Venture Debt: The third rail of venture financing

I’ve taken venture debt in all three of my start-ups. Additionally, many of our portfolio companies have taken some or are in the process of doing so. No doubt it’s a frothy market for debt. Nonetheless, when I polled others I respect, I heard everything from an unwillingess to comment  to outright dislike. Why is venture debt the third rail of venture financing?

A couple of years ago Fred Wilson wrote a post stating his view that debt is not appropriate for an early stage start-up. The primary argument was that venture-backed start-ups who have no current means of paying it off shouldn’t take on debt.

I, however, frequently encourage debt despite that most venture folks share Fred’s view. Some VCs argue that the start-up is riding on the VC as the financial backstop. This is true. In fact, most debt funds are only willing to finance companies backed by top tier, well-known funds. For the entrepreneur, this is another good reason for the start-up founder to get capital from such a fund! Secondly, the price of debt, often over 10%, takes into account this default risk. If the company defaults, ultimately the company reverts to the debt holders. These investors know what they’re getting into and have generally shown decent returns because most of their portfolio gets further equity capital.

Another counterargument to venture debt is that it can spook prospective investors in future rounds. There’s certainly merit to this argument. However, what the argument fails to consider is that founders need runway above all else. In my experience, the debt enabled my team to achieve the milestones we needed to raise more capital.

Investors are either buyers or sellers. Most investors put in equity dollars and want to see meaningful traction before further investment. When companies are going sideways or the trajectory isn’t obvious, debt is often the lowest cost way to extend runway. When I was a CEO/founder, I would ask my investors, will you put in money at the debt terms? The answer was always “no” and investors acquiesced.

Venture debt does have a dark side. When things start to go wrong, as one CEO said to me, debt can exacerbate decline. Servicing the debt can be costly to the burn and may make it harder to exit (typically on “soft landings”) because prospective acquirers don’t want to pay off the loan. That said, I’m a believer that the entrepreneur needs to “play to win” and as a result it’s beneficial for the CEO to get debt early, when it’s still possible to get it.

Venture debt is a case by case decision. By no means would I advocate it in all cases. The amount of debt borrowed, whether it’s drawn down immediately or not, and the terms are extremely important to consider when deciding to take it on.

 

3 thoughts on “Venture Debt: The third rail of venture financing

    • I think it will be awhile before social lending hits start-ups. I think social lending continue to grow for things like student loans, mortgages and small business loans. Though, I think Angelist is democratizing equity financing for early stage ventures. Change is definitely afoot …

  1. Micah – I’ve been in the venture debt space for some time, and have spent a lot of time with VCs and entrepreneurs addressing perceptions around the asset class. Totally agree that debt decisions should be made on a case by case basis, and I’d also look to address a few of your points above:

    I’d be careful to generalize that most venture debt funds (meaning non-bank sources of debt capital) focus only on opportunities from “top tier” firms. This seems to happen more with lenders that focus exclusively on early stage companies, and can be a pretty dangerous investment thesis. I absolutely don’t want to discount the value that a rockstar VC partner or firm brings to the table (and we have the pleasure of working with a number of them within our portfolio). But VC funds irrespective of their quartile have a fiduciary responsibility to their LPs, and that often conflicts with supporting a company particularly where their use of proceeds would go in part to repay a venture lender in a company where they do not expect to see a return.

    By investing in companies with little to no intrinsic value of their own or in a space with true binary risk, lenders can wind up taking equity risk while only making debt returns. In contrast, working with later/growth-stage companies where you can underwrite against a level of created intrinsic value first doesn’t carry that same level of risk. These later stage businesses are where the bulk of venture debt activity seems to be concentrated these days and where we see the best alignment in cost of capital, risk, and value for the entrepreneurs, lenders, and existing equity investors.

    If you’re interested in digging in more, my colleagues and I at NXT Capital just released our first ever venture debt index which can be found here: http://t.co/RGBEDuk4Lz

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