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When should you get venture debt, and how is it different from venture capital?

Written by: Mercury

Whether you’ve raised venture capital already or you’re thinking about raising soon, venture debt might be something you’re curious about — and for good reason.

Let’s start at the beginning: What is venture debt? Venture debt is a type of financing designed to meet the needs of high-growth companies that are also venture-backed.

Eligibility-wise, if you’ve never raised an equity round from institutional investors, then venture debt doesn’t make sense for you right now. If you have, you’re in a better position to raise venture debt if your most recent equity round was within the last year — the more recent that round, the better.

Say you’ve just closed an equity round to fund your company. With all those equity dollars in your bank account, your next thought likely won’t be to get your hands on even more capital. However, this is exactly the right time to secure venture debt: before you actually need it. You’d be extending your runway at a low cost of capital, topping off the equity round you just raised with up to 50% more cash, and buying precious time to grow your valuation ahead of your next dilutive equity round — all on your own terms.

When providing a loan, venture debt lenders take a very small equity stake in the form of a stock warrant, typically amounting to less than 0.50% of the fully diluted shares, and significantly less dilution than the dollar equivalent in equity raised. A warrant functions as a promissory note that allows the lender to own a certain amount of common stock — as opposed to preferred stock — priced at the company’s valuation in the event of an exit.

Venture debt can be thought of as less like a loan and more like a fundraising tool that can complement equity. If the first rule of raising venture debt is that you need to have raised venture capital already in order to qualify, then the first rule of venture capital is: Don’t get it without considering venture debt, too. Features of venture debt and venture capital

Here are four things to know before deciding whether using venture debt to augment venture capital makes sense for your company:

  1. Will lenders loan to my company at my current fundraising stage?

  2. What performance metrics are lenders looking for in a venture debt prospect?

  3. How much capital does my company need?

  4. What can I use debt capital for?

1. Will lenders loan to my company at my current fundraising stage?

Since venture debt requires a preceding venture capital raise, your company’s fundraising stage will help determine your eligibility. Some lenders have different stages or round sizes they prefer, but most are looking for companies that have at least raised a few million dollars from a seed round led by an institutional investor.

You should begin the venture debt process either alongside or shortly after an equity round, when your creditworthiness and bargaining power are at an all-time high, and when you’re likely to still have most of the capital you raised sitting in your bank account. Recognize that lenders will loan to you based on whatever amount of that round you still have left.

Roxanne Bras Petraeus, the co-founder and CEO of Ethena, had been hearing for a while that raising debt could be a smart move from an optionality perspective — in fact, fellow founders had told her that it could benefit companies that were as early as Series A. She eventually opted to start raising venture debt from Mercury for Ethena, a compliance training platform, right after its Series B.

On how she came to this decision, Roxanne explained, “As companies grow, so do the number of paths they can take. Having those options often requires you to plan far enough in advance. For us, it just seemed like the right time.”

Don’t wait too long after raising venture capital to secure venture debt — you might expose yourself to execution risk, which can occur if key developments or performance milestones remain delayed or unmet. This will ring alarm bells for lenders, who may question the strength of your company’s investor support.

2. What performance metrics are lenders looking for in a venture debt prospect?

Venture debt lenders follow many of the same signals as their investor counterparts when determining whether a company is credit-worthy. But for lenders, the selling point of your company may not necessarily be the potential of your idea or even your future profitability — it’s your likelihood of repaying the loan.

A lender’s goal is to provide you with enough capital to significantly extend your runway so that you can continue growing, achieving milestones, and increasing your valuation without having to worry about diluting your equity. So while they won’t require an assessment of your company’s valuation during the diligence process (like what your VCs asked for), they will want to see realistic cash flow projections that detail how their money will be used and when it will be returned.

Venture debt lenders will also look at the track record of your current investors and board members as an indication of your startup’s health. Some questions that might be on your lenders’ minds include:

  • Does your cap table have solid representation from institutional VCs?

  • Have any of your investors played a part in helping their portfolio companies reach their milestones?

