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With Scott Orn

A Startup Podcast by Kruze Consulting

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Scott Orn

Scott Orn, CFA

What is Venture Debt? Scott Orn breaks down how startups use debt financing

Posted on: 04/16/2019

Scott Orn

Scott Orn

Startup CFO
- Kruze Consulting

Healy Jones

Healy Jones

Vice President FP&A and Marketing - Kruze Consulting

Scott Orn & Healy Jones of Kruze Consulting - Podcast Summary

Venture debt expert Scott Orn, of Kruze Consulting, explains what venture debt is and how startups use debt to boost growth while optimizing their cap table.

Scott Orn & Healy Jones of Kruze Consulting - Podcast Transcript

Scott: Hey, it’s to got learn to Kruze Consulting and today we are having a venture debt nerd out, we were going to talk about a ton of Internet. We’re going to answer a bunch of questions and joining me is the Healy Jones head of Kruze Consulting’s financial modeling group.
Healy: Nice to be here.
Scott: And he is going to fire away.
Healy: Sounds good. So, let’s talk just a little bit about venture debt trends. I think first of all maybe, 45 seconds for people who don’t know about what venture debt is.
Scott: What is venture debt? Yeah, venture debt is essentially taking a loan from a highly specific kind of lender, either a startup bank like SVB, Square One, Bridge Bank, Comerica, or a fund, like Triple Point or WTI that specializes in making loans to startups that are losing money. And the natural question is…
Healy: Why would you ever loan money to a company losing money?
Scott: And the answer is, in the small segment of the world venture capital back startups have different a repayment source than traditional companies, which is usually cash flow. They are able to pay back loans based on equity that they get from the VCs. And so, whenever a startup hits a bunch of milestones, as able to raise a new round of funding, they can pay back some of the debt they borrowed before in, or take on debt from a lender. And so the lender is basically betting that the startup has a great market opportunity really strong management really interesting product and great investors who will support the company in tough times. And they are betting that they will it, by giving a little bit of extra money to start up, that will enable a startup to hit their funding milestones and raise the next round of capital does that make sense?
Healy: Sure. So, from the start of CEOs perspective, venture debt is a way to get a little extra runway maybe de-risk hitting certain milestones while not giving up, like a big equity chunk an exchange, though, you are taking some debt onto the business and obviously, debt changes your capital structure and introduces a little bit different time.
Scott: Taking a little bit extra money to dearest, the next round. And the reason why is they’re basically buying additional cash runway and it does kind of increase the risk profile of the company. And that, if you don’t hit your milestones, it can be tough to raise more money can be tough to get insiders to pony up again. But if things are working, it’s an incredible tool is super friendly for the founders because remember, when they raise VC dollars, they’re the ones bearing all the dilution. They’re selling shares of the company. They basically own and selling 20. every time they raise venture capital money. So getting a little bit extra money with only a little bit of delicious in the form of some, just the additional warrants in exchange for agreeing to pay this money back is very, very found a friend.
Healy: Okay, great. So, how does the startup CEO know, if their startup can get venture debt and how do they estimate how much they can get, you know, just even make sure it’s worth their while it was like, 1000. it’s pretty sure they’ve got other things they should spend their time on. But if it’s five million bucks, maybe yeah.
Scott: It’s typically kind of 25 to 40 percent of whatever your equity raised was, and there’s old an saying, you have to have money to get money. Right? Like, we all kind of heard that. So you want to do a venture debt Dio right? When you raise new equity because at that point, there are no adverse selection problems. The VCs obviously love company the, because they just put a bunch of capital. N, that means the lenders can kind of rely on their underwriting. That includes the VCs or aligned with the feces, or saying what you don’t want to do is try to raise venture debt when you’ve got, like, three months cash of left. Because the lenders are going to ask themselves. Why are the VCs? Not putting more money into this company. Why are they trying to get me a person new on the outside to put more capital and so do it when you first raise a bunch of equity.
Scott: What do you need to give us that you need to have again?
Healy: Exciting market opportunity, differentiate technology good management team and milestones. That is achievable. But that will get you another round of capital.
Scott: If you think about the lenders really underwriting the next round of capital. So, with the lender gives you the money, you spend it to hit your milestones then when you bring that next round.
Healy: Then you’re going to start paying on her back on Monday that dearest them. That’s how they get their money back. So, again, it’s all about raising that next round of equity for the lender.
Scott: Okay so startup. First of all, can hopefully raise somewhere between 25 to 40 percent of whatever their most recent round was. So, if you raise ten million dollars, you might be able to get two and a half to four billion dollars. So that’s a substantial extra amount of cash.
