg puts it, “occupies a more obscure corner of the capital markets”, so we will elaborate.

Venture debt is a form of debt financing provided by non-bank lenders to fund growth.  It typically complements a VC investment, but can also stand alone. The main benefits of raising venture debt (instead of equity) are that it reduces dilution to existing shareholders and leaves the strategic direction of the business in the hands of the existing board and shareholders.

Who can get it…and how does it work?

Venture debt is typically put to work in well-managed, high-growth companies with a solid, defensible outlook.

These companies may not be cash flow positive yet or have significant assets to use as collateral. They do, however, have great recurring revenues and very strong visibility into their future cash flows. Equity backing from reputable shareholders is a plus.

Venture debt lenders structure their loans with warrants, royalties, or some other form of upside to compensate for the higher risk they are assuming.

Borrowers will start repaying interest from day one, but deferrals of principal payments are common. Covenants often relate to growth metrics (revenue growth or cap on burn rate), differing from traditional bank covenants such as debt to equity or term debt to EBITDA. Disbursements typically match growth milestones.

Venture debt in Canada

There is limited data on venture debt in the United States, and Canada’s market is at least as opaque. FirePower Capital estimates that about $1 billion in venture debt opportunities arise annually in Canada, based on total VC funds flowing into Canadian companies and the limited number of participating lenders deploying this capital (including FirePower’s own venture debt fund).

A case study

Returning to Company X, we can reasonably assume that it is worth $10 million today. It needs to raise $2.5 million to fund further growth. Equity and venture debt are both viable and available options. Let’s further assume that with funding in place, Company X will maintain its growth trajectory for the next five years, at which point, it will be sold for $40 million.

What are the relative costs of equity versus venture debt in this scenario?

Venture capital (equity)

Today: 20 percent stake sold to a VC for $2.5 million, with a 1x liquidation preference

In five years: On the $40 million sale, VC gets a total of $10 million back, comprised of its $2.5 million (the 1x liquidation preference), and 20 percent of the remainder (20 percent X $37.5 million = $7.5 million). The net cash return to the VC is $7.5 million, which is the cash cost of the equity.

Venture debt

Today: sample loan terms: 14 percent interest, 5 percent warrants, 50 percent straight-line amortization of principal with 50 percent bullet at year three.

In five years: during the term, the lender is paid $0.8 million in interest. On the $40 million sale, the lender is paid $1.75 million for the warrants. This adds up to $2.55 million, the cash cost of the venture debt.

In this example, with its reasonably representative terms, the difference in cost between the two funding options is significant: almost $5 million.

What’s the downside of venture debt?

Given its tremendous cost advantage and that it does not require board representation, why would an entrepreneur choose equity over venture debt?

In contrast to equity, venture debt (like any debt) imposes restrictions on the ability to operate freely (through covenants), and must be repaid at regular intervals and within a fixed timeframe.  Indeed, if things go south, venture debt lenders have levers to protect their investments.

That said, because the venture debt lender is awarded warrants, it is incented to help increase enterprise value along the way. Conversely, keep in mind that equity isn’t free of constraints: VCs impose checks and balances of their own through voting rights and board seats.

The best decision for Company X

At the end of the day, Company X will be best served by considering all available options, generating proposals from both venture equity and debt funds, and making a well-informed decision that, depending on the priorities and comfort level of the business and the shareholders, may be comprised of one or the other, or a combination of both.

 

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