The companies we back spend a great deal of their time planning their runway and trying not to run out of cash whilst creating big, exciting businesses. We often get asked about alternative financing options and venture debt in particular can be a complementary supplement to venture capital. We spoke to both European and US banks and funds including Barclays, Silicon Valley Bank, Triple Point Capital and Columbia Lake Partners to get their view on when this type of financial product is suitable for a startup; the types of facilities offered and their key terms; the process to get funded and what happens when things go wrong (this is startup world, after all!).
This post is directed at European companies and we note that the market terms referred to herein are not necessarily reflective of the US market.
A US perspective
From our conversations with Triple Point Capital, Columbia Lake Partners and Silicon Valley Bank, who have all backed US and European companies, the overwhelming sense is that European startups, and the European market in general, is still far behind the US.
Daniel Bull of Columbia Lake Partners noted that “The vast majority of US startups raise their Series A and then immediately raise venture debt. This is the ‘insurance policy approach.’ 99% of companies at this stage do not hit the numbers in their projected business plan, so to avoid going back to their investors, they extend their runway from the outset and avoid those awkward conversations. The upshot is that they haven’t had to raise earlier than they said they were going to and the existing investors haven’t already used their follow-on reserves on the business. It makes a lot of sense.”
The feeling was echoed by Alex Barry at Triple Point Capital who believes that the European market needs continuing education on the benefits of debt products that banks and funds can offer to high-growth companies.
Silicon Valley Bank also stressed that they still find themselves educating founders, particularly in Europe, who often (i) see ‘debt’ as a scary term; and (ii) cannot understand that they are creditworthy and in an appropriate position for venture debt financing. Their view was that venture debt should be seen as a tool for leverage, allowing the entrepreneurs to push the business to an even better position as they set themselves up for future equity raises.
Some of the most obvious benefits of debt financing are as follows:
- Saves dilution for founders/executive team
- May be a less expensive solution and the cost of debt reduces as your business becomes more established and stable (there are some helpful models that are freely available for you to work out what a facility may cost you — here and here).
- Similarly, larger facilities are typically available as your business scales in size
- Can be a flexible product with limited covenants (meaning contractual agreements to do/not do certain things) and restrictions on use of funds
- The debt provider is a passive investor, will not take a board seat or include stringent control provisions
Sounds great — but is it for all startups?
Absolutely not. Ask yourself: What is the profile of your business?
If the answer is yes to the below criteria, you can start exploring conversations with debt providers:
- At least 1–2m GBP in annual revenue (although there are always examples where debt has been advanced for pre-revenue companies)
- Fast growth, but loss-making
- Likely to require more equity
- Still refining your business model — seen as venture risk but you have built a product, have product-market fit and ‘lighthouse’ customers
- Raised at least 1m GBP with credible external investors
- “You know what you are doing and have proven this out, you just want to go faster and need some lighter fuel”
Of course, if you are further down the scale-up journey, closing down on breakeven, naturally you are an even better debt candidate! We are not going to cover growth loans, account receivable credit lines, revolving credit lines or acquisition finance facilities — all of which are readily available for companies later in their lifecycle. It appears that more mature companies with sustainable business models and leverageable balance sheet assets understand the opportunities around debt-financing but younger companies may still be missing out on this potential complement to their equity funds.
What do you want to use the funds for?
Sensible answers are:
- Extending cash runway
- Providing working capital
- Supporting capex
- Acting as a tool to allow the execution of your business plan to take slightly longer than originally anticipated
However, you are going down the wrong path if:
- You are attempting to replace an equity raise altogether (at a bare minimum, you would be raising the debt to prove out certain metrics to allow a higher valuation at the next equity raise)
- You want to finance research and development
- It is being used as a short term bridge, but you have no certainty of future funding
- You are in a tough patch, close to running out of cash (more likely to get better pricing and successful debt package if you approach lenders when you are in a positive position)
- You’re a mature business with assets and stable revenue (you’re in a different risk profile and should be looking at different debt products)
Please note, that we should include an emphatic disclaimer here that, like all funders, there are edge cases and lenders have the ability to be flexible around these terms but the below gives a good guideline as to where the European market is currently operating for venture loans. Another point to flag is that there is a difference between senior debt financing and subordinated debt (a bank will more typically insist on a senior position, meaning they have priority and are first in line for the company’s assets) — a bank that insists on providing senior debt may still be cheaper (vis a vis the interest rate and warrants) than set out below:
- Loan Amount — How much can you get? — £250k-£8m (may go larger and syndicate, may be provided in tranches).
