Learning how to place the Venture debt asset class. Differences between risk-reward balance for venture debt, venture capital and bank financing.
Author: Lucas de la Vega for Medium.
The whereabouts of equity financing are clear to all entrepreneurs, from initial Family, Fools and Friends to Seed, Series (A-B-C) and a final IPO. Most of these milestones are frequently on the papers and are understood as critical steps for tech companies.
On the other hand, the path to debt financing is still unclear to most entrepreneurs, there is no defined roadmap to debt financing and the access is typically asymmetric depending on the company nature and geography.
Venture Debt should be considered also as an alternative to Venture Capital. To my understanding the most successful way to use Venture Debt is as a complement to an equity round.
Venture Debt is meant to bridge the access to bank financing in Tech companies supporting companies along the initial stages of financing. The market lies somewhere in between commercial banking and pure Venture Capital activity. Nowadays is often used as a leverage for Venture Capital.
For the ease of convenience, we have simplified the commercial banking category presented above. However, you we may find an important number of different of products, these are often structured to finance short-term business needs. Some of the more frequent are: (i) Bank loans and overdrafts, (ii) Peer-to-peer business loans, (iii) Leasing and hire purchase lines, (iv) invoice financing and factoring and (v) asset-based lending.
In contrast to equity rounds, debt should be considered as an ongoing workout for companies. Bank debt may not come easy or in one-step and therefore the transition between Venture Debt and Bank debt is a process not an isolated milestone.
Why should I finance my company with Venture Debt instead of bank financing?
Bank financing should be the cheapest and therefore I strongly encourage all companies to look for bank financing in the first place. However, banks tend to be more cautious than Venture Debt who could fund more volatile credit profiles.
The main difference relies on the risk-taken by Venture debt fund. Venture debt is able to commit substantial amounts of money in a flash against the standard procedure of banks which are subject to a long-term relationship process with small increases of exposure over time.
How do banks and Venture debt look at companies?
Banks study essentially to the probability of default of the companies (failure to fulfil their repayment in a timely manner). To do so, they are very much focused on the financial metrics of the company and their industries.
They use credit scoring tools based on the historic performance of a large set of companies and their methodology is similar to the credit rating agencies, their will is to understand the probability of default (not to mention the poor LTV ratio of Tech companies).
As rule of thumb, banks may need to see more track record in a company, audited figures and may not like assets light companies (such as Tech companies). They may require guarantees and include all sort of covenants (including the pledge of a collateral) to ensure that their risk is partially mitigated as their upside is limited.
On the other hand, Venture debt analysis is slightly skewed towards a more optimistic scenario given the remuneration in shares. It is a two-fold basis analysis based on:
First, a credit appraisal similar to banks is performed to understand the creditworthiness of the companies. Funds are generally more exhaustive than banks as they have a limited number of companies under the radar while banks have a wider reach (banks often follow a top-down portfolio approach to credit risk guided by industry research).
Second, Venture Debt funds will also perform a qualitative analysis on the company (metrics, current sponsor, industry trends and exit multiple) similar to Venture Capital funds to assess the ability of the companies on raising new money from other equity investors and evaluating the equity capital appreciation over time.
When is the correct timing to ask for a Venture debt?
Ideally, Venture debt should be raised once the product market fit is validated and you are 12–18 months close to breakeven (see J-curve). Therefore, Venture debt will obviously aim to finance for more predictable business models (i.e. SaaS).
However, for those companies that do not have a strong visibility on earnings the most intelligent way to use Venture Debt is to balance early-stage rounds with Venture Debt but at the same time keep on working you banking relationships. Bank financing will typically enter the company 24–36 months after Venture debt once the company has validated several milestones and it could be helpful to refinance your current debt position.
If your company is appealing to a Venture debt provider, you might be able to leverage your round and therefore ask for a less important equity amount. This could significantly reduce the dilution of the round.
The more you extend the dilutive milestone of equity rounds the more value is retained by current shareholders. Venture debt increases runway of the company and enables a deep J-curve on the expenses while it maintains governance rights for current shareholders.