Should founders beware of venture debt?
As one of the most active VCs in Europe, our main business at Octopus Ventures is making equity investments and backing founders through their growth journey – so it might be surprising to read a blog about taking on debt. But after coming across an article suggesting that founders should ‘beware of debt,’ and with founders confronting the realities of the funding landscape, it felt important to explore the topic in a little more depth.
The article in question didn’t sit well with me. Against a challenging macroeconomic backdrop, many of the entrepreneurs who raised through 2020 to early 2022 are facing some hard questions. Valuation multiples have contracted, while the demand outlooks for many products are weakening. These factors are likely to increase the likelihood of down rounds – which, as we’ve written elsewhere, isn’t the end of the world. Still, they’re not ideal, and founders who can extend their runways will avoid unnecessary ones.
With the equity funding environment more constrained than we’ve seen in recent years, entrepreneurs are right to consider alternative funding options – including debt. But there’s a right way and a wrong way to think about it.
At Octopus Ventures, we put pioneering founders at the heart of everything we do. In this blog I hope to bust some of the myths surrounding debt, and offer some tips on how it can be leveraged as a useful source of funding. To start with, let’s explore what, exactly, makes debt structurally ‘scarier’ than equity – what are the warnings you might hear from investors, and how should you think about them?
Reasons to be fearful?
1. ‘Debt needs to be repaid’
Whilst this is obvious, the fact that debt (unlike equity) must be repaid is a key point that often gets overlooked. For a loss-making company, this can be worrying. Debt also comes with an amortization profile, which is the length of time the loan will need to be paid back over, and a contractual obligation to make repayments – usually monthly or quarterly.
When considering repayment, it’s worth bearing in mind that typical loan periods range from three to five years – enough time for a business to reach its next major milestone, such as increased annual recurring revenue (ARR) and/or profitability. This means new paths to repayment through equity fundraising proceeds, new debt, or an exit, have time to open up. But it’s also crucial to get to grips with exactly how much effective cash is being raised into the business through the loan – and manage cash burn appropriately.
2. ‘Debt puts future equity investors off.’
It’s easy – and responsible – to worry that introducing priority ranking instruments into the exit waterfall might put future equity investors off, but venture debt is widely accepted as a normal funding source for venture-backed companies.
As a founder considering taking on debt, the key thing to think about is how much is being taken on in the context of the business’s value, or the size of ARR. Put simply, a homeowner with a property worth £1m, would be unlikely to consider a mortgage of £250k to be ‘risky’. By the same token, taking up to 0.5 – 1 x ARR of senior ranking debt into a performing software as a service (SaaS) company (where the average company on the BVP Index is trading at a multiple of around 6 x EV/ARR) is relatively negligible (less than 20% of the enterprise value).
3. ‘Covenants are bad.’
Venture debt will sometimes come with financial covenants, such as growth, profitability and/or cash runway requirements. These can increase pressure on the business to perform in a certain way.
It’s worth remembering that this pressure can be alleviated by agreeing to ‘achievable’ milestones in advance with the lender. It’s rarely in the lender’s interest to undermine a company if the milestones are missed, but if it happens repeatedly it will be necessary to course correct (usually by extending cash runway). Founders in this position will probably also have to engage with the lender to re-set the covenants to more appropriate levels.
There is, of course, always a risk that the lender won’t engage. That’s why at Octopus Ventures we always recommend our portfolio companies use a debt investor or institution with a proven history of working in partnership with their investee companies – not against them. We readily make such introductions to our portfolio companies as needed.
4. ‘Priced rounds are better.’
Some people claim that having a ‘priced’ round (i.e. taking on equity funding at a fixed price, even if it’s lower than your previous round) is more favourable than taking on debt as it helps you face reality.
As we’ve written, down rounds are not necessarily a bad thing, but the decision isn’t binary, especially if it can be avoided. Debt is a sensible alternative to taking on a down round if it provides sufficient runway for a company to meet its next major milestones. Founders will, theoretically, always be able to raise a larger quantum in equity than debt, which makes it a question about which funding source (or combination) provides you with the appropriate runway.
All of this is to say that debt shouldn’t be dismissed out of hand as a potential funding source. It can be a low-cost capital solution which, if used in the right way and managed carefully, can generate meaningful shareholder value. So, when is the right time to raise debt?
The right time
1. Runway extension:
Right now, there are likely to be many founders with a sound underlying business, who are struggling because the last valuation round they raised was too high relative to the current valuation environment. In this situation, debt can be a useful way of carving out extra room to reach the next valuation milestone.
2. Safety net:
Even if everything feels fine, founders might find it worth considering raising some opportunistic capital, to bolster the war-chest and provide ‘insurance’ in the face of the market’s continued uncertainty.
3. Doubling down on growth:
It’s possible that even against the economic backdrop, some pioneering entrepreneurs have tapped a new opportunity or go-to-market strategy which is delivering exciting results. In this case, debt can be a way of mustering more resources to invest into it.
4. Bridge to profitability:
If a business is close to break-even, debt can provide the additional runway needed to make that a reality.
As I hope we’ve shown, debt can be scary, but it can also be useful. Rather than treat it with fear, it offers pioneering entrepreneurs a potential liquidity tool to drive growth or unlock opportunities. But it’s not a panacea, and there are certainly situations in which we’d strongly recommend against taking on debt funding. These include:
- If a business is significantly underperforming, and/or no equity investor is willing to invest at any price.
- The debt is being used to fund unprofitable growth, because the business is growing inefficiently or delivering poor unit economics.
- The value of the debt (including your preference stack) is considerable relative to the value of the business or its ARR.
Clearly, there are major watchouts when it comes to taking on venture debt, and it won’t be right for everyone. Founders considering it need to think carefully, to manage risk and to draw up a clear plan for how the capital will be allocated. But in an uncertain climate, with founders facing a new set of challenges, simply writing debt off entirely is reductive.
Used strategically and thoughtfully, it can be an invaluable tool that helps extend runway, avoid down rounds or bolster the war chest in the face of a challenging economic outlook. At Octopus Ventures, as equity investors, we work carefully with our portfolio companies to help them assess the funding options that are right for them – at every stage of their growth.