Tom and Tony of tastytrade talk with Brad about Foundry Group, Techstars and Bootstrapping…
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.
Q: Convertible notes are popular instruments for angel investors when a future VC round might occur. But, if it takes longer to get to the venture round than you thought (doesn’t it always?) what happens when the note comes due? Can one investor call the note and put you out of business?
A: (Jason). Yes, technically they can, but in practice this rarely happens. Normally, one of two situations exist:
1. the company is doing “okay” just behind in it’s fundraising and it will get funded; or
2. the company is not going to get funded and it’s realistically done.
In case one, the investors would be irrational if they called their notes, as they would get pennies on the dollar (remember the company is spending their money along the way) and preclude any chance of funding and thus them getting an attractive return. Even in cases where funding seems remote, most of the time investors will give the company the maximum opportunity to get funded and continue on.
In case two, the company is going to shut down probably, so it’s probably not too traumatic to call the notes. In any event, the investors will get back pennies on the dollar, so it’s still in the best interests of the investors to let the company run as long as possible before throwing in the towel.
One thing to note: don’t personally guarantee angel notes. In that case, the calling of the notes will attach to the entrepreneur’s personal assets and may indeed incentivize investors to call their notes sooner than later.
Q: What is your view on venture debt?
A: (Jason) I like Venture Debt under the right scenarios. Companies can fund themselves through debt much more cheaply than equity in most situations and debt can help smooth receivables lumpiness, provide equipment financing and a host of other useful things. I think Venture Debt sometimes gets a bad rap, because it’s easy to find stories out there of companies who had their venture debt called at the most inopportune moment.
“Venture Debt” is not bad. It’s the debt holder that can be. My suggestion is to only deal with venture debt providers who are regular, long-term players in the market who themselves, exhibit good financial strength. There are plenty of banks who have dabbled in our market. They’ve made huge pushes to acquire a start up portfolio and then have decided this is not a strategic market for them. They’ve then started calling loans and exhibited other weird behavior.
We’ve seen other debt providers who don’t enjoy financial strength themselves and their financial backers get flakey and thus they become even more difficult to deal with.
Bottom line, all debt is not equal. Make sure that your provider has been around the block and intends to stay in this market long term. With this, you’ll generally get fair play in the debt arena, as each of you intends to be around the venture ecosystem for a while and has no incentive to act poorly.