Venture Debt & Alternative Financing
The Rookie VC #5
Amid the current situation, VC’s acceptance bar to invest has dramatically risen. Between bootstraping a business and taking financing early on, it’s not always as much of a blue pill and red pill situation.
A few months ago, I turned in an end-of-studies dissertation paper on Venture Debt financing for startups, that I’ll attempt to summarize for you today. I’ll also try and touch on other alternative financing routes for startups.
Venture Debt is somewhere at the crossroads of bank debt and equity. Just like any form of debt, it has a principal and attached interests. What really differentiates Venture Debt is that it is structured to comprise warrants or rights to buy the company’s stock.
Venture Debt is ideal for companies with explosive growth and that are just moments away from cash profitability, whose revenue is highly predictable and whose financial and operational rigor match the need to repay interest every quarter.
This type of financing is useful in the following situations:
Fill up the rest of a financing round and increase investment capacities thanks to non-dilutive financing
Offer some time in anticipation of an M&A operation or an IPO, to increase key KPIs and negotiate a better price
Act as an insurance policy in case of delay to attain operational milestones in time for other fundraising
Oust minority investors who do not share the strategic vision of the company or liquidity outlooks and timelines
The perfect candidate would look something like the following: a company that has just raised a €20m Series B round and adds €5m in Venture Debt, reducing further dillution. When said company gets acquired for €150m, the dillution spread’s value represents €5m at the benefit of the company.
Carlotta Perez describes in her book the relationship between capital’s different forms and innovation cycles: a changing cycle of relationship between production capital (the factories, equipment, processes and real-world objects that financial capital owns) and financial capital (the equity and debt owned by investors).
According to the author, the first phase of any innovation cycle, the installation phase, is ending in many industries. The following phase is a phase of deployment, where financial capital and production capital recouple. Financial capital turns away from speculation and pours into more deliberate and aligned investments. All because investors have a much better idea of what they’re investing into. By then, leaders have a tried-and-true method of putting production capital at work.
Huge swaths of the tech industry are already a-changing. The internet infrastructure business, for instance, is how companies have given up their entire tech investments and just pays rent instead. A perfect example of production capital. Other platform businesses are also on the line: by arming all the rebels of the online retail industry, Shopify delivers a consistently predictable performance. All parties know where the money has to be put out to work. A great instance of production capital.
Equity financing is a muscle memory reflex for VCs and startup investors at this point. Yet equity is far from being the most efficient financing instrument when a company is in the deployment period, where financial and production capital are coupled and aligned.
Common belief goes that equity is why we finance companies that have so little chance to succeed. In fact, maybe it is because equity is the dominant funding instrument that most start-ups fail.
Selling more and more equity over the years at higher and higher valuations drives the number of options for the founder down. Both valuation and dilution are the two most important optionality factors in any company. The higher the valuation goes, the more limited its options will be in the coming months or years.
Debt is the way to have your cake and eat it too. With less dilution in the cap table, companies with predictable revenue and client acquisition patterns are first in line to let venture debt flow freely. Yet, there is a number of reasons why Silicon Valley and other tech ecosystems have not moved past the all-equity funding stack. Lenders are not ready and open to the idea of lending to growth-stage software businesses, and debt on the balance sheet signals bad things could have happened. Then there is the fear of growth equity investors who fear they will not be the most senior money in the stack. The tension between financial and production capital induced by the way VC works also does not seem to bother today’s founders, who see themselves as bet allocators rather than production capital savvy operators.
In my opinion, more complex forms of financing will likely emerge. Instead of taking on debt or equity to fund an entire business, founders will likely focus on securing a first cohort of users, then securitizing the revenue they bring in to move them off the balance sheet in exhange for cash. Said cash will be then used to immediately fund the next cohort, etc.
It is really not impossible that an outside investor partners with founders and starts financing diverse portfolios of recurring revenue bundled into fixed-income products. Actually, it’s also likely that when this is democratized, VCs will partner with bigger banks to pin occasional venture debt loans to Series B and further term sheets.
This is the last step. The former step is when founders really get addicted to dillution-free capital when they can afford it. Once this point is reached, there is no going back to the old days.
Ressource list:
Debt Is Coming, Alex Danco
Technological Revolutions and Financial Capital, Carlotta Perez
Quel Avenir Pour la Venture Debt en France ?, Pierre-Alexis de Vauplane
Venture Debt, A Capital Idea for Startups, Kauffman Fellows
List of Europe Venture Debt Investors, Crunchbase
A Founder’s Guideline to Debt Financing, Mesh Lakhani