Blog

Understand Venture Debt

Entrepreneurs need capital to support their businesses, but they often think venture capital is the only way despite a number of other options. One of those options is venture debt, which startups can qualify for once they’ve raised a venture capital round.

We spoke with Bailey Moore, Vice President of Wintrust Ventures, about how venture debt works, and how Wintrust Ventures makes its venture debt decision.

At it’s most basic, venture debt is a loan from either a bank or a fund to a company that does not qualify for traditional commercial financing but is backed by one or more strong institutional investors.

Moreover, venture debt is low-cost, non-dilutive capital. This makes it highly appealing to investors and entrepreneurs alike.

As Bailey put it, “The biggest benefit of venture debt you don’t have to keep calling your investors for dilutive capital to bridge cash runway or working capital needs. [For example], if you raise $10M, we’ll lend between 20% and 50% of that round without taking ownership of the company.” Interest rates are low in these deals. Since banks are lending the funds out, they aren’t looking for control but are in a senior position on the capital stack. They’ll also provide venture debt in the time after you’ve already raised venture capital.

“A lot of companies that have taken one or two big rounds will take a bank loan and use that money to bridge to profitability.”

For a lot of companies, this strategy makes sense. Loans typically last anywhere from 12 months to 3 years, with an option to renew once it matures in many cases. In that scenario, the companies are taking a line of credit where they will pay all of the interest until it’s due, and then make a decision to renew the loan or pay it off when they get their next round of institutional capital.

Companies that aren’t looking to take this approach have another option; they can structure a term loan where they pay down the debt with interest over time, just like an individual would pay down a car or home loan. This structure allows for startups to have more flexibility in when they raise their institutional capital, but can also be financially constricting.

In either case, startups get the opportunity to receive capital with advantageous terms despite being high-risk clients for banks. Why are the banks willing to take these risks?

The theory behind [venture debt] is that we as a bank would not lend to a startup because it is losing money, but because they have X, Y, and Z venture capitalists that have invested a sizable amount of money into the deal, the investors are incentivized to pay the bank back in order to get their capital back.”

In other words: venture debt is always paid back first. Legally, the company has to repay the loan, and if they do not, they risk being liquidated so the bank can reclaim its assets. Strong institutional investors want to protect the capital investment they made in the company, so they’d make sure that loan is repaid before getting to a point of liquidation.

Of course, this is the worse case scenario, though still a possibility. That’s why banks like Wintrust extend venture debt to companies that meet their own special criteria for success.

“We want to lend to companies and venture partners we are comfortable with. The relationship is important. Cash flow efficiency is also super important,” Bailey explained.

Namely, banks are taking on risky deals because they trust the parties involved — the companies and investors — and believe they will work together to lay out cash-efficient financials that will allow for loan repayment.

Banks also set revenue floors for a given industry to make decisions. Specifically, a SaaS company may qualify for venture debt once it hits $1M in revenue, but a product company that relies heavily on assets would need much higher revenues since capital costs affect cash flow and efficiency.

So far, Wintrust has done five venture debt deals, with another two in the final stages. This is part of a larger focus on entrepreneurship and innovation deals, which has involved Wintrust taking the unique approach of also doing equity investments. The bank has an allocation for equity and unlimited resources for debt. “The whole goal for us is a long-term relationship. We’re not looking for transactional relationships,” Bailey stressed.

Making equity investments and structuring venture debt deals gives Wintrust the opportunity to be supportive of the local business community (specifically, Chicago, Wisconsin, and Indiana) in ways other regional banks cannot, while also developing mutually beneficial long-term relationships.

Silver and Amaranth” via PhotoPin (license)