Venture Debt is a loaded term. It can mean different things to different startups. And it can come in all different shapes and sizes.
The two most common structures are Revolving Lines of Credit and Term Loans.
Think of Revolvers like giant credit cards, where you can run up a balance, pay it down, and then run it up again - just remember to stay below the limit.
Revolvers are great for short term needs, like spikes in payroll (bonus season), big vendor pre payments, and working capital needs (stocking inventory to prepare for busy season - not that I’d know; I’ve never sold anything you can touch, lol).
On the other hand, Term Loans are like a big whack of cash generally reserved for larger priced items, like, say, another company.
Term Loans are more like a mortgage than a credit card. You can prepay it to make it go away, like a mortgage, if you fall ass backwards into excess cash (I’ve done this after raising an equity round).
In my simple mind, Revolvers are great to smooth for fluctuations in the natural course of the business, while Term Loans are great for preserving equity and avoiding dilution on bigger commitments.
It’s common for companies to set both structures up in tandem, and have the flexibility to pick which one to use based on the scenario they’re faced with. They’re both insurance policies in a sense - you don’t need them until you really fucking need them.
This is our second of three posts on cash management.
Part I: Bank Accounts (LAST WEEK’S POST)
Stages Covered:
Startup
Growth
Maturity
*Redflags*
Investment Policy Template you can download
Part II: How to Negotiate Your Venture Debt? (THIS WEEK’s POST)
Revolvers vs Term Loans
Fees
Typical Debt Covenants
Negotiation Points
Venture Debt Players and Sizing
*Red Flags*
Part III: 13 Week Rolling Cash Flow Forecast (NEXT WEEK’s POST)
How cash enters the building
How cash leaves the building
13 week forecast template you can download
In this post we’ll give you illustrative examples, break down the key differences between the different types of venture debt, define common terms, cover the big players to be aware of, provide negotiating tips (from real world experience setting them up myself), and call out some red flags.
Revolvers:
Illustrative Revolver structure and terms
Flexibility: A revolving line of credit operates similarly to a credit card. It offers a maximum credit limit, and the borrower can draw funds up to that limit as needed.
Reusability: As the borrower repays the borrowed amount, that amount becomes available to be borrowed again, making it a flexible financing option for short-term or recurring funding needs.
Interest: Interest is charged only on the amount borrowed and utilized. It provides flexibility in managing cash flow as the interest expense can be minimized by repaying the borrowed funds promptly.
Renewal: Typically, revolvers have expiration dates after which they might need to be renewed or renegotiated based on the lender's terms and the borrower's creditworthiness.
I’d like to emphasize the Renewal portion here - it’s common for companies to “upsize” or increase their effective credit limit over time. I’ve worked with startup friendly banks like SVB who build this into their strategy - they want to creep up the size of the Revolver as you become more successful and have the capacity for more debt. In this sense they share in the success of your business by getting their foot in the door early with a small Revolver (e.g., $2m) and upsizing it upon renewal over time as the company hits important financial milestones (Boom! Five years later it’s $200m).
Banks are building a portfolio similar to VCs - they bet on companies early and take on risk to hopefully grow with the business when it will produce larger returns. The SVBs and PacWest’s of the world loan smallish amounts that a big bank wouldn’t get out of bed in the morning to write, and then participate in the upside years down the line as the relationship stays intact.
Some of this is done through a genuine growth in trust (“you bet on us early in our company lifecycle and we appreciate that”). And some of it is achieved through terms which we’ll cover below, which allow banks to get their talons in, and box potential competitors out.
Term Loans:
Illustrative Term Loan structure and terms
Fixed Amount: A term loan provides a lump sum of capital upfront, which the borrower repays over a specified period in regular installments.
Repayment Structure: Term loans have a fixed repayment schedule, often monthly or quarterly, consisting of both principal and interest payments.
Usage: Unlike a revolver, once a term loan is repaid, the funds are not reusable. It provides a one-time infusion of capital for specific purposes like expansions, acquisitions, or long-term investments.
Interest: Interest is typically calculated based on the outstanding balance of the loan and is paid along with the principal in each installment.
Term loans are great for M&A, or as a bridge to a future rounds. These are the two most common cases, which we’ll elaborate on below. Term loans might also be used for construction projects (like an office build), or even paying down other debt that’s coming due (LOL, how meta - debt to pay down debt).
