Editor’s note: Venture debt is a savvy alternative growth financing option. In this post, we take a look at why that’s true and how it can be used in conjunction with equity capital to help businesses grow and build enterprise value. For even more information on this topic, download “Venture debt: An alternative growth financing option.”
Among the many worries that keep founders and CEOs up at night, raising capital is often one of the most pressing. That’s because capital is essential for driving growth as a company evolves from a great idea into a thriving business. Unfortunately, all of the media hype about venture-backed companies reaching astronomical valuations only adds to the pressure. In fact, it can make founders and CEOs see raising huge rounds as a sign of success, even when it isn’t always in their best interest.
To be clear, there’s no question that equity has a critical role to play in helping founders and CEOs meet their business goals. But it’s important to recognize that like all capital, it comes at a cost. While the idea of raising a large equity round can be very appealing, the fact is that using equity alone to grow a business has some important implications. That’s because raising equity:
- Leads to dilution
- Requires you to give up board seats
- Forces a valuation of your business now
- Eats up precious time
While companies should always plan to be well capitalized, CEOs and founders need to find the right combination of capital sources. The goal should be to optimize the company’s cost of capital while enabling them to maintain more control over their business longer. The way to do this is by blending venture capital with venture debt.
As we’ll see, incorporating venture debt into your overall capital mix is a simple, efficient, and cost-effective way of growing a business. Plus, it doesn’t have the downsides that come with relying exclusively on equity.
The truth about venture debt
Debt is a common tool that can be used to accelerate the impact of equity. In traditional business sectors such as manufacturing or retail, securing your first loan — typically from a bank — to grow your business is a well-accepted milestone. Among other things, using debt is a very common way for traditional businesses to acquire equipment or machinery, expand production capacity, and finance inventory.
And yet, founders and CEOs in the technology sector often don’t apply the same logic to their businesses. Instead, they think that the only way to raise the capital needed to grow a technology business is to partner with angel investors or a venture capital firm to raise equity. While the historical lack of debt-funding alternatives for technology companies used to drive this approach, the allure of being backed by top-tier VCs also plays a role. Founders and CEOs see VC funding as a proxy for success, even when that’s not always the case.
The data on debt provided to technology companies is not as well documented as data for equity venture capital. Nevertheless, by some estimates, venture debt accounts for at least 10 percent of all venture capital deployed.
So what exactly is venture debt?
Venture debt is a form of non-dilutive financing that complements equity. It typically takes the form of a term loan or line of credit that companies can use to proactively fuel growth. They can do this, for example, by using the capital to invest in sales and marketing, accelerate product development, hire more people, fund acquisitions, or to simply provide basic working capital.
For startups and companies that don’t have significant assets or positive cash flows and therefore often don’t have access to traditional bank loans or material amounts of bank financing, venture debt can be a powerful debt financing tool. Not only that, it offers a variety of benefits, including:
- Founders and their teams maintain control over their business longer. Maintaining control enables founders and their teams to drive the strategic direction of the company they are working hard to build. That’s important not just because of the impact it can have on morale, but also because it typically leads to better business outcomes. In fact, according to a study by Purdue University, companies where the founder still has a significant role, whether as CEO, chairman, a board member or in some other capacity, tend to perform better longer.
- It’s non-dilutive. As part of a long-term financing strategy, venture debt allows companies to create greater economic value for co-founders, employees, friends and family, and other early supporters. You can see that illustrated in the graphic below.
- It’s flexible. You can combine venture debt with senior debt from a bank to reduce your overall cost of debt capital, draw it down when it makes sense for your business, and, unlike equity, repay it when you want.
A word about senior vs. mezzanine venture debt
Throughout this post we’ve referred to venture debt as the debt that is used to fund growth. In most cases, it will be the junior or mezzanine layer of the debt portion of the balance sheet. While senior bank facilities are sometimes characterized as venture debt, it’s important to understand the differences. Bank facilities, generally structured to support a company’s working capital needs, will carry lower interest rates and offer less lending capacity than venture debt. They also might be subject to amortization and include other covenants designed to minimize the lender’s risk.
Adding venture debt as the junior or mezzanine layer of debt capital ranking behind a senior bank facility can therefore be an attractive option. Combining senior bank facilities with mezzanine venture debt structures enables companies to maximize their debt funding while minimizing their blended cost of debt capital, diversifying funding sources, and avoiding dilution.
