There are several forms of venture debt. Convertible notes are the most common, today. Most startups raise seed rounds using convertible notes. Startups that have substantial working capital requirements often employ lines of credit/revolvers. Last, many startups take out term loans. They borrow money for several years and repay it over time. Venture debt can supply additional capital for a startup to grow at a lower cost of capital than equity. And the difference can be material.
A hypothetical startup raises $5M at Series A and sells 25%. Then they raise $2M of venture debt. In addition to the interest that must be repaid on the debt, the lender also receives warrants (options to buy shares) typically between 5-20% of the amount of money lent. In this case, 20% of $2M is $400k worth of warrants or about another 2% of shares.
The $5M in equity costs 25% and the $2M in debt costs 2% in warrants plus interest over the course of the loan. Of course, the debt must be repaid, so it's not quite the same, but the marginal impact to dilution of the insurance policy and/or runway extension is meaningful.
Debt can delay the timing of the next raise and reduce dilution. A startup growing at 15% per month will double revenues after five months. At this point, the company should command twice the valuation when it raises its next round. So, the startup should then be able to raise more capital at the same dilution or suffer less dilution for the same amount of capital.
Term loans can be quite useful for SaaS startups. SaaS companies benefit from high gross margins and relatively predictable businesses. With a known sales quota, sales attainment, cash collections and churn rate, a SaaS startup should enable the business to model a conservative scenario for growth and cash flows, and determine whether the business can support paying the principal and interest over time, or with an interest only payments until the loan matures and a balloon payment at the end.
Not all investors advocate for venture debt. Fred Wilson wrote a post in 2011: “I'm not a fan of venture debt for early stage companies. If the startup is getting the money because of the credit worthiness of my firm and the other firms in the deal, then I'd rather be putting more equity in instead and getting paid for my capital at risk.”
In addition to Fred's points, there are risks. If the business cannot repay its debt, the lender has several recourses, which can be serious. They include controlling the business’ bank accounts and taking possession of the business. Like any debt, before deciding to assume it, the borrower must weigh the benefits and the risks.
Lenders also weigh these risks. Glen Mello, a managing director at Silicon Valley Bank, which lends quite a bit to startups, explains how his firm lends in this interview conducted by Jay Azcuno at NextView. “Cash is actually a big piece of the analysis. Among the elements we look at are the burn, the cost to hit certain milestones or inflection points and whether or not there’s a buffer built in, whether we’re providing the buffer or the equity investors are providing it, and so on.”
Venture debt can be a useful financing option for SaaS companies to elongate runways, command higher valuations and suffer less dilution to achieve growth. The predictability of a well-understood SaaS business enables the founding team to project how much, if any debt, the startup can support. Like every financing strategy, there are pros and cons to debt and understanding them is essential. A good startup attorney can help.