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HEIDI: Welcome to The Startup Solution and "The Case of the Venture Debt Dilemma." I’m Heidi Roizen from Threshold Ventures.
A few months ago, I got a call from an entrepreneur friend of mine, that I’ll call Al, who was in a bit of a panic – and for good reason.
. . .
AL: Hey Heidi, it’s Al. I’m sorry we haven’t chatted in a while, but I’m in a really tough spot with my bank, and I was hoping to talk with you a little bit about my situation. I took out some venture debt last year, and the bank is threatening to call the loan next week. I really want to try to talk them out of it. I was hoping you would have some ideas on leverage I could use to get them to back off. Could you give me a call? Thanks.
. . .
HEIDI: I called Al right away, but I didn’t exactly have good news for him because, in my experience, the vast majority of situations like his end badly.
A lot of people have been asking me about venture debt recently, so I thought I’d use Al’s predicament to talk about it today. I’ve seen some entrepreneurs use venture debt very effectively, while I’ve seen others get foreclosed on by their venture debt providers – and much like Al, they’re shocked and surprised when it happens.
There’s nothing inherently good or bad about venture debt – it all depends on how it's set up and how you use it. But like anything else involving money, it pays to understand the details before you sign on the dotted line.
Let’s start by clearing up what venture debt actually is. Many entrepreneurs hear the term and think it must be something similar to venture capital. But let me straighten that out for you right now – venture debt is not venture capital – it’s just plain old bank debt.
The term “venture debt” seems to have been coined by Silicon Valley Bank in the 1980s. SVB made its mark in its early days by being the banker of choice for venture-backed startups. They believed that lending to venture-backed startups was a safer bet than lending to just any old startup because they figured that we VCs did a lot of diligence before we invested, and we tended to pick the winners. Plus, the money that we VCs invested would ultimately be junior to their bank debt – meaning that the VCs wouldn’t make anything until the bank got paid back first. So, the bank believed that if the company got in trouble, the VCs would put more money in to support it, making that bank loan even less risky. And they were often (though not always) right about that.
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Although we VCs would have no direct obligation with respect to bank debt given to portfolio companies, the bank also wanted at least verbal assurance from us that we would be there to support the company if things went sideways. They’d call the VC investors as part of their diligence process and ask us not only lots of questions about the company but also about our commitment to the company, including how likely we were to invest more money and even what kind of financial reserves we had earmarked to do so. But again, just to be crystal clear, the actual debt contract was between only the startup and the bank, and its terms were that of debt, not of venture capital.
And unlike venture capitalists, banks are not in the risk business. The banking firms that provide venture debt don’t have a power law business model like we VCs do, where a few winners more than make up for all the losers. Instead, banks make their money the old-fashioned bank way – that is, on the combination of your interest payments and the proceeds from any other business you contract with them. And, of course, the bank also counts on you to fully repay the debt principal when it comes due. They will quite reasonably operate under these assumptions and will act in accordance with all the rights and remedies available to them if you get in trouble down the line.
. . .
Now that I’ve laid out how the bank thinks about that debt let me lay out how an entrepreneur should think about it in order to decide whether it’s a viable option for financing their company.
To do that, I’m going to suggest that you ask yourself five questions before you take on venture debt. And the first question is, how much is the debt going to cost you?
This first question should be fairly easy to answer. There’s the principal amount and the interest rate. And that should be relatively easy math.
We’ve just come out of a decade of almost free money – with interest rates at or near zero, and that made debt very cheap. But today, debt is more expensive and, therefore, may be less attractive – even though it can still be cheaper than taking on more venture capital in certain situations.
There are also other forms of debt beyond just venture debt, such as receivables financing, which means taking out a loan against the amounts your customers already owe you. Or equipment financing, which means borrowing against the value of hard assets such as the machines on your factory floor. These types of loans, where there is a known asset on the other side of the equation, are generally less expensive than venture debt because they’re also generally less risky for the bank.
There are also some hybrid debt vehicles that sit between venture capital and venture debt, such as one that General Catalyst offers, and I’ve put a link to that in the show notes. Some entrepreneurs get funding through a SAFE agreement, which is a simple debt agreement funded by entities and people who expect to be future equity investors. And if things go to plan, that debt will turn into equity in the future. And I just heard about a new version of this kind of debt called a SAFER agreement – got to love that name – which stands for Simple Agreement for Equity with Repurchase. A SAFER agreement differs from a SAFE agreement in that it gives the startup the opportunity to use future revenues to repurchase some of that debt, which would otherwise turn into more equity dilution.
I think some of these other forms of financing are interesting possibilities for early-stage startups. But like everything involving money, you need to fully understand the details before you take any one of these on.
And while there may be many different debt options available to you, that still doesn’t answer the question of whether it’s a good idea to actually take one of them. And as anyone with a maxed-out credit card would warn you – just because someone’s willing to lend you money, that doesn’t necessarily mean it’s a good idea to take it.
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But let’s get back to today’s topic, which is the specific form of debt commonly known as venture debt. When it comes to venture debt, that debt isn’t going to convert to equity; it needs to be repaid with cash.
