Venture debt is becoming an increasingly popular option for venture-capital-backed companies wishing to stretch their equity investment dollars. Venture debt lenders, including some banks, provide a company with a loan and the borrower can then use the funds to build its business.
If used properly, it can be a boon for the company and shareholders alike. By leveraging capital provided by venture capitalists with venture debt provided by banks and other venture debt providers, a company can potentially enhance its valuation.
“Typically, venture debt is used for early-stage and emerging-growth companies that are backed by venture capitalists,” says Bonnie Kehe, senior vice president and regional managing director for Comerica Bank’s Technology & Life Sciences Division.
Smart Business spoke with Kehe about venture debt, how it is typically structured and why it has become so popular lately.
What is venture debt and how can a business use it?
Venture debt augments the equity raised by the venture capitalists and enhances potential return to the investors and management team by lowering the overall cost of capital. The funds can be used for equipment purchases or growth capital, enabling venture-backed companies to reserve equity dollars for a sales ramp, product development, clinical trials and so on. Quite often, venture debt can lengthen the time between equity rounds, thereby enhancing valuation.
Only several federally regulated commercial banks in the country provide this type of financing. There are also numerous non-regulated venture debt funds in the market today. In addition to providing venture debt facilities, commercial banks are able to provide working capital loans that can be used to finance asset growth. Typically, venture debt lenders do not provide working capital lines of credit.
How is venture debt typically structured?
It can vary, but venture debt facilities typically are structured as two- to five-year loans. There is normally a drawdown period ranging anywhere from 2 months to 18 months, in which a company can take the money down as it needs it while it pays interest only. At the expiration of the drawdown period, there is a monthly amortization of principal plus interest of between 24 months and 48 months. Pricing on these types of facilities depends upon several factors including the competitive environment and level of risk. The costs will typically include a percentage above prime, closing fees and a warrant kicker.
What do venture debt providers look for when deciding whether to lend to a company?
One of the most important underwriting criteria for a lender is the quality and makeup of the investors. Are they known to the venture debt provider?
If the venture debt lender knows the investors and is confident of investor support, this will often help dictate terms. Lenders must be confident that investors are not looking for third parties to shoulder the investment risk. We don’t want to fund a company that’s bumping along with nowhere to go; there needs to be a high potential for growth.
We look at how much cash the company currently has and how long it’s expected to last. How the debt will be repaid is another factor. Will it be through additional equity rounds or with future cash flow? The strength of a company’s management team, its ratio of debt to equity and where the money will be used are also important considerations.
What are the risks associated with this type of debt?
There are risks to the lender as well as the debtor. At the end of the day, it’s debt. Unlike equity, it must be paid back at some future point. If a company is burning more cash than it had originally projected, its ability to retire the debt becomes questionable.
The lender must be relatively confident that the borrower will be able to raise the necessary equity and/or generate sufficient cash flow to amortize the debt as structured.
How can these risks be minimized?
First and foremost, it is important to ensure that the company is adequately capitalized and that venture debt is being used for the right reasons. Also, it is important that the borrower is doing all the right things: the right management team is in place, the right investors are on board, and they are hitting their key milestones.
Why has venture debt become such a popular option with companies recently?
The availability of venture debt has skyrocketed in recent years due to the proliferation of venture debt funds/players in the market. This is due primarily to excess liquidity in the capital markets. Limited partners and investors with liquidity to invest have helped fuel the venture debt industry.
BONNIE KEHE is senior vice president and regional managing director for Comerica Bank’s Technology & Life Sciences Division. Reach her at email@example.com or (714) 433-3266.