Today’s guest blog is by Mark diTargiani of Pacific Western Bank’s Venture Banking Group. He explains how startups can take advantage of venture debt, what options for venture debt financing there are, and the typical terms involved.
Traditional middle-market lenders generally require tangible assets to collateralize loans and/or a track record of operating cash flow to qualify for the debt – two things that most startups don’t have. Pacific Western Bank’s Venture Banking Group takes a different approach. By underwriting the quality of the technology, the market opportunity, the management team, any revenue, and the investor syndicate, Pacific Western Bank can provide access to an alternative to relying entirely on raising capital throughout a company’s lifecycle.
Let’s look at a few examples of the types of venture debt financing options available:
- Cash Runway Extension Loans: Supplement a recently closed equity financing round with venture debt to extend runway or improve negotiating leverage in advance of the next fundraise.
- Growth Capital Loans: Utilize venture debt to accelerate growth through investment in sales & marketing or research & development.
- Working Capital Loans: Front customer acquisition costs until payback is achieved or product delivery costs until customer payment is received.
- Acquisition Loans: Acquire assets of another company for synergistic, defensive, or “buy vs. build” reasons.
Typical Venture Debt Terms
Now, let’s take a look at typical venture debt lending terms and the implications of each.
While there are many factors to consider, the borrower’s stage of commercialization and capitalization generally dictates the amount of venture debt available to startups.
For early-stage companies (i.e. pre-revenue, Series A-B), venture debt lenders will typically commit 25%-33% of debt relative to a recently closed equity round (e.g. $3,000,000 of debt for a company that just raised a $10,000,000 Series A).
Expansion stage companies (i.e. post-revenue, Series C-D) may be able to obtain upwards of $7,500,000 of debt based on revenue traction (whereby up to 50% of debt relative to annual revenue might be considered a comfortable debt load for venture lenders).
Later stage companies (i.e. nearing profitability, Series E+) typically garner as much debt as collateral coverage or cash flow can support (similar to middle-market lending, but venture lenders generally provide it sooner than others).
At the end of the day, prudent borrowers and lenders will err on the side of “how much debt is required” rather than “how much debt is possible” because over-leveraging a business today can weigh down the operating trajectory of a business tomorrow via the burden of future principal payments (particularly if things don’t go according to plan).
Most venture lenders offer two types of debt facilities: term loans (whereby the borrower advances against the facility during a 12-18 month interest-only period, then repays outstanding loans over 24-30 equal monthly payments thereafter) and revolving lines of credit (much like a credit card, startups can borrow and pay down debt over a set period – generally 12-24 months).
Depending on their needs, borrowers may favor one type of facility over the other. For example, term loans provide the ability to defer repayment until later, which works well for early-stage companies that are not (yet) generating sufficient income to repay debt or plan to raise additional equity (at which point, loans might be refinanced – so beware of prepayment penalties included in some term sheets).
Alternatively, expansion-stage companies that are selling products may utilize a revolving line of credit (usually with advance rates up to 80% of accounts receivable or 4x monthly recurring revenue) to bolster cash position between the period in which they deliver a product or secure a new customer and then ultimately receive customer payment.
Interest rates from venture banks typically range from 4% to 5% with upfront fees up to 0.50% and warrants or success fees (both payable at M&A or IPO) of 1% to 2%.
Private venture debt funds, lessors, and asset-based lenders may charge 2x to 3x that amount for a variety of reasons (cost of capital, risk/reward profile, etc.). We’ve worked for and partnered with venture banks, venture debt funds, lessors, and asset-based lenders. Each has its pros and cons and there’s no “one-size-fits-all” solution for any given borrower.
That said, like most business, it ultimately comes down to working with people, so I’d encourage to value a banking partner with the right philosophical and cultural fit for you and your company.
Venture lenders generally take a lien against the borrower’s assets with a negative pledge on intellectual property (meaning, the lender does not hold intellectual property as collateral, but the borrower agrees not to pledge a security interest in its intellectual property to anyone else). You can think of a lender’s security position like a liquidation preference: senior lenders are repaid first in a liquidation scenario (such as a sale of the company or its assets), subordinated lenders are repaid next, preferred shareholders are paid after that, and common shareholders are paid last.
