Source: Capital Advisors Group

With venture capital difficult to obtain, more startups are looking at venture debt to finance either growth or equipment purchases.  Venture debt involves a specialized financial institution extending a loan to a startup.  Traditional commercial lenders are hesitant to give loans to startups because they usually do not have tangible assets.  Unlike a venture capitalist, the venture lender does does not receive equity in exchange for capital.

What The Entrepreneur Needs To Know About Venture Debt

1. It's a loan.

Venture debt is a loan made to a startup.  That means the main features of a loan -- principal, interest rate, repayment terms -- are present.  The loan either provides operating capital or equipment financing.  Operating capital is used to grow the company.  Examples are research and development, marketing, and acquisitions.  Equipment financing is used to borrow against equipment that the startup buys, such as manufacturing equipment.

An important feature is that the lender does not receive any equity in the startup.  Like any other loan, the relationship ends when the company repays the loan.

2. It's more complicated than a loan.

• Interest rate. The interest rate will often be a function of the company's prospects and the reputation of its venture capitalists.  Another point entrepreneurs should understand: the cost of capital is not just the interest rate, but rather a multiple of the interest rate.
• Term. The loan is usually structured as a two to four year term loan.  The loan may sometimes include interest free payments or a final balloon payment that allows the company to avoid paying cash at the beginning of the term.
• Warrants. Venture debt loans generally include warrants.  The warrants give the lender the right to purchase a set amount of the company's common stock at a predetermined price.  This price is often at a discount ranging from 5 to 15 percent.
• Material Adverse Change Clause. Make sure you understand the material adverse change (MAC) clause and the circumstances that qualify as a MAC.  For startups,  something as common as the founder leaving the company or the company experiencing a change in its financial statements can trigger the MAC clause.  This can lead to the lender calling on the principal of the loan and closing down the company.  In 2009, Hercules Technology Growth Capital foreclosed on Kadoink's loan and sold the company's intellectual property assets because of a change in its financial statements.

3. Who qualifies?

One venture capitalist, Mark Peter Davis, notes that a startup generally must (1) be cash flow positive or (2) have a venture capitalist who will guarantee the loan to qualify for venture debt.  Anurag Chandra of Lighthouse Capital argues that venture-backed startups who are cash flow negative are prime candidates for venture lending.  Having highly regarded venture capitalists as backers and a promising future increase the company's attractiveness.

4. Venture debt lenders are not as involved as venture capitalists.

Venture lenders do not ask for a seat on the board of directors.  Nor do they get involved in the operations or management of the company.

5. Choose a reputable venture debt provider.

Because venture debt is a highly specialized type of lending, pick a provider who understands your industry and has an established track record.  Reputable players include Silicon Valley Bank, Costella Kirsch, Western Technology Investment, Hercules Technology Growth Capital, and Velocity Financial Group.  Silicon Valley Bank is an established venture debt lender with over 25 years of experience.  Costella Kirsch has also been around for about 25 years.  Western Technology Investment recently closed an oversubscribed $294 million venture debt cleantech fund.  Western Technology has provided debt funding to Facebook, Google, and Palantir, among others.  Hercules Technology Growth Capital recently lent $15 million to Reply.com, a company focusing on the online targeted marketing space. Velocity Financial Group has recently backed companies including Sportsvision and Alphion.

Conclusion

Venture debt is often overlooked as a potential source of funding.  Certainly, this type of financing is not for every startup.  In the next post, I will examine  the pros and cons of this type of financing.

As always, I welcome your comments.

Douglas Y. Park

Twitter: @DougYPark

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