From the book Straight Talk for Startups: 100 Insider Rules for Beating the Odds—From Mastering the Fundamentals to Selecting Investors, Fundraising, Managing Boards, and Achieving Liquidity by Randy Komisar and Jantoon Reigersman. Copyright © 2018 by Randy Komisar and Jantoon Reigersman. Published on June 5, 2018 by Harper Business, an imprint of HarperCollins Publishers. Reprinted by permission.
There are many types of debt. There are bank loans, leases, and venture debt, among others. Bank loans are usually reserved for later-stage businesses that have predictable cash flows and profitability. They have relatively low interest rates and favorable terms.
Leases are debt granted in conjunction with the purchase of assets that can serve as security for the loan. The lender may be the vendor, or a third party. The terms are attractive if the assets hold their value and are easily repossessed by the lender in the event of a default, though there are usually down payments and pre-payment and post-payment requirements that can add up. Fortunately for startups, the viability of the lessee is less important than the residual value of the assets.
Venture debt is a specialty loan provided to high-risk startups that aren’t yet profitable and may have very limited or nonexistent cash flows. Unlike leases, they can be used to pay for anything. They don’t offer the advantages of a security interest in the assets purchased, so the terms can be very expensive. And venture debt lenders often demand a security interest in your intangible gems, like your intellectual property, which will give them oppressive leverage in the event of a default.
The arguments for venture debt seem convincing: (1) it provides more time between equity rounds for extending your runway and achieving higher valuations; (2) it allows the owners to retain larger ownership stakes through lower dilution; and (3) by bringing additional capital earlier, it helps the company achieve milestones, and therefore liquidity, sooner for its investors. It may be used for factoring receivables (e.g., a cash advance for yet uncollected receivables) or financing working capital. It may seem even sweeter if the venture debt postpones any repayments of principal or interest for some time, even if like those “zero down, no payments until next year” car loans, they always come due eventually. In a perfect world, venture debt does have its appeal.
Needless to say, the world is not perfect, and you should preserve the option to pivot, refine course, and adjust milestones in response to the challenges and risks ahead. Venture debt locks you in. With the debt repayment overhang, changes may be impossible, because your investors are only interested in investing in the creation of new value, not paying old debts. At the very least, a venture lender can negotiate for more when you are in distress, because they control the cards.
Some ventures choose to pay the fees and grant the warrants to secure venture debt but then don’t actually take the cash down unless they see a clear opportunity for it, such as a bridge to a significant bump in valuation or a cash gap that needs filling. Be careful, however, about accepting a loan with the intention of taking it down later if things get difficult. Loan covenants such as strict material adverse change clauses (so-called MAC clauses, whereby any significant change in your business could result in your lender calling the loan due) or minimum-deposit rules or compensating balance requirements (which require you to keep sufficient money in your account with the lender to meet your debt requirements, effectively tying up the loan proceeds as collateral and netting you nothing) could mean that when you need the money most, you simply don’t qualify for it any longer. Caveat emptor.
If, after considering all the risks, you do decide to take venture debt, choose wisely. Terms are usually comparable, but the best terms don’t necessarily equate to the best deal. Terms include the interest rate, payment schedule, loan security, warrants to buy your stock at an advantaged price in the future, loan takedown conditions, and funding covenants, among other things. More important, pick a lender with a reputation for working with companies and investors when problems occur to help the business survive rather than to pull the plug—a so-called relationship lender.
In contrast to venture debt, if structured properly, venture leasing could provide a lower cost of capital with limited risk to the venture. Those expensive computers, desks, chairs, and pieces of production equipment can be paid for over time, by lease, rather than today with expensive venture capital.
Copyright © 2018 by Randy Komisar and Jantoon Reigersman. All Rights Reserved.
About the Authors:
Randy Komisar is the co-author of Straight Talk for Startups (HarperBusiness; 2018). He is a venture capitalist with decades of experience with startups. He is the author of the best-selling book The Monk and the Riddle, about the heart and soul of entrepreneurship, as well as numerous articles on leadership and startups. He is also the co-author of Getting to Plan B, on managing innovation, and I F**king Love that Company, on building consumer brands. He taught entrepreneurship at Stanford University and is a frequent lecturer at universities, as well as a regular keynote speaker on entrepreneurship, innovation and leadership. He joined Kleiner Perkins Caufield & Byers in 2005 to focus on early stage ventures. Prior to that he created the role of “Virtual CEO” to partner with entrepreneurs to help them and their businesses achieve their potential, serving as Virtual CEO for such startups as WebTV and GlobalGiving. He was a co-founder of Claris Corp., and served as CEO for LucasArts Entertainment and Crystal Dynamics. Randy was a founding director of TiVo and Nest. He served as CFO of GO Corp. and as senior counsel for Apple, following a private practice in technology law. He has also served on dozens of private and public company boards and advises such organizations as Road Trip Nation and the Orrick Women’s Leadership Board.
Jantoon Reigersman is the co-author of Straight Talk for Startups (HarperBusiness; 2018). He’s a seasoned financial operator with extensive experience in startups and growth companies. He serves as Chief Financial Officer of publicly traded Leaf Group (NYSE: LFGR), a diversified consumer internet company. Earlier in his career, he served as CFO of Ogin Inc., investor and member of Goldman Sachs’ European Special Situations Group and investment banker at Morgan Stanley in their mergers and acquisitions team. He also initiated and led the 9000METER expedition, the first expedition to attempt 9000 vertical meters on human power by diving over 152 meters below sea level and by climbing the summit of Mount Everest at 8848 meters. He is a Fellow of the inaugural class of the Finance Leaders Fellowship and a member of the Aspen Global Leadership Network.