Venture Lending 101

Many of the companies in which I invest spend more money than they make for considerable periods of time. Given the early stage at which I invest, this is neither surprising nor necessarily concerning (even those companies that could be cash flow positive if they so chose, often go negative in an effort to accelerate their growth). Nonetheless, it is an important factor with which I must deal as I try to help my portfolio companies move forward. After all, at some point any company burning more cash than it makes will have to acquire more money or go out of business.

The typical route for venture backed startups to bring more money into the company is to do a equity financing. The management of that company goes out and pitches various investors and, with any luck, sells equity in the company in exchange for some number of millions of dollars (that process is repeated as many times as is necessary until the company turns cash flow positive, is sold or goes out of business -- even the much coveted IPO is just another sale of equity for cash and if the company remains cash flow negative it will still ultimately need to do a secondary or it too will go out of business).

In the alternative, one way that a company can extend its runway without selling additional equity is to borrow money. There are a number of potential sources of debt for early stage companies. To my mind, the key issue for any company considering debt financing is whether or not the debt will actually extend that company's runway. Often times, proposed Debt will bring money into a company when it is already cash rich (usually shortly after a equity financing) but will bring with it a payment schedule that does not in fact give the company any more time before it runs out of money. In those circumstances, it is hard to see how borrowing the money makes economic sense.

There are, however, circumstances in which debt makes a pile of sense for a company. I recently received a newsletter from Lighthouse Capital that spoke directly to the issue. A buddy of mine named Anurag Chandra, who is a Managing Director at Lighthouse, wrote an article on how one may reasonably assess the appropriateness of venture debt for your company. I found the article to be a valuable overview of the issues at hand and Anurag has kindly agreed to let me reprint it here. So without further ado, here are Anurag's thoughts on venture debt.

There is no question that in today's fundraising environment, capital efficiency is paramount. Ray Lane, among other industry leaders, has commented that a software startup should require no more than $20-25 million to achieve positive liquidity. This means that today's entrepreneur needs to stretch every dollar to achieve success.

Making equity dollars last is particularly important � since they come at the high price of forking over a percentage of company ownership. Although the price is high, these precious equity dollars are often a critical factor in an emerging company's success. Yet taking this equity investment means accepting painful dilution due to the low valuations given to companies at this early stage. So what's the alternative?

Enter venture lending
Venture lending offers a low-cost method for venture-backed companies to leverage fixed assets and their enterprise value to get more runway out of their equity dollars. These types of loans can give a young company the extra time and resources needed to reach major product or customer milestones. And, being able to achieve important milestones such as shipped product or securing a first customer can provide real uplift in valuation and significantly reduce dilution at the next VC financing round.

Venture lending is usually offered in two forms: "growth capital" and equipment financing. Growth capital provides operating capital that can assist in product development, product or geographic expansion, acquisition of complementary technologies, or just about any key operational imperative. Typically the cost of such capital is interest, along with principal, paid over a fixed period of time (generally 24-48 months, depending on the company's risk profile) and a small pledge of stock warrants. There may also be a "final payment," which helps the lender earn the appropriate risk adjusted yield, but pushes off the cash outlay by the borrower to a future date so it doesn't have to part with precious (and typically more expensive) dollars in its early years. Some flexible providers are even willing to structure deals that provide companies with a period of interest-only payments to help preserve cash at critical junctures for a company. Meanwhile, equipment financing allows a company to borrow against the equipment it purchases, such as computers, manufacturing equipment or other assets, and frees up the equity dollars that would have otherwise been spent to obtain such items for higher value add use, namely research and development or sales and marketing. Like growth capital loans, the lender receives monthly payment of principal and interest plus warrants and possibly a final payment.

Both forms of venture lending are available to promising early-stage startups backed by top-tier venture capitalists, usually when they are still cash flow negative. Venture loans may either help you raise less equity than you otherwise would have or help you increase the total amount of capital available to your enterprise with less dilution. From a financial planning point of view, venture loans can be an attractive insurance policy. If there's risk that critical milestones may slip, having the ability to borrow and extend runway so those milestones can be safely achieved insures a trip to the equity fundraising market with a better valuation. If the milestones are not in jeopardy and you ending up not borrowing, your worst case is to have given away warrants that typically amount to less than one or two percent of dilution. (Compare this to raising money at a lower valuation by having to go to market with those significant milestones not achieved).

Bank loans vs. venture loans
Established companies leverage their balance sheet assets through typical asset based debt products offered by commercial banks. Venture lending is territory that most banks are wary to enter because early-stage companies just represent too much risk for traditional banks because such companies have no tangible assets. Typical bank financing is tied to receivables. You must have sales revenue and probably "meaningful" sales revenue to attract bank financing. Even then, an established company with a steady, predictable revenue stream can use accounts receivable financing at best to smooth out cash needs, not leverage its enterprise value to extend runway. For a company that is cash-flow negative or just starting to achieve revenue, it's worse because it's tough to rely at all on a formula based A/R line for expansion and growth. If you miss a monthly or quarterly revenue projection, chances are you'll have less in receivables than anticipated and may have to pay down your outstanding on your accounts receivable line of credit.