Healy: Which could theoretically give you some significant runway.
Scott: Right? Exactly. I mean, that’s I usually say three to six months of additional cash runway is what you want that. So regardless of what your burn is, you know, that’s another kind of Benchmark. Because if you take more than six months, you’re probably taking too much debt. And it could work out for you, you could just be a rocket ship company and hit all your milestones. But if you don’t, then there’s a debt overhang. And, you know, you’re going to go to your insiders, ask them to put more money in. And they’re going to look at the cap table and say, like, well, every dollar I’m putting in the lenders, get their money out first. I don’t know if I want to do this. It’s not exciting. And remember, you’re only going to the insiders when you’re usually not hitting your milestones.
Healy: So it’s already kind of a tough sell to them.
Scott: And then having a big debt overhang, makes it even tougher.
Healy: Okay. And then, you know, how does the startup CEO? Know, if they can raise your not one, you probably should have recently raised your most recent venture out. So yeah. You’re not doing it when you’re on your run out of gas. It’s you it’s always at work for an investment banker guy. You always said it’s best to raise money when you don’t need it.
Scott: So, as it has enough things very good. Secondly, it sounds like the lenders are looking for all the same PC stuff. Right? Exactly. Ok, and the third they’re going to unlike the next DC, they’re really fixated on the next round.
Healy: Exactly. Well, everyone is the VC who just put money into the company is fixated on next round two. They will all they will give guidance and target milestones that give the company a good chance of raising the next round. So, like, the whole venture capital ecosystem is a kind of design that you put your money into the company and then someone else funds the next check. That is what everyone’s trying to do. All the way up to the ecosystem, all the way to Softbank Softbank’s putting their money in. And the next check is the public markets and an IPO. You know, that’s how the world works.
Scott: Great. And then, I think a final point, which you may or may not have mentioned is the prestige of the feces that you have mattered as well.
Healy: It’s hugely important. And so getting the TopTier VCs makes your life easier in many different ways recruiting, getting introductions to customers. Getting and they take you seriously also, lenders, lenders know that the best reputation VC firms invest best VC partners, look at the best deals. And so.
Scott: If they’re able to invest in the company, that makes the world easier because they have I always joke that. There’s like, speed a dial the Series A investors, have speed dial. So, if your work at Sequoia is Koestler Andreessen Horowitz or Benchmark, or whatever when your company’s coming up for their next fundraiser, you’re going to make five phone calls and it is some to five different other VCs that you like that. You had a productive working in. Matt with before, and that’s the speed dial. Those series be. Investors actually are kind of lucky. They’ve developed relationships with these TopTier VC firms the same way. The lenders are and so having these guys be able to make these calls on your behalf. Dearest, the funding of the next round and that’s what the lenders care about they want that company to raise the next round. They also know the TopTier VCs often stick with our companies kind of irrationally. Actually, like, oftentimes will keep putting money into the company, even though it’s not clear, it’s going to work and that’s because they’re interested in demonstrating their good investors. They have a reputation for helping and are, therefore, the company and downside. So those are all really attractive to the lender.
Healy: So let’s talk about something that I didn’t fully appreciate until I was working for a company that raised venture debt. You know, we raised, I don’t want to say how many millions, but millions, but we only drew small amount up front, which is pretty different than a typical venture round where you raise ten million and, you know, next thing, you know, you’re banking on his ten million dollars like. About how sometimes the startups can choose when, and how to draw the adventure getting what that means yeah. Your typical structure of Ford commitment because again you’re raising money when you don’t need it when you’ve just done an equity round. And so the last thing you want to do is draw this money down as a company.
Scott: And then pay a bunch of interest. The lenders understand that. So they’ll structure something. We have six to 12 months to draw the money down. At that point. You’ll have kind of a, your interest-only period will be really tied out to when you start running out of cash. Most lenders want you to draw the money down. We have at least three to six months of cash in the bank still. So, you might structure a deal or completed deal when you have maybe 15 months of cash. And if you follow my math nine months later, draw the money down. Now, there’s a real art to this. Because what you don’t want to do is draw the money down on, like, the last day before you run out of cash, which some entrepreneurs like to do because they minimize the amount of interest or paying to me. That’s very shortsighted. Because say, things are not going. Great and the lender puts doesn’t want to fund you, there’s something called a funding material, adverse change clause, or funding