- Loan Term — How long will you have to pay the money back? — 12 to 36 months.
- Repayment — Do you have to pay it back in instalments; all at once; can you re-use any that you have paid back? — Remember to discuss when you want to actually draw down your loan (if you’ve raised equity, you might want to delay drawing down the loan, so you don’t have to start paying it back when you aren’t using it!). There will typically be a drawdown period of 12 months (it may be longer, up to 18 months) during which you are able to draw on the loan and it is likely that you will only be required to repay interest during the drawdown period. Bullet repayment (bank) – pay it all back at the end. Amortising (fund) – pay it back in instalments, skewed more to interest payments at first and then principal repayments.
- Price — How much is it going to cost the business (fees; interest rate) — Interest rate: LIBOR plus 8–12%. Other fees: Arrangement fee 1–2%.
May also require: Maturity fee / backend fee 1–2% and Early repayment fee.
- Covenants — What promises do you have to make to the funder and what metrics might they be regularly testing that your business is fulfilling? — No covenants. No restriction on use of debt proceeds. No board seat; just information rights. Analysis: Debt/equity ratio: <25–35% loan to (cumulative) cash equity that has gone into the business. Debt/enterprise value ratio: <10% debt to enterprise value which has been implied by the most recent equity raise. Enterprise value: >£5m. Unit economics:Consider whether there are elements of the cost structure that could be pulled back to have a positive impact on revenue. Is the negative EBITDA a product of high revenue generation? Financial model forecast — EBITDA performance is tracked monthly by the funder to ensure the trajectory is where the business was planning. Where this is not within 25% of plan, conversations will be had with management to understand what is destabilising the business.
- Security — What will the funder ask for from the business to make sure the loan is repaid in full and on time? — All assets debenture (IP, receivables, mortgage over property) — you will also promise your lender not to use your assets as security for anyone else.
- Warrants — Is the funder going to ask for the option to subscribe for some shares in my business? — 1–2% of fully diluted share capital (10–20% of loan amount). These operate passively, no pre-emption rights on future fundraises, 10 year deadline to exercise, typically the funder does not exercise until an exit event.
It is highly recommended to keep together everything you assembled for your equity fundraise, this can be really useful when approaching lenders in the 12 months following your round. The process is likely to be less painful than when you were raising your equity round, but you will need the following for the debt provider:
- Cap table and KPIs
- Most recent pitch deck
- Forecast financial model
- Group structure chart
- List of clients/customers/reference partners
- Senior management available for meetings
It is typically a two stage process on the funder side; with the above information, they can quickly move to letting you know whether there would be a fit and a term sheet could be issued (1 week). After that, there is a fuller diligence process and analysis where further information may be sought (1–2 weeks subject to responsiveness). A term sheet can then be agreed and legal documentation drawn up (2 weeks). From the first conversation to funds hitting the business’ bank accounts, this is likely to be a 6–8 week process.
When things go wrong
This has fortunately only happened a handful of times but when we asked the funders about pursuing enforcement action and “taking the keys to the business”, the unanimous response was that this is the last thing they want to do. There is practically zero value in the business and little useful a debt funder can do with a high growth startup. Security is taken so that it can be used as a tool to leverage conversations with management and to bring them around the table. Here, cost reduction exercises may be implemented, business plan pivots and ways in which the business and/or loan facility can be restructured are all openly discussed and may be actioned.
Downsides of debt
The biggest thing to remember is that debt must be repaid. Servicing debt repayments can be onerous if they are too high and you must properly factor the ‘all in’ cash cost and impact on the cash runway when considering this as an option. Having the right lender is just as important as having the right VC — they will be your partner for the long term, so choose wisely and never pick your funder on price alone. On the upside, if you position it properly, you may end up continually refinancing your venture debt with each equity round and only ever repay at exit!