Venture Lenders specialize in extending a Startup’s runway for 3 - 6 months with debt. It’s an add on to equity dollars, not a replacement. A hypothetical situation is taking the runway of a venture backed company from 9 months to 12–16 months in order to hit a huge milestone that creates a valuation inflection point.
After the milestone is hit, the Startup can raise a much less dilutive round and/or more capital than previously available. The Lender gets paid back over time and makes an attractive return for extending the Startup’s runway.
The short hand that a venture lending fund looks at when underwriting a deal is:
1) Equity Invested in the Company - Is there an investor commitment, is there equity to pay back the loan and will the investors step up if things go sideways? Venture Lenders like following “Top Tier VC’s” because the best Investors are magnets for follow-on capital. I call it the “VC Speed Dial” - every good early stage VC has 5 - 10 follow on investors who love leading the next round. That is a huge value add for the Startup and makes the Venture Lender more comfortable doing a loan now.
2) Business Traction - It’s always easier for a company to attract capital when there is traction - revenue, customers, etc. If the startup is doing great, a weaker existing investor commitment is acceptable because the company’s results should be able to attract outside capital.
3) Collateral Value - Can the Lender recover its debt capital from the Assets? Normally Account Receivables are high quality assets and banks can lend against them. But if they are to smaller companies in an emerging country, they are much harder to collect on.
The Intellectual Property of the Startup can be valuable in a downside scenario, however the value will be greatly impaired. There is not as much value in IP as an Entrepreneur might think. It’s almost always better for the Lender to restructure and facilitate more Equity coming into the company than foreclose and sell in a fire sale.
4) What Covenants & Terms Can the Lender Introduce to Limit Risk? - Lenders use Financial Covenants like the Minimum Cash Requirement, Investor Abandonment Clause, Material Adverse Change Clause, Receivable Aging & Advance Rates and Funding Contingencies to reduce the risk.
If you don’t understand these terms, hire someone who does to negotiate on your behalf. An Entrepreneur wants to negotiate as many of these terms out of the deal as possible. A violation of one of these Covenants invokes an Event of Default. At that point the Lender controls the situation unless the Startup can Cure the Default.
Venture Lending Funds & BDC’s use fewer of these restrictive terms in an effort to “let the Startup use the money.” However, these funds charge you a higher interest rate and warrant coverage.
Banks are highly restrictive and use all of the terms I listed, but are incredibly cheap. Banks are cheap because they take much less risk. That means the Entrepreneur is taking more risk by working with the Bank.
Startups go through different cycles and the appropriate lender is different at various stages.