Many early-stage companies leverage equity when fundraising after considering certain risk profiles and limited liability to the founders. Though, in unique and more regularly-occurring situations, there are other options to consider. If you’re looking for capital but don’t want to raise equity, James Turner of 5th Line Capital recommends looking to venture debt instead.
Venture debt is a type of debt financing for venture-backed companies that helps them fund their businesses without diluting capital through an equity raise. While some venture debt has a higher interest rate than a bank like SVB, it likely won't be as expensive as the equity. In this episode of The Modern CFO, James explains the mechanics of venture debt, when to use it, and how to be more strategic overall with your capital.
5:54 – The best time to raise venture debt
Knowing when to raise venture debt can be a challenge. The best opportunity for companies is when they’re in between major equity events.
“If you're a CFO and you're not one hundred percent well versed in a venture debt market, or this isn't something that you've done very recently, that can mean 30-40 names you have to shoot a ton of emails to. You have to disclose all your documentation, [and] make a bunch of phone calls to handle preliminary diligence processes. A good chance for them all to come back and say, “No.” So, I'd say the opportunity that we've identified as a result is that we know who fits where. It used to be, if you were a SaaS company, and you raised money from a big name VC or any VC really, you knew who your options were. But that was the only time you could really go raise venture debt. So where we actually see the greatest opportunity in the clients we work with is they’re most of the time in between major equity events.”
9:40 – When to use venture debt
As your company grows, venture debt will be more available. Once you hit the $2 million ARR threshold, more venture debt opportunities open up.
“If you're a traditional business-to-business SaaS company–you've hit all the metrics, and have a decent retention margin. You can still be cash burning, but annual contracts, things like that, the bread and butter stats–At the earliest stages, at maybe $500,000 a year or so, if you don't have a robust capital need, there are early-stage SaaS financing options that have popped up. A lot of them are platform-based like a Pipe or Capchase. But once you hit around the $2 million ARR mark, that's when true venture debt options start opening up to you. You can look at taking on maybe a million-dollar term loan or a lot of credit at that point, and that can continue scaling with you as you grow.”
10:24 – How 5th Line Advises Clients on Venture Debt Options
Companies don’t always need all of their capital upfront. Your venture debt can scale with you as you grow.
“Most of the time, what we're doing on educating our clients is they'll tell us, ‘Hey, we're doing $10 million a year. We need $12 million or this won't be a fit.’ Okay, do you need $12 million now? Or do you need $12 million over the next two years? Because that's how they've always thought about equity. They're like, ‘Oh, well we actually need $12 million over the next two to two and a half years.’ We run through their plan with them, say, ‘Okay, let's model this out. Well, let's start with five to seven now. And that scales with you over time.’ And we've had a lot of clients come around to the idea as a result. A lot of entrepreneurs, especially, hear the word debt and they’re like, ‘No, we're not sure. How do we repay it? We're burning cash.’ Venture debt providers look at companies in a very similar way that the equity investors do in my personal experience, with the caveat that obviously as we don't need a 10x return on this, and we also need to be paid every month on our capital, but they are banking on the ability for the entrepreneur to grow. They are banking that there is validity in what they're offering and scalability and that eventually down the road, someone will come along and buy the company or provide another equity investment.”
12:58 – Know where your money is going
You shouldn’t take on capital equity or debt unless you know exactly where it’s going to go. Figure out a product roadmap before you borrow.
“I think one of the common misconceptions is that a lender's going to be meaner to you than an equity investor. At the end of the day, everyone's writing a check to you, and everyone's looking for a return. So, my theory personally, and this is my personal opinion, is you should never take on any capital equity or debt unless you know where it's going. Obviously, you want to have room for a rainy day or an off-plan scenario, but if you're raising, whether it's $5 million in equity or debt, you should have a good idea, in my opinion, on where at least $3 million of that is going. You should have a product roadmap, a hiring plan for sales, marketing–whatever it may be. What I've seen that works the most for companies is just that.”
13:37 – Be strategic with your capital
Don’t raise capital if you don’t need to. Venture debt can increase your cash flow without forcing you to sell a percentage of your business.
“We're actually working with a few companies now where they're profitable, or at least break even, which is rare in the growth stage market. They have a pretty extensive product development roadmap and they're trying to drive towards an acquisition in a couple of years. They may tell us, ‘Well, we can raise another venture round, but we're cash flow break even. We don't want to raise another venture round and sell off 10% of the company to get the same amount of capital.’ So we're in the process of securing them a loan that's going to allow them to go into a cash burn mode, but it's very strategic. They have a direct correlation, a proven strategy that scales their top line. When someone's buying a company, that's obviously what they look at: what is the top line? I think the best successes come from when you know you're going to spend the money, and you know how it's going to go out the door, and making sure that it's not just capital they're going to have sit on their balance sheet for no reason.”