Having said that, there are banks that offer venture loans to early-stage companies. But be careful. At smaller dollar amounts bankers can convince their credit committees and the federal regulators that monitor their bank to make "aggressive" venture loans, but it is with the understanding that the goal is to grow the lender into a traditional commercial credit, replete with financial covenants and asset-based borrowing, which box in a company. Either it's the proverbial "banks are only willing to lend you money when you don't need it" or it's that the typical slippage in a startup's projections necessitates a talk with the banker about "waiving" a covenant violation. Banks also typically require young companies to maintain their deposits with them and require a "right of offset" in the loan agreement. This right of offset can be used by the bank at its discretion to pay down the loan in an event of default.

Independent venture lending providers, particularly ones that are private companies, have the ability to structure flexible deals that give you true runway extension. And, the better funded ones can support their companies with these structures at higher dollar amounts and through a startup's maturation process. The established venture lenders also know how to evaluate and manage the risks involved in dealing with early-stage companies. They are willing to take a lien on a company's assets when no real assets exist in anticipation of success.

Less expensive in the long run
Perhaps the greatest benefit of venture lending is that it injects money into a business without heavily diluting the equity stake of the entrepreneur or venture capital investors. While equity dollars are necessary in financing a company's development and a typical prerequisite to obtaining venture loans, they come at the high price of sharing significant ownership. Venture loans can be a real aid that can enable an early-stage company to have access to low-cost capital and minimize entrepreneurs' and VCs' dilution. An added benefit for VC's is that they can improve their ROI on a given deal by encouraging their portfolio companies to take on a responsible mix of debt along with their equity dollars.

Consider this example. A communications startup determined that they needed a round of financing totaling $47 million, of which $8 million would be needed for equipment. They evaluated whether it was in the company's best interest to finance the equipment using debt or equity. In other words, they were weighing whether they should raise $47 million from VC's, or $39 million from VC's with the expectation of financing the additional $8 million of equipment through a venture lease. After taking a careful look at options, they concluded that the larger equity sum would cause significant dilution that would be costly to company employees at time of liquidity; meanwhile the venture lending route would preserve more of the employees' stake in the company and simultaneously create a stronger balance sheet.

Choosing a venture lending partner
When considering venture loans, it is important to ask key questions that will determine if the provider is going to offer you the flexibility and resources needed to help finance growth of your company.

Important questions include:

Is the lender really offering you cash runway? Or do they require cash balances equal to the amount your borrowing? Will most of the loan be paid back before you run out of cash? It's important to examine exactly what the lender is offering. If the deal comes with too many restrictions, chances are you need a more flexible partner that will work with you to structure a deal that accommodates your company's specific needs.

Does the lender have a track record of supporting its companies through various market cycles? Every startup has hiccups. The need to restructure debt can happen to the most promising of companies. Ask your lender for case studies or referrals where they've demonstrated an "investor's mentality" of supporting its companies through various market conditions.
If the lender is a bank, is it their ultimate goal to help you achieve market success or is it to grow you into a traditional commercial credit customer? Beware of the limitations of commercial banks that claim to offer venture loans. Often times, they will finance an initial deal, but their goal is grow you into a commercial credit customer. Plus, they are burdened with heavy regulations that make it difficult to offer the kind of flexibility that startups often require.

Does the provider understand your market and your requirements for success? While venture lenders don't take board seats and offer the same level of day-to-day guidance companies as venture equity investors, it is critical not to underestimate the importance of the partner with whom you'll be working. The better he or she understands your business and the market you are playing in, the less likely they are to view your success or promise

Not surprisingly, Anurag, as a venture lender, puts a positive spin on the debt world. I believe that both debt and equity can serve a company well. The crucial question is how much the money will cost (in equity, interest, management time, etc.) and will it materially increase a company's options.

Comments

[Jason Lemkin]

I wonder about the value of venture lending at least since 2000 or so.

My experiences in my last two companies suggest limited value. Also, my Ec 101 view of venture lending suggest that they can really only afford to lend to very low risk start-ups, b/c their returns are not THAT great. They simply cannot afford to take substantial risk. So these days many seem to only want to lend to companies who don't really need the money.

Further, many of the leasing companies simply invoke their covenants when things get at all uncomfortable. Perhaps as well they should. But in my experience this means you may not be able to draw down on as much of the instrument as you expected -- or at least when you want to. For example, b/c the implicit interest rates are SO high on these loans (when you consider orgination fees, exit fees, buy back fees, administration fees, etc.), you may want to drawn down as late in the line as possible. The lendors tend to get squeemish here when you have 18 months of runway these days. One reaction is shorter terms (e.g., 24-30 months), which makes these expensive lines even less valuable.

In my most recent company, when we rec'd our venture financing, we had about 24 months of runway. After talking with all the usual suspects, it became clear equipment financing (apart from Dell's) made no sense. It was cheaper to fund the equipment with the very expensive equity dollars we had raised. Most lenders for equipment especially wanted to lend on a 24-30 month schedule at total interest rates which I think were at least 15-18% when you added in all the explicit & hidden fees, probably more. Thus, taking down a line would not have added to our runway at all.

Perhaps in the coming 1-2 years terms will get restrictive, lenders will take a little more risk, and these venture leases will be the decent deal they were back before and during the bubble. But what I've seen in the last 3 years at least suggests that any debt line you'd want, you can't get, and the lines you can get, you don't want.

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I think this is the general rule of venture lending - all geared towards the long term results.

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I've just been reading about the mis-adventures of Rand from SEOMoz on his recent Venture Capital experience.

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