The Best Strategies for Raising Venture Debt: A Comprehensive Guide
The optimal timing for raising venture debt is just before or just after a round of equity financing. This window of opportunity allows you to leverage strong momentum in your diligence materials and benefits from positive financial projections. Venture debt can serve as an excellent supplement to required equity while minimizing equity dilution. It is a short- to medium-term debt, typically up to three or four years. The standard permissible principal amount is approximately 30% of the total amount from the most recent round of equity financing.
Understanding the Variety of Venture Debt
It is important to note that the nature of venture debt can vary significantly depending on the firm you are working with. For example, when working with banks, you might encounter thinner pricing in all-in terms but a more structured deal with covenants. Traditional venture debt firms, on the other hand, may offer a different pricing structure tailored to their borrowers. This variety highlights the importance of understanding the specific terms and conditions offered by each lender.
The Growing Venture Debt Industry
The venture debt market remains a relatively small industry, with approximately $2 billion lent annually. Despite its modest size, finding the right venture debt firms has become easier, as there are approximately 15 active firms in the United States. Identifying these firms and receiving term sheets is the first step in the process. Once the firms are identified, the next challenge is to choose the right one. How do you decide?
The wrong approach is to focus solely on the internal rate of return (IRR). Entrepreneurs should prioritize choosing a lender based on their reputation and their workout strategy. If your company is on the verge of failure and out of cash, the lender's response to difficult situations will be crucial. Therefore, it is advisable to perform reference checks on potential lenders early in the process.
When evaluating the terms of the deal, it is also important to look at the deal from the entrepreneur's perspective rather than the lender's. A common method is to use a discounted cash flow (DCF) model, which assesses the cost-benefit of the deal considering the unique time value of money of your company. Another approach is to examine the balance of the financing at your flame-out date when you run out of cash and compare the economic costs to that balance. These methods can provide a more accurate picture of the deal's impact on your company.
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In conclusion, raising venture debt is a strategic decision that requires careful planning and consideration. By understanding the terms, evaluating the lenders, and assessing the deal from your perspective, you can make an informed decision that will benefit your company's financial health.