Typical amount of venture debt
With the recent startup valuation reset, we’ve had a number of conversations with founders about the role and optimal amount of venture debt, especially in the Series A phase and beyond. How much is enough? Or is it too much? What is the best way to secure a venture debt loan? Are there other financing options to consider?
While every Series A situation is different and there are many variables, there are good rules of thumb to follow to use debt as an effective financial tool, especially in uncertain markets.
One of the benefits of partnering with SVB is that we have decades of experience working with growing startups in all kinds of niches and all kinds of market situations. There aren’t many scenarios that we haven’t experienced firsthand over the past 40 years. This depth of experience gives us a unique perspective on how venture debt can be used to drive startup success.
Generally speaking, there should be enough momentum in your business to justify taking on debt. Therefore, the amount of venture debt tends to be proportional to specific milestones that indicate a company’s growth or progress. These include new product releases, clear signs of product-market fit, and entry into new or expanding markets, to name a few.
It should be noted that life sciences or pre-Series A companies have unique dynamics to consider when seeking funding. This article focuses primarily on technology innovators who have at least an early product market fit and are evaluating financing options.
“There should be enough momentum in the business to justify taking on debt. Therefore, the amount of venture debt tends to be proportional to specific milestones that indicate the company’s growth or progress.”
The key to venture debt is to use it wisely
By the numbers, the typical amount of venture debt for a startup company is:
- 20-40% of the latest equity round.
- Not to exceed 10% of the startup’s permanent enterprise value.
- Consider keeping your debt service below 25% as a percentage of net burn.
- The debt should provide about six months of runway, but most lenders expect at least 12 months of substantial runway on top of the debt.
These numbers are in stark contrast to the 2021 market, where equity valuations were inflated, as were expectations regarding the debt terms that could be secured. Companies that pushed the envelope to maximize the amount of debt they could secure around the peak of the last cycle now find themselves carrying burdensome levels of debt well over 20% of their current enterprise value. ing.
Of course, this is a dangerous ratio. A more healthy level, and a common measure of debt value, is typically 6-8% of the company’s final valuation (i.e. after the most recent funding round).
It’s important to note that there is no hard and fast rule for this ratio, but a range of 6-8% is most common across different stages of companies, business models, and industry sectors. Nevertheless, we also see debt-to-equity ratios becoming more debt-heavy in subsequent funding rounds, particularly where lenders can see increased enterprise value, revenue traction, or actual profitability increases. I did.
Too much venture debt almost always turns into debt.
Debt is a powerful tool, but like any tool, its effectiveness is determined by the skill of the person using it.
Too much debt can affect a company’s next financing. Ratings can also suffer if a company performs below expectations or fails to meet its core goals. Of course, investors are looking for growth opportunities, but they may be wary of funding companies with too much debt. They don’t want to see new equity capital used to pay off debt. If a company is properly capitalized, most lenders will be happy to refinance the debt alongside new equity.
There’s also the risk that if you take on too much debt, you’ll have a shorter runway once your loans start to amortize. For example, a company with monthly operating income of his $250,000 and his $5 million debt facility amortizing over 30 months will see an increase in debt. Once payments start, your burn rate increases by more than 50%.
Entrepreneurs lean toward optimism, and society has benefited from amazing innovations because of that optimism. This is one of the things that distinguishes our economic system from many other countries in the world. However, proper recognition of downside risks can help ensure that these breakthrough innovations survive and make it to market. That doesn’t mean you shouldn’t take on debt, but you should be aware of how much your burn rate can affect planned and unplanned scenarios.
More importantly, too much debt can limit a company’s strategic options and spending decisions going forward. Also, if you rely too much on equity capital to pay off debt, you may end up owning less of your company. Rather than using debt as a substitute for equity, we want to use it as a complementary source of capital.
It’s important to know when to harness the power of debt.
Another way to look at debt is that it can be like a jet engine strapped to a train. You can accelerate in the direction of travel, but you’ll run into problems when making sharp turns.
You should only take on debt if you have a clearly defined roadmap and business plan. It’s important to plan for financing, develop financial projections, outline your business goals, and understand how debt fits into that roadmap.
But if you expect a pivot to occur at some point, or if you lack the strong belief to achieve your plan, debt may not be the best financing option.