16:08 – Repaying a loan may be a better route than justifying a valuation down the road
If you take on more equity than you need, chances are you’re going to underperform. You need to ground your ideas in reality.
“The vast majority of companies who raised a Series B end up drastically underperforming, because they have to tell their VCs, whether it's current or prospective, certain targets to justify these massive valuations. And they're just not grounded in reality. They're not something that’s anything more than numbers on a spreadsheet that they build out. So they ended up laying off sales teams, missing quotas, and then they have flat or down rounds, whether they're inside or on a new round down the road. I always tell people I think it's a great opportunity for the debt markets. Like that CEO I told you about; I talked to right before Christmas, $12 million for his company is nothing. It's a very good deal for his side of the company, and that's all he needs. He's not going to have to justify a massive exit down the road, based on that $12 million raise. He just needs to be able to repay that loan over the next 12 to 24 months until he sells the company. That's really where I think companies see the most value.”
22:11 – Understand your options
There are times when your best option is to go to a bank or raise venture capital, while other times venture debt is your best bet. Weigh your needs carefully so you know which to choose.
“What I always tell people is that if someone just wrote you a $25 million check, do not come to us. Go talk to a Silicon Valley bank. They'll give you what you want at 3%. You can't beat it. So I'd say for the clients that come to us and they're the best fit for us, it's, ‘I'm looking for $5 million. This is where I'm at. This is what I got most of the time. These are some issues I've had over the past couple of years and going forward, what are my options?’ And then we'll tell them, just to your point, these are your options. This is what it’s going to look like. We always outline upfront before we engage with them. These are the risks and the hurdles that you'll see, and that we should be prepared to review during diligence, whether it's retention, liquidity, flat revenue, or things like that. And then what terms and structure will look like. Sometimes they say yes, sometimes they say no–but if they say yes, then really where we plug in is, ‘Okay, here's what you're going to need to get everything wrapped up.’”
25:45 – Venture debt is cheaper than raising equity
While venture debt has a higher interest rate than a Silicon Valley bank, it’s still cheaper than raising a round of equity.
“What we try to educate the market on is, one, it is an option either sooner than you think, or in different scenarios than you think. You don't need a big equity round. You don't need to be generating $10 million a year. As far as beyond that, sometimes it's on the other side. Yes, it's an option, but it's not Silicon Valley Bank rates. It's not 3%. It's not your SBA loans, whatever an SBA deal charges nowadays, but the rates are 8% to 12% on the rate. Compared to your car loan or an SBA loan, yeah, that's pretty high. But if you compare it to an equity raise, it's a lot cheaper. So there are two sides to education. One is on if it's an option, and let them know that it is in that case, but also letting them know you may not have all of the options that you've thought. This is where you fit in the market. And we do that education for clients upfront to let them know what their options will be if we go forward with the process.”
28:44 – Agile CEOs can navigate change
During the pandemic, many companies were forced to evolve or fail. The most agile CEOs were the ones that helped their companies shift to a new business model.
“We've talked to some CEOs whose business model did a complete 180. They are in a completely different market offering something completely different, and they did it during the pandemic. They saw an opportunity and quickly capitalized on it. They had to go outside their comfort zone. They had to make investors comfortable. They had to work with their team on completely changing their business model or their customer base. And they've done super well. A lot of people underestimate founders. Granted, some get overestimated in that an idea can sometimes lead to a billion-dollar valuation sooner than it should, but at the same time companies had a very hard time over the past few years. And if you're a good founder and especially if you're the founder and CEO, you've figured out how to navigate that. You’ve figured out how to work with limited or minimal resources. You’ve figured out how to capitalize on an opportunity that probably didn't even exist six months earlier, but you've been able to save your company as a result.”
30:22 – Use equity sparingly
Venture debt can be good for both investors and CEOs and CFOs, as long as they know how to use it properly.
“If you're an investor in a company and you're not looking to write the check that your portfolio company needs, venture debt could be an option better than you think. You may not get the markup or the write-up as far as valuation in your book just yet, but you may get a better return on your overall investment two years later when they go to exit and you aren't diluted by another equity investor coming in. If you are a founder, CEO, CFO, whatever may be in a company that's looking for capital, it might be available sooner than you think. It might be a better alternative than you think. Equity is obviously the go-to fundraising process for companies because they do see all the flashy headlines about it. But it may be an opportunity sooner than you think to be able to get some capital on the balance sheet and you may not get the valuation right up just yet, but two years later, you may be able to exit and own an extra 5% to 10% of the company as a result.”
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