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Venture debt: What is it and how does it work?

DocSend CEO Russ Heddleston shares his insights on venture debt. He explains what it is, how it works, and when it makes sense to raise a round of venture debt.
DocSend Venture Debt Explained

I get a lot of questions from startup founders about fundraising in general, but venture debt is a particular topic that comes up a lot, so I wanted to shed some light on the process of raising venture debt.

What is venture debt?

Venture debt is a special category of debt that is unique to the high-growth tech industry. Unlike convertible debt, which you don’t pay back and converts into equity in the next financing round, you actually do pay back venture debt.

Venture debt is primarily used as a runway extension vehicle. By getting a bit more runway out of your most recent round, you can buy time to push up your metrics and increase the valuation of your next round even further.

In almost all cases, it’s expected that venture debt will be a cheaper financing option than an earlier equity round.

How does venture debt work?

A venture debt “round” is the option to withdraw up to a certain amount of money within a given time frame (the “draw down period”). After withdrawing the money, there is an “interest-only” repayment period follow by an “amortization” period (principal plus interest).

In addition to paying the debt back plus interest, the company typically will issue a small number of warrants to the venture debt firm. These warrants can be issues at the time the round closes or when you draw down the money—or both.

There can also be “covenants” included in your term sheet. These can be company metrics or cash balance requirements. If you violate these covenants, then you are in default of your loan. In the rare case that this happens, the venture debt firm has control of the company and could choose to liquidate it or shut it down.

In summary, here are the variables you end up negotiating in a venture debt round:

  • Principal: The amount you can withdraw
  • Interest rate: The annual interest rate you pay
  • Interest-only period: The period of time you over which you pay back interest
  • Amortization period: The period of time over which you pay back principal plus interest
  • Covenants: Any requirements the firm puts on your business

Who can typically raise venture debt?

Venture debt is not an option for all companies. With a typical loan, the company has hard assets or revenue to use as collateral against the loan. Companies that raise venture debt often don’t have standard levels of collateral. The firm issuing the venture debt gets a higher interest rate because of this. They also need to be convinced that the company will be able to cover the debt by raising enough money or getting acquired, or that the company will become profitable in time to pay back the principal.

Another important detail is that you must have at least a year of runway left at your current burn. Venture debt firms don’t want you to be almost out of money when you come to them. They are selling a runway extension option that you might use down the road.

Practically speaking, you need to one or more of these conditions to raise venture debt:

  • Have the backing of solid institutional investors who can keep you funded
  • Already have offers for additional financing
  • Already have acquisition offers
  • Show impressive growth in traction (monetization, product usage, downloads, etc.)

Who did you raise from?

When we raised venture debt, we got four term sheets. Three were from more traditional banks, and one was from a firm focused only on venture debt called WTI.

We decided to go with WTI, even though it was a bit more expensive than the rates offered by the banks. The team at WTI is fantastic, they have a great track record, and we liked the structure of their terms the best.

This seems complicated. Can I see an example?

Of course you can! Let’s go through an example from StartCo.

Here’s StartCo’s financial situation:

  • They have $1.2m in cash in the bank
  • They have $0 in monthly revenue (just to make things simple)
  • They have a monthly burn rate of $100k

If StartCo continues in their current state, they have 12 months until they are out of cash—and game over.

Let’s say they have the option to raise venture debt with the following terms:

  • $1m in debt
  • 9 months of interest-only payment
  • 30 months of interest-plus-principal payment
  • Effective interest rate of 11%
  • No covenants
  • The option to draw down the loan is available for six months

Let’s say StartCo raises the venture debt, and then in six months they withdraw the full $1m in debt (right before the option to use it expires).

How will this change their situation? Long story short, it will give them an additional 8 months or so until they are out of cash. Keep in mind that this isn’t free; they would still have the majority of their venture debt left to pay back. Here’s the graph comparing the two scenarios:

Screenshot 2014-11-13 17.57.17_large

The real question is: What can StartCo do with those six months? Will they make enough progress to cover the cost of the debt? For any high growth startup, the answer is typically yes.

For the full financial model, visit the spreadsheet here.

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