As such, it’s important to balance the relative capital contributions of parties throughout the preference stack to align interests in a likely exit scenario. Put another way, what’s good for someone at the bottom of the preference stack (e.g. turning down a $25,000,000 acquisition with an 80% chance of close to chasing a $40,000,000 acquisition with a 50% chance of close) may not be good for someone at the top of the preference stack. The expected value is the same ($20,000,000), but the probability of outcomes is not (i.e. 80% chance of $25,000,000 and 20% chance of $0 in Scenario A vs. 50% chance of $40,000,000 and 50% chance of $0 in Scenario B).
Couple that dynamic with each stakeholder’s relative risk/reward profiles (e.g. 1-2x return expectation for someone at the top of the preference stack vs. 5-10x for someone at the bottom of the preference stack) and you can run into some sticky situations.
Ultimately, it comes down to managing relationships and expectations: a senior lender shouldn’t insist on a sales process driven by the lowest common denominator any more than an entrepreneur or investor should insist on a sales process driven by the highest common denominator.
To verify the ongoing financial health of borrowers, venture lenders require periodic reporting like monthly income statements, balance sheets, and compliance certificates (i.e. attestation that the borrower is abiding by the terms and conditions of the loan agreement).
On an annual basis, borrowers also provide Board approved plans and perhaps audited financial statements (though venture lenders will often forego CPA audits for early-stage companies). If loan advances are governed by the borrower’s assets, venture lenders may perform periodic collateral audits to verify the value of the underlying collateral against which they are lending.
No matter what type of information is shared, we believe that proactive, transparent, and honest communication between borrowers and lenders is the key to a mutually beneficial relationship and avoiding surprises that may later cause problems.
The fundamental premise of venture lending is that capital provided at Point A will be sufficient to get a startup to Point B (e.g. product launch, revenue growth to attract follow-on investment, positive cash flow, etc.).
Since many early-stage companies are still trying to identify product/market, it can be inherently difficult to predict the timing of projected financial activity with a reasonable degree of accuracy or establish financial covenants that won’t produce false positives if future performance deviates from expectations.
For example, a revenue covenant might force management’s hand to launch a product before it is ready when positive initial customer reviews may be more critical for long-term value creation. Accordingly, venture lenders may offer no covenant availability to early-stage companies. As business models become more predictable (and loan amounts get larger), venture lenders may govern debt facilities with financial covenants that hold startups to some percentage of revenue or cash burn plan.
Alternatively, venture lenders might require minimum cash or liquidity covenants to ensure that Borrowers have sufficient runway to reach the next inflection point (e.g. a Series C fundraise or sale of the business). In the event of a minor covenant trip, lenders might simply waive the violation and move on. More significant covenant trips might prompt conversations with management to reduce burn or with investors to verify ongoing support.
Whatever the case may be, lenders and the Board should establish a scoreboard that makes sense for the business upfront to properly ascertain risk appetite because no one wants to find themselves in an uncomfortable situation without knowing how the other party might react.
Other Terms & Conditions
Hire a good lawyer, but remember that time is money, and 99% of the things that get negotiated happen only 1% of the time.
About Mark diTargiani
Senior Vice President, Technology Banking
Mark manages debt originations for venture-backed early-stage companies throughout the western US. He has 25 years of experience developing relationships and leading sales, business development, revenue generation, and go-to-market strategy for startups, SMBs, and public companies. Mark has a deep ecosystem of relationships in the SF Bay Area and beyond.
After teaching high school English after college, Mark entered the sales world with RS Hughes, a distributor for 3M and Loctite. After doing another stint as a teacher, Mark became a fully commissioned packaging salesman, helping companies like Applied Materials, Codexis, and Shutterfly build their brands and deliver their products. He then started his first company helping small businesses that couldn’t qualify at banks to gain funding. Mark worked at TriNet during its IPO and helped build the sales team from 30 to over 300 reps selling into vertical markets. Before joining Pacific Western Bank’s Venture Banking Group, he ran a consulting business coaching startup founders on go-to-market strategies and sales execution.
Mark builds high-touch relationships, getting to know his clients and their businesses. He and the team focus on adding shareholder value for founders and investors.
Mark holds a B.A. in English from Wesleyan University, where he also captained the lacrosse team. Mark continues to be involved in lacrosse as a youth and high school coach.