Venture debt is an important tool that will add value to venture equity investors. However, to make the best use of it you will have to know a few specific things. To begin with, you must know that Venture Debt is not to be treated as a substitute for Venture Equity though it may complement it most of the times. It is simply a process that allows any startup to borrow money especially when these businesses are not creditworthy enough from a traditional lending perspective to avail any loan otherwise.
The basic principle of Venture Debt is however not to take on the equity risks. The primary objective and investment thesis of Venture Debt is based on backing the startup companies that have successfully build up enough institutional equity. It is also required by a startup to have enough potential and prospects to attract strongly the follow-on equity interest.
Therefore, the Venture Debt providers usually collaborate with the VCs so that they can help the investee startup companies to succeed.
How it helps
You will ideally have several different funds which may offer both Venture Debt and equity. The existing venture equity investors can enjoy a lot of benefits from venture debt such as:
- Faster scale-up: The primary aim of any equity investor is to scale up the portfolio companies and at the same time help them to hit the key metrics that will result in an increase in the valuation of the company. This is especially needed for all rapidly growing business as time is money for them. It will trigger the growth of the company with aggressive marketing campaigns, acquisition of all available business opportunities and even follow a productive and useful global business expansion strategy. For all these, the business will need adequate capital on time and without Venture Debt it is not possible to relieve these companies from such constant pressure. Ideally, the next round of equity investment must be raised within 12 to 15 months of the previous one.
- Equity dilution: Since Venture Debts cover almost all cash needs of the companies with high growth potential, it sizably reduces the equity dilution of the investors. It helps them to extend their runway to another 24 months. Ideally, this will provide the founders with enough time and space required by them to focus on business expansion and growth. As a result of this, the companies are often successful in raising ensuing equity round at a much higher valuation. Apart from that, the equity investors are also able to avoid dilution from the new investors when it comes to an interim equity round. All these and an extended runway will give the VCs a longer time to evaluate the worthiness of the startups for a follow-on round.
- Capital flow: Venture debt ensures proper capital flow at all times which not only allows the VCs to delay or reduce the amount of capital they are compelled to draw down from the fund investors but also ensures that the company does not have to take on any further debts. This will prevent them from focusing on other aspects such as debt management and considering debt consolidation reviews to get rid of one. This will also improve the Internal Rate Of Return or IRR of the VCs. Just like in any other type of investment this will allow the VCs to diversify their portfolio if they want and create a separate portfolio of investments. If you have Venture Debt as your additional source of capital it will allow the Venture equity investors to backup capital for fresh investments in other companies or for follow-on investments in different portfolio companies. That means they will have a better chance to allocate capital more judiciously and mitigate the risks involved in it.
- Working styles: Encouraging and ensuring complementary working styles and relationship with the VCs is another added benefit of having Venture debt by the portfolio companies. Usually, the VCs have a hands-on relationship with the investee companies but by design and nature of Venture Debt investors, they are more hands-off. Venture debt investors are far too less involved than the VCs when it comes to the management of the company. They typically provide only strategic guidance to the companies. This feature enables the equity providers to avoid any potential conflicts in the role of the investor or board with the lender.
- Aligned interest: Both the VCs and the founders have their interests aligned. This ensures a strong relationship between the Venture Debt providers and the VCs as well as the entrepreneurs. However, the VCs will usually have a broader perspective having typically a seven to a ten-year life expectancy of their funds. The Venture Debt providers, on the other hand, are more focused on the next fifteen to twenty-four months. Therefore, while VCs look for the probability and bottom line of the company, the Venture Debt providers, on the contrary, are more focused on the prospects and probability of the survival of the company. As for the founders, the key is to focus both on the survival and profitability in order to keep their business growing. That means the Venture Debt acts as the insurance of the company providing enough protection during difficult environment when raising equity capital for any startup is really tough.
There are also a few collateral benefits in taking on early debt. It helps the company to build a positive track record early in their lifecycle with their healthy borrowing history. This, in turn, helps them to avail conventional debt capital later in their later stages.
Apart from that, it helps them to adopt a fruitful fiscal discipline to develop a strong and effective habit of managing their finance that includes cash flows, allocation of costs, analyzing and reporting different metrics on a regular basis on time and much more.
Ideally, the risk-reward outline of Venture Debt is much different from Venture Capital and therefore it will help the startup companies to attract investments from other different pools of investors as well.