Which brings us to my second question: How are you going to pay the debt back when it comes due? This may be the most important question of all when you’re thinking about taking on venture debt. And my opinion is that if you don’t know the answer to how you’re going to pay the debt back, then you probably shouldn’t be taking it – and you’ll learn more about why when we get to the later questions. But for now, let’s talk about what constitutes good and bad answers to the question of how you are going to pay it back.
Here are some answers that I consider pretty good ones. Maybe you have a very large, signed contract, but the cash doesn’t flow for another year, and you’d like to take advantage of some of that revenue to grow your salesforce now. Or maybe you’re a retailer, and you know from past experience that every store you open pays back the capital it took to launch it within 12 months. So, you’re highly confident that if you borrow capital to invest in a new location, it’s going to generate the cash you’ll need to pay off the debt.
On the other hand, here’s an example of a bad answer to how you are going to pay it back: You went out to the risk capital market, and no one wanted to fund you at terms you were willing to take. Your existing VCs also said they won’t give you any more money unless you get your revenues to go from flat to up. So, you decide to take out some venture debt to give you more time to figure out how to turn up those revenues. In this case you’re hoping to pay the debt back from the proceeds of this miraculous turnaround. Or at least, if you don’t get quite that far on revenue, maybe you’ll be able to raise more VC money and pay off the debt as part of that future raise.
This is what I’d call a bad answer. That’s because these types of justifications, as they play out once the debt is taken on, often lead to the startup hitting insolvency – which is when the startup’s assets are lower than its liabilities. And when a company hits insolvency, it’s highly likely that the bank can and will recall the loan, which is usually very, very bad for that startup.
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This is why question number three is: can you maintain solvency throughout the duration of the loan? Because if you can’t, just move right to question four – which is, if you can’t pay that debt back when you’re asked to, what happens then, and how bad can it get?
And that solvency question is going to play a major role in the answer to “how bad can it get.”
The question of what will actually happen if things don’t go to plan is an extremely important one, and I’m surprised more entrepreneurs don’t seriously consider it before they take on venture debt. This question is also pretty easy to answer since there have been many startups who’ve gone before you in taking debt that they ultimately couldn’t pay back. And in almost all those cases, when the startup couldn’t pay back the debt, the bank used whatever rights were contractually available to it to recoup as much of its funds as possible.
This is where that insolvency test comes into play because almost all debt comes with a condition that it can be recalled, that is, the bank can demand immediate payment, if the company enters balance sheet insolvency, which occurs when the total liabilities of a company exceed its total assets.
And here is the inherent catch-22 about using debt to extend your runway. The debt itself is a liability on the balance sheet. So, if you have a million dollars in the bank, and then you borrow two million dollars thinking you can extend your runway with it – well, as soon as you spend the million you already had, and unless some other money came in in the meantime, you become technically insolvent.
Entrepreneurs who think that they can get away with this are almost always wrong. And sadly, they often don’t realize that until the moment the bank tells them. That’s because they usually borrowed the money when they still had other money, and they didn’t realize that once they crossed into balance sheet insolvency, they wouldn’t be able to keep or use that borrowed money anymore.
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This is exactly the situation with Al, the entrepreneur at the beginning of this episode who called me in a panic about his bank. Al had borrowed three million dollars of venture debt when he still had two million dollars of venture capital in the bank. He was burning about two million dollars a year, so he thought this meant he had two and a half years of runway.
But it turns out that once he spent his last two million dollars of VC money, well, he was technically insolvent.
When Al called me in a panic, he said that the bank was going to foreclose and sweep everything out of his account since that money would almost cover what he owed them. But then he wouldn’t be able to make payroll, and he’d have to shut down. Al asked me if I had any ideas for leverage he could use to keep the bank from doing this. But in a situation like this, pretty much the only leverage you could have is if you could get some other money in immediately, like from your VCs or your customers, to get above that insolvency line again. Short of that, the bank is likely to make the very rational decision to pull the plug on you, because again, they aren’t in the risk business.
Al wouldn’t have been broadsided by this – if he had only read the loan documents. All bank loans are documented in fine detail, and virtually all bank loans have covenants. A covenant is just a fancy word for a term that requires the startup to meet certain conditions throughout the life of the loan in order for the loan to remain outstanding. And the most common, basic covenant is to remain solvent, which we’ve already talked about.
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There can be other covenants put in place to provide the bank with deeper insights about the health of the startup, as well as give them additional triggers for loan recalls if those covenants are not met. For example, there might be a debt service ratio, which specifies a multiple that the company needs to be able to cover the debt with from its operating income. Or the bank may set a number greater than one to one for your assets versus your liabilities. This is called a current ratio, and it can sometimes be set to a higher bar, like 1.5 times or even twice as much in assets as liabilities.
The sad thing is that what ends up tripping one of these covenants is often quite predictable right from the start. Why? Because when applying for the loan, companies will often give banks aspirational plans for their next year’s revenue. And the bank, very rationally, sets the covenants against the plan that the company provided.
But because the plan was optimistic, the company ends up missing it. And then, because the revenue comes in lower than planned, the debt service ratio, or some other covenant dependent on revenue, gets tripped, and the bank can then call the loan. And if you don’t have enough cash to pay the loan back, the bank could even seize other assets or force you into bankruptcy.
