It's tough to obtain another round of financing these days. Venture debt can keep you financed longer, but there are some caveats to keep in mind
When a venture capitalist invests in an early-stage company, the structure set forth in the term sheet (BusinessWeek.com, 8/15/08) is usually in preferred stock. These securities have a variety of protections—such as liquidation preferences and voting rights—that provide venture capitalists with downside protection and control. Because of the high risks involved in startups, the VC wants the opportunity to get a big return when a company is eventually sold or goes public.
At the same time, there are a growing number of venture firms that don't just focus on equity investments—they will also provide startups with something called venture debt financing. Venture debt usually comes as a part of a Series A or Series B investment and will be 20% to 30% of the total. Often it is for companies with strong financial backing, such as from VCs. Or it could suit nonfunded companies that have a customer base. (In this case, the venture debt provider can fund against inventory/receivables). Venture debt is also available from other funders, not just VCs.
So why take venture debt? Essentially, you are getting some extra capital on relatively favorable terms. This could mean five or six months of extra "runway" for your company, allowing you more time to reach your goals or get another round of funding.
How venture debt works
Of course, the current instability in the financial markets is likely to have an adverse impact on venture debt. Simply put, expect terms to tighten and interest rates to increase. This makes it even more important that you put together a conservative forecast and negotiate hard on loan terms. You should hire a lawyer to help you with the negotiation process (BusinessWeek.com, 8/28/08).
Here's how venture debt works: In most cases, the interest rate on the debt depends on the prospects of your company, as well as on the quality of your funders. Rates can range from prime plus 1% to prime plus 5%, with the loan term ranging from 24 months to 48 months. A funder is also likely to take liens on all of a company's assets. In the event of a default, the funder can legally take the whole company.
The venture debt deal will also include a warrant, which is a right to buy your company's shares at a fixed price. The concession, normally 5% to 15% of the loan amount, is negotiable and is definitely something to spend time on. You'll have more leverage if you are talking to several funders.
MAC Clauses: Vague
Before you take on venture debt, you need to be wary of certain legal contraptions, such as covenants and "Material Adverse Change" (MAC) clauses in the agreement. For insights, I talked with Ryan Roberts, a deal lawyer and blogger on The Startup Lawyer.
Essentially, covenants limit a company's actions. Thus, an affirmative covenant demands that a company supply financial statements, pay taxes on time, comply with government regulations, maintain certain minimum financial ratios (such as working capital or burn rates), and so on. Negative covenants prohibit a company from changing ownership, issuing stock, incurring debt, making distributions, and pledging collateral.
MAC clauses can be particularly tough on a company. The problem? Again, it's a matter of definition—what exactly is "material adverse change"? The legal meaning of the phrase is: Something very bad happens. For example, it could be a terrorist attack or nuclear war. But it could also be the founder's departure, or the loss of a major customer. Is the clause triggered in either case? Or when you fail to meet the revenue projection?
It's really not clear. As a general rule, try to eliminate the MAC provision. If this can't be done, make sure the definitions are clear and minimize the chances of their being triggered.
Deal with reputable institutions
It's also a good idea to perform due diligence on venture debt providers. Keep in mind that there are many fly-by-night operators that may provide loans with onerous terms, which may ultimately lead to your losing control of the company.
So I suggest you focus on firms that have a long history with venture debt, such as SVB Silicon Valley Bank, Western Technology Investment, Hercules Technology Growth Capital, and Square 1 Bank.
In the current capital-constrained environment, it's probably best to raise as much money as possible. As the economy slows down, it will likely be harder to reach milestones and take longer to get another round of funding. With venture debt, you get some extra juice in the bank account—without giving up as much of your company.