Finding the right financing for your company is one of the most important jobs for a CEO. For many high growth companies, this means navigating the maze of raising equity capital via friends and family, angels, or institutional venture capital firms. As companies mature, it is often a smart idea to consider debt as an alternative source of capital to most efficiently capitalize the business. While there is quite a bit more written about raising VC money than raising venture debt, I have previously discussed many of the more theoretical aspects of the debt side of the table. In this post, I hope to lay out some very practical and actionable steps to consider as you look at debt as a financing option.
1. Figure out If you can support debt
For many pure startups, debt financing is not going to be an option. Debt providers are in the business of figuring out how they can get their money repaid. Thus, they typically look to things like operating history, a proven ability to generate positive cash flow, or hard assets as sources of repayment. The caveat to these traditional measures is high growth companies that have raised material amounts of institutional equity capital. Venture lenders will often look at the probability of a company raising additional equity as a source of repayment. It’s all part of the implicit contract between lenders and VCs.
When considering whether your company can support debt and at what levels, it’s important to think like a lender.
- What will you be using the funds for and what will be the sources of repayment? As a general rule, debt providers are willing to provide debt up to a certain fraction of the total equity (25-50%) for companies that are still burning cash but backed by high quality investors.
- If you’ve raised equity and want to layer in debt to extend runway to the next round, what are the milestones that you will need to accomplish to get there?
- If you’re hoping to manage a working capital gap, who are your vendors and what is their credit worthiness? For true working capital financing needs there will likely be many options from banks, specialty finance groups and other short term lenders but the cost and administrative overhead will be dependent upon the fundamentals of the business as well as the types of customers and contracts.
- How much cash do you have in the bank and how much is your burn? What’s your worst case number of months of runway (because this is how a lender has to think).
- If you’re generating positive cash flow, what level of comfort do you have with leverage against your annual free cash flow? Debt can be much less costly than equity but comes with certain strings attached, namely a first position security interest in the company.
As a final point, the best time to raise debt is exactly when you don’t need it, particularly right after a round of equity financing. This is when you’re likely to get the best terms and it usually makes sense to think about debt and get a structure in place before you absolutely need the funds.
2. Be prepared with the right materials
Different lenders will have differing needs in terms of diligence materials but below is a list of items that are fairly standard:
- Annual audited financials for the 2-3 most recent years: Lenders will ask for company prepared materials if you haven’t yet performed an audit (but will require an audit going forward). In addition to verifying numbers, lenders will often use the audit to understand the revenue recognition dynamics of the business as well as any notes related to the balance sheet.
- A financial model for the next 12 months: Lenders love to see detail, so to the extent that you have a model which breaks out revenues and expenses by month (or quarterly) that is a plus. Experienced venture lenders are used to looking at models and hair-cutting based on our experiences (we know they are often collections of guesses) but it’s imperative to understand what expectations are for the company.
- Cap Table: Lenders will want to know who the equity holders are and how much skin they have in the game, especially if they are looking at additional equity as a meaningful piece of the risk equation.
- A recent Accounts receivable and Accounts payable aging: Especially if you’re looking for a true working capital line of credit.
- A crisp powerpoint deck which highlights what the company is doing is a plus. Most likely this is the deck you used to raise equity. It can help with underwriting and with getting internal decision makers aligned with who you are - and thus able to better structure a facility which meets your needs.
3. Get feedback from multiple lenders
While I would of course love for all entrepreneurs to only come to my favorite venture lender (and employer!) Square 1 Bank, it just makes sense to get multiple looks. In particular, it’s important to focus not just on price but the following:
- Ablility for the lender to understand your business and structure a loan facility that makes sense. Does the borrowing availability allow you to gain real leverage?
- Ask the lender for some references from other entrepreneurs who they’ve worked with and make a couple reference calls. If you do, ask if the reference has ever been through a situation in which they tripped a covenant and see how the lender reacted. You can also ask your venture investors of their experiences, as lenders tend to have multiple relationships with many firms.
- Communicate expectations and desires up front. To the extent you can be transparent about your desires from a facility, it will allow the lender to be equally transparent and get to an efficient outcome for everyone. This is especially important when you get into docs and negotiate the finer points of the legalese - starting from a foundation of openness helps to make this much less painful.
In summary, take a holistic look at your company and it’s needs and figure out if debt is appropriate. Once you do, you can go ahead and get the majority of your diligence materials together ahead of time. Then, through transparent communication with multiple lenders you can set yourself up for a easy close and capital to grow your company.
Postscript: As is inevitable in any summary such as this, there are exceptions to every rule and it goes without saying that each deal is different, both from the lender and company side. With that said, I think this represents a general framework for how to go about raising venture debt.