Venture debt

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 protected] or (714) 433-3266.