If a startup is low on cash, it’s very likely the lenders will require an equity investment alongside the debt. Lenders are constantly battling asymmetric information and adverse selection. They’re not sitting in the Board Room so they don’t know exactly what is happening.
By requiring an equity investment alongside the debt, the venture lenders are testing the commitment of the Equity Syndicate. A sizable new check means that the company is in good standing and there is no asymmetric information. It also provides a cushion in case the startup misses plan, which happens 90% of the time. :)
Lenders requiring equity is not an absolute rule. If the startup is doing incredibly well, the Lenders don’t have to worry about future equity support from the VC’s. They know more equity is available. Therefore, the venture lenders can get comfortable.
This happens if the company is in talks to be acquired. The Insiders don’t want to raise a full new round because the valuation on the new round will scuttle the acquisition. Some extra debt capital can help a startup wait out stall tactics by a big acquirer and the valuation stays the same. If the acquisition doesn’t come together, the startup can raise the equity round.
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