Life.SREDA VC report: Venture Debt
Life.SREDA VC is focused on financial, mobile and internet businesses shares their findings on things you need to know about venture debt.
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Venture debt is a form of debt financing for venture equity-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. A complement to equity financing, venture debt is generally structured as a three-year term loan (or series of loans), with warrants for company stock. Typically, venture debt is senior debt that is secured by a company’s assets or by specific equipment. Overall, venture debt is a form of “risk capital” that is less costly than equity when structured appropriately.
The value of venture debt is often described in a number of ways—the phrases “bonus round” and “insurance policy” are common—but fundamentally, it exists because it makes venture more efficient. Capital is invested in startups to achieve milestones critical for the development of the firms and integral to increasing value, as reflected either in the value accorded in future rounds of financing, or in the value captured at the sale or initial public offering (IPO).
The incremental capital afforded by a venture loan allows startups to achieve more progress ahead of the next valuation event, or to increase the certainty of reaching such milestones, while minimizing the dilution that would occur by securing additional capital at an earlier round.
The value provided by venture debt can be further understood as the incremental ownership retained by raising debt, reduced for early-stage companies by the additional equity raised at later rounds to repay the debt. Specifically, consider $1 of venture debt with 8% warrant coverage, and interest and principal repayment terms such that 20 cents will be paid prior to the next round.
The company has gained the use of 80 cents of capital for roughly 6 cents of dilution, reducing dilution by over 90%. To the extent that the company will raise additional capital in the future to repay the debt, based on common repayment terms and taking into account the average increase from round to round, dilution is reduced by 45% as compared to raising more equity at the outset.
Venture loans can generally be arranged much more quickly than equity financings, saving valuable management time or meeting unforeseen needs (e.g., an acquisition). A venture-debt financing does not establish a valuation for the company, which can be helpful ahead of a new round of equity financing, before a potential sale, or in avoiding an inside round, where management and existing investors would otherwise need to negotiate a price. Finally, venture lending firms do not generally require board seats or observation rights, removing questions of board dynamics.
Venture debt is less suited to the following three situations.
First, it does not suit a company that is already at a low cash balance or when used as a financing of last resort. The weaker the cash position of the company, the worse the terms will be. Raising the financing early and structuring it appropriately (to avoid paying back the loan before it is useful) can put the company in a much stronger position.
Second, venture debt is not suitable when the debt payments will amount to more than 20 percent of the company’s operating expenses. At this point, the financing may discourage future equity investors and can become a burden to the company.
Finally, venture debt is less useful when a company has highly stable revenue streams and receivables, in which case a line of credit tied to accounts receivables is likely to be more appropriate and cheaper.
Silicon Valley Bank (SVB) – the biggest player
SVB Financial Group, owns warrants in 1,625 companies. Warrants give SVB the right to buy shares in those companies. “It’s a whole ecosystem we are building,” says Gregory Becker, president and chief executive of Silicon Valley Bank and SVB.
The boom in technology startups has made SVB one of America’s fastest-growing banking companies, with a profit of $263.9 million in 2014, up from $48 million in 2009. Total assets, including loans, swelled 40% in the last 18 months to about $42 billion at the end of the third quarter. “SVB is a long-term player,” says Byron Deeter, a partner at venture-capital firm Bessemer Venture Partners, which steers startups to the bank.
Since opening its first office in San Jose, Calif., in 1983, the bank has done business with tens of thousands of startups, including Cisco Systems Inc., Twitter Inc. and Uber Technologies Inc. in their infancies. Along the way, SVB has learned how to lean on venture-capital firms for leads on potential loans and feedback on existing ones. The SVB spokeswoman says: “It is a data point among many in our decision-making process.” Because of those connections, the bank often is more willing than others to give companies a break on their loans if they run into trouble, according to entrepreneurs and venture capitalists who have done business with SVB.
“Guess what? Ninety percent of companies are off-plan at some point in their history,” replies Mr. Becker of SVB. “Maybe they violate a loan covenant, and then that’s when we have the dialogue with the venture capitalists.”
Sometimes, help arrives in the form of what Silicon Valley entrepreneurs and venture capitalists call a “runway.” That can mean making a loan to a young company between fundraising rounds, extra time to recover from a rough patch or money that keeps the company alive while it is seeking a buyer. “SVB is the kindest bank in the business,” says Martin Pichinson, who has worked with the bank through Sherwood Partners Inc., the Mountain View, Calif., restructuring firm where he is co-president. “They will work with clients because of their relationship with VCs.”
Mr. Ali, TinyCo’s co-founder, says the mobile game maker breached covenants on its $10 million loan from SVB, including once at the end of 2013’s third quarter. TinyCo couldn’t fix the problem for six months. “No other bank would have waited more than 45 days,” he says. The SVB spokeswoman says: “We worked with the company because we understood the risks and concluded that it made sense to work with them, as evidenced by the outcome.”
[su_pullquote]While innovation is sexy, it’s more important to ask if it makes sense to the customer at the end of the day.[/su_pullquote]
When borrowers are in financial trouble, SVB often makes a “comfort call” to venture-capital firms that provided funding to the startup. For instance, if the venture-capital firms express willingness to do another funding round, the bank sometimes relaxes loan terms, according to some borrowers. SVB will often “get you to that next milestone, and it’s cheaper than raising equity.”
Overall, SVB had revenue of $1.43 billion in 2014, nearly triple its 2009 total of $482 million. Gains on investments made largely through venture-capital funds totaled $49.2 million. SVB made $71 million on warrants.
Among venture-capital-backed private companies valued at $1 billion or more, Airbnb Inc. and DocuSign Inc. have been SVB customers. So have Cornerstone OnDemand Inc.,Fitbit Inc., TrueCar Inc. and Zendesk Inc., which grew from startups to publicly traded companies.