In terms of M&A, for a growing company with increasing equity value, it makes little sense to crush the cap table when you can conjure up more cash for the deal through a term loan.
I’ve personally used Term Loans when rates were super low (under 5%) and our equity value was growing more than 25% year over year as our valuation grew. It was a no brainer to use cheap debt, rather than expensive equity, to fund an acquisition.
In less favorable macro scenarios where it doesn’t make sense to raise equity funding, or when the company isn’t performing well enough to get the valuation it wants, Term Loans can be an effective “bridge” to the next funding event. Why do a down round when you can delay catalyzing your valuation reality?
Source: FloCap
In terms of size, lenders will typically provide 1/5th of of whatever you have on your balance sheet already, 25% to 35% of the last equity round.
OK, let’s compare and contrast, and then teach you some crucial negotiating points.
Key Differences:
Flexibility: Revolvers offer more flexibility as they allow for multiple withdrawals and repayments within the set credit limit, while term loans provide a one-time lump sum.
Usage: Revolvers are suitable for ongoing or fluctuating funding needs, while term loans are ideal for specific, one-time capital requirements.
Interest Calculation: Revolvers charge interest on the utilized amount, whereas term loans accrue interest on the entire principal amount (usually).
Repayment Structure: Revolvers have more flexible repayment structures, allowing for varying payment amounts based on the borrowed amount. Term loans have fixed repayment schedules (which can usually be repaid entirely).
Despite these differences, the two share similar fees and covenants, as we’ll break down below:
Fees:
According to SVB, there are four key cost components:
An upfront fee to arrange the facility (1% to 2% or a fixed fee)
Interest rates with repayment flexibility (7% to 15%)
A back-end or final payment fee (0% to 4% or a fixed fee)
A warrant component (3% to 8% of loan amount)
Warrants are the most nuanced bit to call out here, as they set venture debt providers apart from typical banks. This gives the venture debt provider the option to buy shares in the business down the road at a fixed price. This is where the debt provider becomes an equity holder. Think about “warrant coverage” at anywhere between 3% to 8% of the commitment amount. This means you take the latest 409a valuation’s share price and solve for the number of options needed to get to 3% to 8% of the facility’s overall value.
Here’s an example of how the warrant coverage might be worded:
Bank to receive the right to purchase that number of shares of Common Stock equal to 0.20% of the Borrower’s current fully diluted shares outstanding, 0.10% of which is earned at close and 0.10% of which is earned based upon the highest amount drawn on the facility. The Exercise Price shall be per the Borrower’s most recent 409A valuation as of the date of this term sheet. The Warrant is to be on the Bank’s standard form and to be mutually agreeable to Bank and Borrower, with a ten-year maturity and inclusive of certain provisions to include, but not limited to, net exercise provisions. At close, Bank to earn $200,000 payable upon a change in control or liquidation event.
However, if you don’t want to dilute the cap table, you may be able to negotiate a fixed “Success Fee” where you pay a certain amount upon M&A.
At close, Bank to earn $200,000 payable upon a change in control or liquidation event.
Typical Venture Debt Covenants
When a bank or lender is considering providing debt to a company burning cash, they typically impose various debt covenant tests to ensure the borrower's financial health and ability to meet debt obligations. These tests are based on financial ratios that the company must maintain or exceed during the loan term.
They will have:
A topline covenant
A bottom line covenant, and
A liquidity covenant
Many times these don’t kick in until you draw a certain amount of cash and the bank has a significant amount to lose. They can also play in one another. For example, if you achieve the topline covenant, we won’t even test for the bottom line covenant.
Some typical debt covenant tests that a bank might require for lending to a technology company include:
Revenue: Either a certain revenue growth rate expressed as a percentage, or achievement against the approved board plan, expressed in absolute dollars.
“Borrower will be held to a Cumulative Revenue Covenant tested monthly set at ~75% of the BOD approved plan. Revenue defined as GAAP revenue measured on a cumulative basis beginning January 1st of each year and tested monthly.”
