For startups using venture debt can be a very helpful way to gain additional financing they need, to extend their runways or bridge to the next financing round. In order to strategically utilize venture debt for the best outcome, arranging a forward commitment is a smart move.
How does a forward commitment work?
Simply put, a forward commitment is a type of contract in which the lender defines the terms and timeframe of the debt use and repayment. For a startup with venture debt, this means coming to an agreement on the period of time the startup is able to draw down the venture debt for different uses. This time frame could likely be somewhere between 9 to 15 months, as lenders don’t want to go out too far for fear the startup may start burning the cash they just raised.
The optionality of venture debt
So, for example, startups will typically raise 18 to 24 months worth of cash. When the startup applies for a venture debt loan, the venture debt provider will then structure a forward commitment to draw down the debt capital within 9 to 15 months.
This will then provide incredibly valuable optionality for the startup, as they don’t necessarily have to draw the money down. Although the startup will usually pay a fee and/or various warrants up front, the allowance for this optionality is very powerful.
When should a startup put a forward commitment in place?
There are multiple scenarios in which having a forward commitment will benefit the startup but the short answer is: as soon as possible after raising equity.
The reason being the big equity checks have just been written, everyone’s happy, and the company has money in the bank. For the lender, things are great and so, at that moment, it’s in your startup’s best interest to set up a venture debt loan and include a forward commitment.
The importance of a forward commitment
If a company is doing well, but not as well as it could be, it is highly likely the startup will want to draw some of the venture loan dollars down in order to:
1. Help extend its runway
2. Achieve the milestones it needs to in order to raise capital and live happily ever after
However, if a company doesn’t have any issues it will just raise more equity and never need to draw down the venture debt. That’s the embedded optionality of a forward commitment, but since the lenders know this, the startup will pay those aforementioned fees or warrants upfront.
Reasons for venture debt fees
Since the lender is reserving funds for the startup to draw down, if those funds are never drawn down the lender really make very much money. Lenders, after all, make money on interest and typically like a usage-based component of a warrant as they are providing a service. Therefore they should get paid something for making this commitment … but really the startup benefits the most.
On the flip side
The opposite of that positive scenario would be a startup that realizes they are running out of cash and trying to put a venture debt loan in place with only three to six months of cash left in the bank.
The lenders have to ask themselves:
- Why hasn’t this company raised enough money already?
- Why are they coming to me with three to six months worth of cash instead of going to their equity holders, like their venture capital partners?
And your chances of getting one are slashed.
That is why we highly recommend startups putting a forward commitment for venture debt in place after they raise their equity financing.
The benefits of venture debt
By putting a forward commitment in place you are betting on your own startup, but you also help yourself avoid the possible pitfalls of venture debt and missing out on its benefits!
If you have other questions on venture debt, venture capital, or generally about startup accounting and taxes please contact us.