Through a unit, SVB also manages investments in venture-capital funds that were valued at $1.2 billion at the end of last year. Those investments include some of SVB’s own money.
Singapore government pushes venture debt financing for startups and M&As
Finance minister Tharman Shanmugaratnam mentioned in his Budget speech on February 23 that the government has added new measures to invest in innovation and modernize its economy.
“SPRING Singapore” will pilot a venture debt financing initiative in which it will share 50 percent of the risk with partner banks to provide loans to startups. Unlike traditional loans, venture debt works with minimal collateral and takes equity in the company instead of charging interest. This eases a startup’s access to capital.
The government also wants to make mergers and acquisitions easier in Singapore. It’s increasing its tax allowance for the acquiring firm from 5 percent to 25 percent of the acquisition value. The benefits can be claimed with a 20 percent ownership in the target company, down from 50 percent in the previous version of the scheme.
DBS Bank launched its new venture debt financing for growth-stage technology startups in Singapore — but not everyone will qualify. Startups in the city-nation ‘primarily rely on venture capital to fund their operations’.
“DBS is making available an alternative source of capital for these firms to tap on, with little or no dilution to their equity. Tech startups can use DBS venture debt for working capital, fixed assets acquisition and even project financing,” the release said.
But DBS has some strict conditions on which startups will have access its venture debt financing. To qualify, tech startups must be strongly backed by DBS’ partner venture capitalists such as Vertex Venture, Monk’s Hill Ventures and Golden Gate Ventures. They should have raised at least S$1 million (US$800,000) of Series A funding, be incorporated for at least two years, be in operation for at least one year and have demonstrated that their business model is commercially viable.
Later, OCBC launched venture debt product. Tan Chor Sen, OCBC’s head of international, global commercial banking, tells: “Because they are growing so fast, the cash generation is not enough for them. Most of the time, they are cash-deficient,” says Mr Tan. Capital to fund these fast-growth companies is currently also limited, he added. Mr Tan points to the top 10 per cent of Singaporean SMEs today, that have been found to take just 21/2 years to reach S$10 million in sales turnover. He added that OCBC’s venture debt offering will be sector agnostic, and not limited to the more well-known fast-growth sectors such as IT. More startups are also setting up headquarters in Singapore, he observed. “While innovation is sexy, it’s more important to ask if it makes sense to the customer at the end of the day.”
Singapore state fund Temasek joined hands with lender UOB to offer up to $500 million in venture debt loans over the next five years to internet start-ups in China, India and South-east Asia. The deal will also see UOB acquire 50 per cent stake in InnoVen Capital (InnoVen), a Temasek subsidiary. InnoVen will function as a UOB-Temasek joint venture in the wake of the lender acquiring a stake in it.
UOB and Temasek will each commit up to $100 million of paid up capital to the joint venture. Ong Beng Teck, managing director, Enterprise Development Group, Temasek said:
“Temasek is committed to building InnoVen and promoting growth of innovative companies by working with entrepreneurs and venture capitalists across Asia. This new pan-Asian venture debt financing initiative will seek the next generation of leading companies, providing the support they need to scale and succeed.”
“Venture debt is important as it enables more of Asia’s best start-ups to develop into world-class companies. We can see this in China and India which have vibrant start-up ecosystems, while Singapore is establishing itself as the start-up hub of Southeast Asia,”
explained Eric Tham, managing director and head of commercial banking for the UOB Group.
According to business consultancy EY (Ernst & Young), the estimated potential market size for venture debt in Singapore, China and India stands at $2.2 billion. The venture debt market is already seeing significant growth in India.
1) When should I raise venture debt?
There is no “one size fits all” approach to venture debt, but there are four common use cases:
a) Extending the cash runway of a business to hit the company’s next milestone (e.g. you’ve raised $10 million of equity but think you may need $15 million to get to the next major milestone)
b) Preventing the need for a bridge round or a down round to get through a tough period
c) Funding large capital expenses, acquisitions, or providing a bridge to profitability
d) Acting as insurance in case it takes longer than expected to execute on the company’s plan
Most companies raise venture debt immediately following an equity financing, when it is most accessible, all of your diligence materials are fresh, and your business has momentum.
2) When should I avoid venture debt?
It’s a bad idea to use venture debt if any of the following apply:
a) You don’t think you can repay the debt by refinancing or raising more equity
b) The terms or covenants of the loan are too onerous
c) Your venture investors are not supportive
3) What happens if I can’t repay the loan?
When the time comes to repay the venture loan, you have three options:
a) Repay: Use cash on your balance sheet or equity from investors to pay it back.
b) Refinance: Find another lender who will refinance the loan.
c) Restructure: Negotiate a repayment plan with the lender.
If things are going well, repayment or refinancing is easy. But if your company is in trouble, you will need to work with your lender to restructure the debtand avoid default. Once you are in default, the lender has the ability to foreclose on your company.
4) What is the venture lender’s typical diligence process?
Venture loan diligence resembles the venture capital diligence process, although less intense. Be prepared to provide much of the same information you provided in your venture capital raise.
5) What’s the best way to run a venture debt fundraising process?
Much like the venture capital world, you need to talk to a number of different banks and venture debt funds. We recommend engaging a venture lawyer who will have a feel for what is “market” and will be able to advise you on getting the best possible terms. And just as you would with an equity round, make sure you have a few horses in the race so you can negotiate the best terms. Venture debt won’t be the right fit for all companies, but if structured properly, it can be a less dilutive way for you to finance your journey to the next milestone.
For more detail, check out the full “Ten Questions Every Founder Should Ask before Raising Venture Debt”.
Life.SREDA VC is a global fintech-focused Venture Capital fund with HQ in Singapore