Jul 29 2008

What Is The Purpose of Venture Debt At The Series A Round?

Q: From my limited perspective, venture debt in proximity to an A round seems awfully premature — restrictive debt coverage ratios, warrant coverage on preferred terms, etc — yet there seems to be an awful lot of venture debt investors out there who essentially have no response to these concerns but want me to take their money anyway. Hence my question: if such financing really is premature and potentially limits the options for a startup, why should an early stage company take it?

A: (Brad) From a tech entrepreneurs perspective, there are two types of banks in the world.  Those that understand tech entrepreneurship and those that don’t.  Those that do – such as Silicon Valley Bank and Square 1 Bank – have good early stage venture debt programs.  Those that don’t either simply don’t have a venture debt program or have transient ones that come and go with the market.

Let’s assume we are dealing with a credible bank in the context of venture debt. These banks have venture debt programs that are largely based on their relationships with the VC firms involved.  The ultimate goal of the bank is the long term relationship with the company – they are willing to extend debt on relatively inexpensive terms if they believe the equity participants (the VCs) are going to be supportive of the company beyond the Series A.

Now, the price of admission for this for the bank – and for the banking relationship – is to extend debt terms as part of a banking package.  This package will have all the expected banking services, but will also include either an unrestricted debt line (usually somewhere between $1m and $2m) and an asset-based line (usually up to $1m).  This debt package will have straightforward terms, including relatively light warrant coverage so the bank can get some upside in the success scenario.

The bank is doing this because it believes the VCs will continue to finance the company beyond the Series A.  This debt will typically give the company one or two quarters of additional runway to make progress which can be very helpful in the context of some early stage companies. 

One thing to be cautious of is a debt package that you can’t actually use.  Many proposals have covenants in them that essentially require there to be an equivalent amount of money in the bank as the debt being borrowed – this is obviously useless.  However, I continue to be endlessly entertained by the proposals like this that I see.