VENTURE DEBT: Friend or foe for startup founders?

A growing number of start-ups are accessing venture debt to fund the growth of their business. With the primary appeal of limiting equity dilution, it’s easy to see why founders might jump on board the venture debt train.

But venture debt has been linked to a number of collapsing startups both here and in the US so the question many are now asking is whether preserving equity and opting for venture debt really is a sensible strategy for founders looking to finance the growth of their start-up. And, are venture debt providers really vultures that will swoop to recoup their cash when a business is collapsing?

Firstly, we need to understand what venture debt is and what it is not.

Venture debt is essentially a short-term loan – between one to three years – that provides additional capital to support investment into pivotal functions needed to achieve the growth strategy.

Venture debt is often used in three scenarios:

1. For the purchase of equipment, hiring or acquisitions at incremental periods between equity funding rounds
2. When the capital required is too small for an equity funding round
3. In tandem with, or following, an equity funding round to preserve founder equity

Venture debt is not an option for all startups and it’s not a lifeline for a struggling business. It is a viable option for those early-stage businesses that are generating revenue, ideally recurring, resulting in a predictable cash flow enabling them to service the debt.

The case for venture debt

The venture debt market is booming. Australian growth statistics are hard to find but in the US, venture debt makes up about 10% of the venture market and is growing every year. In 2017, US venture capitalists invested $84.2B in companies meaning an estimated $8B was loaned to start-ups as venture debt.

Venture debt has a number of advantages. It can be structured with flexibility, affording the founder the option of repaying the principal in a lump sum at the end of the loan period. Interest can also be capitalised or repaid over the life of the loan.

Venture debt comes at a cost and, given the tightening of credit in the post-Royal Commission era, it is notoriously difficult for startups to borrow money. At around 10-20% per annum, rates might be viewed as expensive however there’s little point comparing to mainstream loan terms when bank finance simply isn’t an option.

Unlike bank loans, a founder is not required to sign a personal guarantee, which means their risk is limited to the business’ assets.

The biggest drawcard for venture debt is of course preserving equity. But it isn’t just the payday in later years that’s important; it’s the control that the founder retains with this greater proportion of equity.

So what’s not to like?

Although venture debt does allow a founder to retain equity, they may not necessarily have the control they would like. For some founders this will mean they are unable to take on any more senior debt, which can restrict their ability to grow if they can’t take a punt on new products or markets. This is counter to the DNA of most entrepreneurs!

Often venture debt providers will also want an option on equity, or a warrant, that gives them exposure to the business’ success – usually a very small percentage compared to that enjoyed by equity holders.

For founders weighing up their funding options, the key consideration should be whether the financing arrangement allows them to have the control they need to grow their business and access to cash without restricting future growth. Founders will inevitably ask themselves whether they are better off having a small slice of a potentially big pie, or holding on to equity leaving them with a large slice of a smaller pie? The devil is in the detail. If the pie can’t grow and reach its potential, the founder may end up with a pie that no one wants to eat –  that is, a business with no future potential including exit opportunities for investors.

Those founders for whom venture debt is a viable finding option should consider the rule of thumb – that lending should be no more than 25% to 35% of the equity raised in the last funding round.

For businesses with venture debts that have collapsed, it is difficult to know how a different funding structure might have led to a better outcome. There are many different headwinds facing start-ups and even those who are bootstrapped or VC-funded have poor odds of survival. What is certain is that the venture debt providers will be amongst the first to get their money out when a business collapses. Equity holders, on the other hand, wait for the business to be sold to see the extent of their losses.

Although we often hear about the failures, success stories of venture debt include Facebook and YouTube. In many cases, venture debt funding is neither a riskier nor safer option for founders. It is also not an alternative for equity funding but rather supplementary for certain businesses needing access to capital outside a funding round.

 * Benjamin Chong is a partner at venture capital firm Right Click Capital and invests in high-growth technology businesses.