Thelander PC Digest: November 2023

What is Venture Debt?

Welcome back to the Thelander Private Company Digest. We have a special November edition with a guest writer, Jonathan Norris, who is a Managing Director at HSBC Innovation Banking. In our newsletter, he clearly explains everything you wanted to know about venture debt financing. We’ll let him break it down for you! 

1. What is venture debt?

Venture debt is a debt instrument used to provide additional cash runway for venture-backed, cash-burning companies. The idea is that this debt will help extend the cash runway for a company to hit a key milestone to unlock the new equity fundraise. Venture-debt consists of an initial drawdown and interest-only period, followed by principal payment over time. You do not need to be cash-flow positive, or even revenue-generating to qualify for venture-debt. We look at companies at the earliest stages, including product development or pre-clinical stage for life sciences.

2. How do we think about venture debt from the provider side? 
We look at the following on the venture debt provider side:

• The type and size of venture funding. 
• The company’s investors.
• Historical funding trends, number of funds raised, sector focus, partner attribution, role in the ecosystem, and ability to continue to fund in subsequent rounds.
• The management team, product, and market fit. 

3. How does venture debt effect compensation? 
Jody Thelander, Founder & CEO of J.Thelander Consulting, adds that venture debt does not cause any dilution to the percentages of ownership or equity for the company. This is a favorable benefit. 

4. When is the best time to raise venture debt? 
After an equity round. At that point the company has the strongest balance sheet and longest cash runway. While that sounds like the company is taking debt when they do not necessarily need it, venture-debt typically provides an extended drawdown period in which to access the debt (see more in the next section). 

Another key consideration revolves around key milestones for the company. What are the key development milestones that show progress in development? What are the key achievements that unlock the ability to raise the next round? Many times those milestones can be used as key points for making more debt available.

5. What are the different terms companies need to think about?
The main terms in venture debt structure are:

• Dollar amount
• Drawdown period
• Interest only period
• Principal repayment

Typically a venture-debt structure will provide for an extended drawdown period in which the company can take down the debt. During this time, the company only pays interest on that outstanding debt (interest-only period). Typical time periods for interest-only can be 12-15 months and then principal repayment is typically around 24 months. The devil is in the details, but the drawdown availability and interest-only period can contain tranches related to development milestones, new equity coming in, etc. Typically in venture-debt to early-stage, strongly financed companies there are no financial covenants, but there are exceptions for bigger deals and for later-stage deals with commercialization and revenue ramp.

6. How has the current market changed venture debt?
In the current challenging venture cycle, venture debt has become much more popular, as access to equity capital has become constrained. However, with constrained equity, debt has become harder to secure. There are certain situations that equity really is the best option and not debt. A good example of this is if a company has limited cash runway (6 months or less of cash). Since debt does not have the upside of equity, it can be difficult to provide debt where the cash runway is short and the next funding round is uncertain. The best venture debt candidate (no surprise) is the company that raised a new round led by a new investor, who also has dry powder to support the company going forward. Those companies have proven their ability to raise capital in a challenging market with a new investor and valuation commensurate with the current cycle. Insider rounds with strong investors that provide substantial runway (12 months plus) would be the next best opportunity.

7. What do you need to get started?
Due diligence typically involves review of your historical and current financial performance, plus detailed projections going forward. Also needed are substantial overviews of the product, development timeline and market opportunity. Conversations with investors about their investment thesis and go forward perspective on the company is also part of the diligence.

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