But banks wouldn’t actually do that, right? Again, banks are not in the risk business. They can, and sometimes they do, call those loans. And they’re not being evil; that’s just their business model and their legal right to do so.
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Let’s play this scenario out further. The bank says that they’re going to sweep the account in 48 hours, so the entrepreneur desperately tries to get his VCs to put in more money – at least enough to get his current ratio back above insolvency for a while. But in this case venture debt was used in the first place because the VCs didn’t want to put more money into the company. And now, with that bank debt riding on top of any new money those VCs would put in, well, that’s an even worse financial bet than before. So, the VCs say no.
Next, the entrepreneur might go back to some of the potential new investors he’d met with when he was last out fundraising and offer them a sweet deal in exchange for moving quickly. But in the eyes of the potential new investor, not only has the company gotten worse off financially, but that venture debt would also be sitting on top of their new money too. You see, pre-existing bank debt is almost never subjugated below new venture money coming in. So those potential new investors are likely to turn the entrepreneur down, too.
Let me digress for a minute to say that, yes, there are a few rare edge cases. There may be a new investor who comes in with an amount big enough to get the company to profitability, but they want the bank to, for example, take some of the money owed to it in equity instead of cash. Or, they negotiate to have the debt holder allow that debt to live below the new money on the cap table, maybe in exchange for a higher interest rate, or warrants, or something else of value.
Sometimes these things happen. But based on my experience, these kinds of deals are extremely rare and only tend to happen when there’s some imminent additional transaction that, in the bank's estimation, will leave them better off than just calling the loan. So, I wouldn’t count on it happening if I were you.
I also want to highlight, again, that venture debt from a bank is a very different animal from a bridge loan from your investors. While a bridge loan from your investors may carry the same face value in amount and interest rate, it is almost always designed to convert into equity with either a new financing or sometimes just the passage of time. And your investors will also be inherently conflicted about just calling the debt and putting you out of business, even if they technically can do that. Because they also own equity further down the stack, they’d like to see it become valuable too, and they know for sure that won’t happen if they call the debt and drive you out of business. So that’s a tradeoff that might end up in your favor when your lenders are also your investors. But that’s not going to be the case for venture debt that comes from a bank that doesn’t have any other investment in you.
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OK, if you’re still with me, there’s one last question you should ask yourself, which is the one most entrepreneurs ask first. But I put it last because all the other questions need to have positive answers before you make the final decision to go forward or not with venture debt.
And that is: is the cost of the money you’re borrowing worth the leverage it’ll buy you?
I mean, that’s why you borrow money in the first place, right? Instead of, for example, cutting your burn rate, you borrow because the money will provide additional leverage for you to build more equity value sooner. And when you can reasonably project that the debt will allow you to create more enterprise value than it costs, such as the retail outlet case I mentioned earlier, then that’s probably a reasonable trade to make.
The problem is that I’ve seen many entrepreneurs kid themselves with their answers, believing that simply financing months of burn with no clear or different plan will somehow increase their company’s value – and it usually doesn’t work out that way.
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Now that I’ve given you all the details and explained how things can go really badly, I have to fess up that, well, that’s not how things ended up for Al.
Al’s case was unusual in that he had recently pivoted to a new product that was showing a lot of promise. His largest investor was excited about the new direction, so much so that she agreed to keep funding him. But she’d only do so if he’d kill off everything else, cut the team down to a handful of people, and focus exclusively on the new product.
Al was also “lucky” that the bank called the loan shortly after he became technically insolvent because he still had most of the money from that bank loan in his account – all except about two hundred thousand dollars. So, Al got lucky. He got a two-million-dollar bridge loan from his investor, and she agreed to allow two hundred thousand dollars of that to be used to repay the bank in full by combining it with the money he still had left. And when everything was settled, Al was left with no bank debt and about a year of runway to play things out with his new product and his very streamlined company.
So yeah, I was wrong this time and look, I’m glad it worked out for Al. But in my experience, this was a highly unusual situation, and most of the time, people aren’t as lucky as Al was.
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So, remember to ask yourself my five questions before you take that money:
If you answered my questions with a bunch of no’s, but you’re still game to borrow venture debt – good luck with that, and consider yourself warned.
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And that concludes "The Case of the Venture Debt Dilemma." For the record, this situation is real, but Al is a composite. No startups were harmed in the making of this podcast. I hope you enjoyed it, and if you did, please forward it to someone else who could use it. I’m Heidi Roizen from Threshold Ventures.
As I mentioned in the episode, General Catalyst has an interesting offering around a financing model for growth equity that is a hybrid of debt and equity. More here.
Also, as mentioned, the next version of the SAFE has arrived in the form of a SAFER loan agreement, which allows for some repayment instead of conversion.
Here’s a solid primer on debt covenants.
Finally, one thing I didn’t cover in the episode but is relevant to the decision-making about debt is that the lender may ask you to move all your banking business to their bank. And that can prove disastrous in situations like what happened to SVB. Here’s a great piece on that danger.
