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.