Mac in most deals meaning the lender has the option of funding you or not when you draw the money down. If that’s in the deal. And the lender decides for whatever reason that something’s gone wrong, maybe you fire the CEO or maybe there are no sales or whatever it is, they can say. No. At which point you’re out of cash. So, I always say, kind of draw. It was like six months left in the bank, in case, anything weird happens with the lender or another thing is just your kind of making the lender feel good. And knowing that, they’re not the last resort. Do you plan on taking this money down? There’s no adverse selection. So that’s how I do it. You know, I have I’ve had other companies that say, you know what? I am going to draw this down very, very early after I raise the money, because I just want it in my bank account. Now. That’s actually there’s something to be said for that because once the money’s in the company’s bank account, it’s very difficult for the lender to get the money back. You’ve heard of clauses like Materia, verse, change Claus. Faster abandonment clauses those are kind of squishy terms designed to create a default. If the company is not doing very well and something’s changed or the investors going are to put more money in. But having the debt capital in your bank account, the lender has to go through extraordinary measures to rip that money out of your account they damage the reputation. The VCs will never do another deal with them. And they’re at risk of a lawsuit.
Healy: Unless it’s highly defensible. So, it’s.
Scott: I, was, that’s kind of I Why say, like, at least six months before you run out of cash, pull the money down. So it’s sitting in your account. But again, I’ve had CEOs who draw down right away regardless of how experienced you are in this market actually going and raising venture debt.
Healy: It is a process and you’ve helped a number of our clients do that. You want to talk to a little bit about who you are, and how your team here helps companies that want to raise me.
Scott: Yeah, totally. So, before I joined crews consulting, I actually worked at lighthouse capital.
Healy: One of the leading venture debt funds for nine years. I worked my way up from analysts. Partners did about a hundred million dollars of the deals. You might have heard of Angie’s list Upwork or impossible foods
Scott: Did tons of deals. I never actually, like, built the company. And so that’s what was really attractive to me to join Vanessa Cruz consulting and we’ve now built the company up quite a bit it’s been awesome, but I still like venture debt and they’re still friends with all the people in the industry and I still realize that’s awesome tool for entrepreneurs and so I do encourage our companies that are doing very well at Cruz consulting the ones are executing and have a real kind of defined path the next round to take venture that because again extend the runway helps them Optimizer valuation and probably raise more money, so, what we do on behalf of our clients, as we go on to introduce them to all the lenders that could ever want to talk to. I think we have, like, fifteen letters on our call sheet. I’m we make an intro cylinder to letters. We scheduled as we do a lender a pitch, meaning it kind of like how you picture VCU pitch the lenders because again they’re looking to underwrite the next round. Sure, you can raise more capital and then once you start getting term sheets will actually break down those term sheets show you the key term show you the key, you know, interest rates weren’t coverage, whatever has changed college, investor management all that stuff. And then we help you negotiate them so we go back to the lenders on your behalf and ask for different stuff. And then finally we put it all into a presentation and do a board meeting. And so oftentimes, you know, we’re probably doing the board call for, like, half an hour, but it’s highly valuable to the board and the CEO. Because I know the industry. I know what I’m doing. So, oftentimes, they have a general idea of what venture debt should look like. But maybe some of the subtleties they’re missing or they only know one lender, and they don’t know three or four the other lenders that they should be talking to. And so, by giving them a board ready deck, it really makes it a really constructive conversation and helps them pick the best loan and lender for the startup.
Healy: Right? Very cool, man. So, how does somebody get in touch with you to get help around?
Scott: Yeah, we’ve got a ton of content on our home page to go to a Kruze Consulting and then collect the venture debt link at the top. You’ll see, I’ve recorded something like thirty videos. They’re all about a minute who long. So, they’re really kind of bite size. We’ve had amazing feedback to them, as the CEOs love the video. So, like, check those out.
Healy: You’ll learn a ton. We also have every important term defined in venture debt. So that’s our main event. Mac draws down period for commitment.
Scott: Anything you can think of is there’s a definition, so you can see it and we have all the lenders that we talk to. So you can see exactly what the universe looks like. And then finally, we have kind of general guidance on what the prevailing interest rates are and more coverage, and all kind of stuff. So, all I got to do is go to that page. There’s so much information, and there’s a popup you just fill it out.
Healy: I’ll get your email and I’ll schedule a time to do a call to you.
Scott: So that’s great. So great conversations got thanks.
Healy: Awesome. Partisan thing.

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