Quick Ratio (also known as Acid-Test Ratio): The quick ratio assesses a company's short-term liquidity by measuring its ability to meet immediate financial obligations without relying on inventory. It is calculated as follows: Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Debt-to-Equity Ratio: The debt-to-equity ratio evaluates the company's leverage and risk by comparing its total debt to shareholders' equity. It is calculated as follows: Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
Interest Coverage Ratio: The interest coverage ratio determines a company's capacity to meet interest payments on its debt with its operating income. It is calculated as follows: Interest Coverage Ratio = Operating Income / Interest Expenses
Debt Service Coverage Ratio (DSCR): The DSCR measures a company's ability to generate sufficient cash flow to cover its debt obligations, including interest and principal repayments. It is calculated as follows: DSCR = (Operating Income + Depreciation & Amortization) / (Total Debt Service)
Fixed Charge Coverage Ratio (FCCR): The FCCR is similar to DSCR but also includes fixed charges like lease payments in addition to debt service. It is calculated as follows: FCCR = (Operating Income + Fixed Charges) / (Total Debt Service + Fixed Charges)
EBITDA Margin: The EBITDA margin indicates a company's profitability by measuring its Earnings Before Interest, Taxes, Depreciation, and Amortization as a percentage of revenue. It is calculated as follows: EBITDA Margin = (EBITDA / Revenue) * 100
Current Ratio: The current ratio assesses a company's short-term liquidity by comparing its current assets to its current liabilities. It is calculated as follows: Current Ratio = Current Assets / Current Liabilities
Net Profit Margin: The net profit margin measures a company's profitability by evaluating its net income as a percentage of revenue. It is calculated as follows: Net Profit Margin = (Net Income / Revenue) * 100
Other negotiation points:
Deposits: This is the most important one to nail down. The scope of the banking relationship is a key driver in how banks get comfortable with lending to high growth, cash burning businesses. This means keeping your deposits as collateral with them.
This is a huge sticking point post-SVB for many companies.
“Borrower shall maintain all its deposits, transaction accounts, and primary investment accounts with [Bank] and its affiliates.”
I’d recommend negotiating for 50% or less
Fees: You’re on the hook for paying the bank’s audit and due diligence fees
The average cost is ~$25k for a vanilla structure.
Success Fee > Warrants: You have asymmetrical information as to the valuation your company is targeting upon exit. Do the math on what the warrants would be worth at that time (it might be much, much more than a fixed success fee - I once did the math on a term sheet that would have been a ~3x difference if we hit our marks)
Future Debt: Any other future debt you take out will be subordinated (after) this debt agreement. And you can’t enter into other debt agreements without approval from this bank.
Board Members: You might not be able to make changes to your board without getting approval.
Warrant Vesting: You can negotiate how the warrants vest to be more back end loaded (e.g., 25% upfront instead of 50% upfront). You can also ask for the warrants to be dependent upon amount drawn.
Unused / Prepayments: Try to get these wiped. You probably won’t be able to dodge the facility fee though
“No unused or prepayment fees, just a one-time $7.5k facility fee.”
Reporting Requirements: Financials and KPIs - ask for extra time. Sometimes the turnarounds they ask for can be aggressive. You’ll want the reporting dates to align to when you are sending stuff to your VCs so you can just do it all at once.
“Monthly consolidated and consolidating financial statements (balance sheet, income statement, cash flow statement) within 30 days of month end.”
“Annual audited financial statements (or whatever level is required by Borrower’s Board) within 180 days of fiscal year end”
“Annual Board approved plan provided to Bank either the earlier of (i) ~45 days from fiscal year end or (ii) within 10 days of Board approval.”
Venture Debt Players and Sizing
Training Wheels: SVB, PacWest
These are specialized financial institutions that provide venture debt to cash burning startups. They understand the risk associated with early-stage companies and structure the loans accordingly, often taking equity warrants or conversion rights as part of the deal.
You’re typically eligible once you’ve raised $5 million or more in a single round
Mid Size Growth: Hercules, (also) SVB, Comercia, Bridgebank, Golub
These banks work with companies that have shown promising growth and have a more stable financial position than super early-stage startups. But they’re still probably burning cash.
These banks usually get involved after $100M in ARR
Post IPO: Blackrock, Blackstone, Owl Rock, JPmorgan, Goldman, Ares
These banks work with mature companies that have gone through an initial public offering (IPO) and are now publicly traded.
These 800 Pound Gorillas don’t typically like sharing with others in the debt stack.
Red Flags:
Asking for a board seat
Asking for a personal guarantee
Aggressively escalating rates over time
