How to Seal a Venture Debt Deal
As the technology startup landscape has developed and transformed in the last two decades, so have the backers and investment vehicles behind it. From micro-VCs to equity crowdfunding, there are an abundance of funding options that either never existed before, or did in very different forms.
Take venture debt. In the early 2000s, there were only a handful of banks offering it, and with double-digit interest rates, heavy warrant coverage, and highly covenanted facilities, it looked more like mezzanine debt. In other words, there were only a very limited number of companies that could actually benefit from it.
Fast-forward to now – lighter warrant coverage, mildly to non-covenanted facilities, single-digit interest rates plus, and loan amounts that are often equal to 20% to 50% of the equity raised in a most recent round of funding, and venture debt looks very attractive to the startups that qualify for it.
We spoke with John Hoesley, head of Technology Banking at The PrivateBank and former venture capitalist, to build on our understanding of venture debt and figure out what it takes to actually get a deal done.
“The biggest misconception out there is when [venture debt] is accessible. Many entrepreneurs would like to access the product immediately after startup, but unfortunately venture debt is not a replacement for early stage equity. Rather it comes into play after a company has raised a couple of million dollars in venture capital and serves to help extend the company’s runway and decrease dilution.”
This is the base line qualification for a startup to be considered for venture debt, but there are a number of other key factors that determine whether the deal will get done or not. For example, the best time to seek out venture debt is right after the equity close when you have 18 to 24 months of runway; “once you get down to 6 to 9 months of runway, it becomes very difficult if not impossible.”
This timeframe hinges on the core economic factors driving your business, but also on one of the most unique elements of venture debt deals: investor sentiment.
Banks aren’t just evaluating you, but also your investors. Your investors need to show enthusiasm and excitement for the deal since banks are underwriting you with your institutional investors in mind. A strong show of commitment from your investors doesn’t just validate your startup, but also indicates to banks that you have the support to continue growing, and more importantly, pay back the debt in the future.
Banks look closely at the strength of your institutional investors. What is their reputation for standing by their companies, investing in follow-on rounds, or being attentive to their needs? Do they have existing relationships with the bank? Do they take a partner-like approach to business?
That last question becomes especially important once you enter into the venture debt deal process. The process — which takes 30 to 45 days end to end — starts with a standard information request. The bank will ask for the management presentation, historical financial projections, and a capitalization table and articles of incorporation, among other items. They will then meet with the management team, and evaluate the business against many of the same metrics and criteria as a traditional venture group. This information will serve as the basis for the bank to issue a term sheet.
This term sheet is much simpler than an equity term sheet since venture debt is essentially a term loan with a set principal payment plus interest. The loan often comes with an interest-only period at the front-end. If the term sheet proves acceptable to the company and the bank, it is then signed and the most important piece of due diligence, investor calls, commences.
“The core to venture debt underwriting is calling the investors and speaking to them. We need to know if they’re setting aside reserves for them, what they view as critical milestones of the businesses,” and how they think the companies will achieve those milestones.
Banks will typically conduct calls with the company’s major investors and discuss the status of the fund, the amount of reserves they are holding for the company, their investment thesis and key milestones and risk factors. Once the calls are completed with satisfactory results, the process shifts into legal documentation, which typically takes 2–3 weeks.
The venture debt deal process looks similar to this regardless of the bank, though the types of deals banks consider and how they evaluate them both before and during the due diligence process may not.
For its part, The PrivateBank considers a few key factors as tantamount to a deal coming together. For one, as a Midwest-based bank, it is focused on strong, backable companies in the region. While it has carved out a unique expertise with SaaS businesses, it’s open to a diverse set of companies across industries, so long as they “understand their customer acquisition cost, the lifetime value of their customers, and they’re providing a product or service with a tangible value.” With combined decades of VC and technology experience, John also looks for “strong management teams where you know they will be responsible stewards of capital.”
John also recognizes that venture debt isn’t for everyone. It comes down to the timing question. Just as seeking venture debt before a business has venture capital backing and a measureable trajectory towards success, seeking it once its reached profitability also doesn’t usually make sense. Specifically, once you hit profitability, there are cheaper, less dilutive products available, like revolving lines of credit. Still, if you’re going into turbocharge and need to burn capital to make your moonshot, venture debt may help you get there faster with less dilution.