  • Are your board members making decisions that benefit your startup?

Having well-established VCs will signal to lenders that your startup is built to last.

For Diego Salas, VP of Finance and founding team member at Yummy, a food delivery app-turned-commerce platform for merchants and their customers, raising venture debt fresh off the heels of raising venture capital was eye-opening.

While he felt that both his investors and lenders were aligned with Yummy’s best interests, the venture debt process seemed to have a particular emphasis on the company’s sustainability. The types of considerations Diego and Yummy's CEO, Vicente Zavarce, were prompted with included whether Yummy would meet the metrics it set out to meet, how to plan for a scenario where it didn’t, and how its legal structure would be impacted in either outcome.

3. How much capital does my company need?

Before raising a round, consider the total amount of outside financing you need to meet your goals. Unlike venture capital, there is a limit to what you can raise with venture debt — lenders typically commit somewhere between 25–50% of your last equity round in debt capital, with terms structured to last around three years. You can decide to use it as either short-term capital (for capital needs that last less than 12 months) or long-term capital (for capital needs that exceed a timeline of 12 months).

Knowing this, you can make a calculation of how much financing you want to raise from venture debt and venture capital, respectively, depending on how much equity you’re willing to part with. Diego recommends taking an 80/20 approach to your capital structure — 80% equity and 20% debt. According to him: “The great thing about venture debt specifically, is that it's debt that you might not even need to take out. If you do it as part of a credit facility, then the debt is optional. You decide how much to take on depending on market conditions and your needs that arise — and some of those might be unforeseen.”

4. What can I use debt capital for?

Like venture capital, venture debt can be used for virtually any business expense. In most cases, venture debt also doesn’t require any financial covenants, which are agreements that entail performance objectives a company must meet in order to prove its continued creditworthiness. In this context, venture debt is as close to equity capital as any debt option available.

Since venture debt has a shorter repayment horizon, a lender may opt to restrict certain activities — like acquisitions, capital expenditures, and stock repurchases — that would jeopardize the company's ability to meet scheduled repayment terms. Venture capital takes a longer view, so the use of funds is fundamentally expected to be riskier in nature.

Venture lenders provide debt capital with a business' equity interests in mind — they expect that money to go towards growth activity. That said, the familiar caveat is that every lender is different and may even limit their loans to specific use cases (e.g., equipment, working capital, etc.). It's up to you as the founder to collect all the pieces of research you need in order to arrive at the best decision for your company.

Yummy ended up raising venture debt from Mercury after its Series A+. For Diego, the rationale for pursuing venture debt was a combination of avoiding too much dilution and wanting access to liquidity for their balance sheet.

“We didn’t know how long the market downturn was going to last, and so for us, venture debt was a way to get financing where we wouldn’t necessarily affect dilution as much, and where we can essentially pull capital as we need it. So we don't have it on our capital structure right away, but just as time goes by.”

Whatever the purpose of your capital ends up being, it will be prescribed by your venture debt term sheet, which includes the structuring, pricing, and duration of your loan. So while the possibilities for what you can use debt capital for are endless, you will need to agree upon a set of business objectives with your lender. The good news is that you can apply for repeatable loans, and working with the same lending partner can give you the option to refresh your loans with each subsequent raise.

At the end of the day, venture debt and venture capital are complementary funding mechanisms. When deciding whether to use each one, Roxanne advises companies to talk to people who have long-term visions. “Get advice from people who have seen your company a couple of stages ahead.” These stakeholders might inspire questions like: “What will we be like as a Series C or D company, and what things would we want to do now to set us up for success there?”

When you’re not sure, her advice is to talk to your advisors, “in particular, the ones who are very financially savvy and can walk you through a model or why you want to opt for one thing or another — because this decision benefits from specialized knowledge that shapes when to pursue one over the other.”

If you’re interested in learning more about Mercury’s Venture Debt product, click here.

Mercury is a financial technology company, not a bank. Banking services provided by Choice Financial Group and Evolve Bank & Trust®; Members FDIC.

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