Debt is a financial instrument that involves a set of promises between a borrower and a lender. For example, for the borrower, that could mean selling the business, making significant changes to the business model itself, changing management, or pledging not to pay dividends to shareholders. Ultimately, lenders are looking for commitment, consistency, and communication on the part of the borrower.
At the same time, established lenders understand the risks they are taking on and expect to suffer losses from time to time. So don’t be afraid to surface negative news early. The best lenders will appreciate early communication, knowing it will ensure you have more options for potential solutions that will help deliver the best outcome for you, your equity investors, and the bank. I will.
“You should only take out debt if you have a clearly defined roadmap and business plan. Plan for financing, make financial projections, outline your business goals and understand how debt fits into that roadmap.” It is important to understand the fit.”
7 important considerations when raising venture debt
In our experience, the most successful startups follow these seven tips when taking on debt.
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Let’s borrow money to extend the runway. – It not only serves as the sole source of runway.
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Ask yourself if you really need the debt – Be thoughtful and prudent. Just because a lender offers debt financing doesn’t mean it’s the right tool for the job.
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Think of it as a three-party effort. Work collaboratively with management, investors, and lenders. Increased transparency allows you to quickly find mutually agreeable terms. Of course, this includes the beginning of the transaction, but also the entire life of the partnership.
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We will perform just as much due diligence on your funding sources as we do on you. – Choosing the right lender is important. Critical to your diligence is understanding how lenders will react in unfavorable scenarios.
Questions to ask yourself include:
- Are they known as patient financiers?
- Is their credit framework approved by regulators?
- How did they react during the economic downturn? Have they ever been tested by such cycles?
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Model the worst-case scenario – It’s natural to hope for the best, but plan for the worst, especially when it comes to your ability to repay your debts.
- If you’re nearing cash flow break-even, compare venture debt to other financing options – Venture debt can be costly compared to other debt solutions.
- Use a lawyer experienced in venture debt – Inexperience with the nuances of obtaining this form of debt can delay the completion of a loan, incur additional costs, and cause unnecessary confusion for entrepreneurs and finance teams.
Why we think venture debt is more art than science
While the tips listed above are good guidelines, there are other factors that can influence your decision whether to take on venture debt.
Our take: It’s better to find a lender that understands your business and the nature of the innovation economy. When something unexpected happens, it can (and does) make a big difference.
An experienced lender will consider more than just your company’s final valuation. A company’s overall performance is a better measure of venture debt viability. For example, creating well-vetted forecasts that show how expected sales and profit targets can be achieved, or creating a signed term sheet for the next round of equity, etc. It helps a lot. The same goes for obtaining full board approval for the use of debt.
When the venture capital market was active, many financial institutions entered the market, but they did not have a long history of navigating the up and down liquidity conditions that are a given in the innovation economy. It’s better to choose a lender with good credit and a track record of solving the challenges faced by many VC-backed companies.
While debt can be advantageous in promoting growth, it is important to be careful not to take on too much debt. Some lenders tend to win business simply by providing excess capital without proper structure. A more cautious and patient approach is preferable. It’s not just about taking on more debt and hoping things will work out. The mutual commitment of lenders, equity investors, and borrowers to a venture debt agreement further helps to make the agreement work to its full potential.
Know the “4 Cs” of venture debt
When assessing the viability of venture debt for your business, we believe it is equally important to assess the viability of lenders. It’s not just about taking on debt, it’s about taking on a financial partner who understands the innovation market, the capital cycle, and the events, trends and issues impacting your business.
Here are some things to look for in the financial partner you choose:
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capital: A strong financial foundation is essential. Will you support me as I scale? Or is this a one-time transaction?
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dedication: It’s not just about making deals and writing checks. It’s important to not only share your vision and help them see it through, but also to provide value beyond the check. This may include connections with other entrepreneurs and introductions to potential investors and trusted service partners who are also passionate about the innovation field.
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Consultation content: When borrowing money, your motivation should always be to solve a specific business problem. Lenders need to understand the challenges you face and the nuances of your industry to pinpoint the right amount of capital you need.
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Consistency: A long track record of funding successful companies, through good times and bad, can make a big difference. In addition to terms, you must evaluate the lender’s stable demand through multiple economic and financing cycles. Great deal terms mean little if lenders overreact at the first sign of distress.