Finding the right mix of venture equity and venture debt
When it comes to developing an overall capital-raising strategy, companies need to give careful thought to their options. They also need to find ways to incorporate a balance of debt and equity. That’s because it’s impossible to build a successful business using debt alone. At the same time, founders and CEOs can quickly get squeezed if they just rely on equity. By combining the two types of capital, however, it’s possible to achieve a capital structure that not only optimizes the company’s cost of capital but also provides founders and early shareholders with maximum flexibility and control.
Figuring out what the ideal mix of capital should look like depends on the specific business. A company that can predict with confidence how investment will directly drive revenue growth (and how much), or otherwise create value in their business, will generally be better suited to using debt capital than one that struggles to do so. Fundamentally, a company’s capital efficiency will determine how much debt it should use.
Is venture debt the right choice?
If venture debt sounds like a good way to raise capital, that’s because it is. But that doesn’t mean that it’s right for every company in every situation. For example, raising venture debt isn’t a good idea if:
- Your business isn’t growing fast or efficiently enough. Venture debt is best suited to fast-growing companies for which revenue growth meaningfully exceeds the cost of that capital. Borrowing at 15 percent makes no sense if you’re only growing at 10 percent. Likewise, if customer lifetime value is too low due to high churn or low margins, or customer acquisition costs are too high, then venture debt probably doesn’t make sense.
- There’s no clear plan in place for using the capital. It’s critical that any funds borrowed are actively put to use to create value. Having excess debt capital on your balance sheet simply represents another cost with no benefit. The same can be said for raising excess equity capital except that the cost takes the form of unnecessary dilution. In that case, the cost is borne by the founder and early shareholders rather than the company.
- The company hasn’t figured out its product market fit. This is an essential step in a company’s evolution. Companies that haven’t reached it are generally too early stage for most forms of venture debt and can likely be better financed with equity.
Remember, venture debt is an obligation. It involves a fixed interest payment every month as well as capital being repaid at the end of the term. If a business isn’t confident that it can meet its obligation, it shouldn’t take on venture debt.
What founders, CEOs, and investors say about venture debt
“When I was raising capital for Achievers I wanted to be backed by the best VCs in the world because that meant that I was in the same league as Steve Jobs and Larry Page. Unfortunately, that led to a suboptimal outcome for the people that mattered most to me — my family, my management team, my employees, my friends, and my other early investors. Had I used venture debt as part of my long-term funding strategy, this group would have made $30 million more at exit. Raising all that equity also meant I lost control of the business too early. That meant that we didn’t always make the right decisions and that we ultimately sold the business far too soon.
Razor Suleman, Founder, Achievers
“During our last financing round we tried to strike a balance between raising enough capital to supercharge our growth and not suffering too much dilution. Once we learned about venture debt, adding it into the equation became a no-brainer. With a mix of debt and equity, we were able to raise the full amount we needed to accelerate our product roadmap and invest in our backend processing capabilities. The result was a broader addressable market and a more valuable business, all while minimizing dilution and retaining more upside.
Eric Green, Co-Founder and CEO, Askuity
“When used right, venture debt is an important alternative source of capital for venture-backed growth companies. For founders and CEOs, it’s an opportunity to raise money in a way that’s fair, unobtrusive, and that doesn’t create dilution. Right now, about a quarter of the companies in my portfolio use venture debt. I will continue to encourage more to do so because it’s a win-win for everyone.
Rob Antoniades, General Partner and Co-Founder, Informations Venture Partners
Some final thoughts
Although the pressure to raise capital is real, don’t associate raising a big round of equity with success. Founders, CEOs, and boards should take the time to evaluate all of their funding options. As part of that, they should consider the near- and long-term financial and operational consequences for the company and its early investors. In many cases, that will mean finding ways to raise capital from a combination of sources, including equity et debt. The key is to build the necessary foundation for the company to grow. But in a way that minimizes dilution and cost, while enabling founders and early investors to retain the greatest control of the business.
By partnering with the right venture debt lender — one that understands the business and offers the flexibility to meet a borrower’s individual needs — companies can quickly access the capital they need to proactively grow their business. And they can do it in a way that doesn’t come at the cost of dilution or control for them or any of their investors. For fast-growing companies looking to further accelerate their growth, it makes a lot of sense.
Check out our white paper, “Venture debt: An alternative growth financing option.”