Growth Stage, Technology

Venture Financing –
Venture Debt

David Litwiller

December 2010
 Overview
 Venture Lender (VL) – Definition
 Main Purposes of Growth Stage Venture Debt
 Model Venture Debt Scenario
 Typical Venture Lender Business Model
 Contrast with Venture Capital (VC) Business Model
 Venture Capital – Venture Debt Interactions
 Why VCs Generally Don’t Extend Venture Debt
 Due Diligence Questions for a VL
 Pivotal VL Risk Management Issues
 Board of Directors Issues
 References and Resources
 Venture Lender (VL)
 Provides secured debt to a Venture Capital
backed business
 Security is typically fixed assets, IP, or
receivables, and in some cases, shares
 Main Purposes of Growth Stage
Venture Debt
 Defer or forestall further equity venture capital investment
1. If further equity venture capital financing will likely be required, to delay
that event, related dilution and obligations for valuation, and terms
negotiation while near-term performance objectives are achieved that will
de-risk the business and investment thesis. Mid-milestone equity funding
negotiations can be very competitive and tense

2. To build cash strength on the balance sheet in advance of an equity funding

round or closing a major customer deal, to show prospective incoming
investors or customers that the company has strength and staying power.
Inbound investors and customers are often more influenced by assets than
liabilities

3. As a final bridge to self-sustaining cash flow. Especially for later stage

entities, there can be a lot of earlier on-boarded investors with a seat at the
table to make valuation and terms cumbersome to negotiate for a new equity
round
 Model Venture Debt Scenario
 Extend the equity funding runway by six to nine months, so goals of
significance over that time can be achieved to lower the risk profile and
enhance valuation

 Clear milestones during the extended runway, in technology, market

development, revenue, regulatory approval, etc.
 No “bridge to nowhere” scenarios

 Entrepreneur, management and earlier-round investors avoid dilution by

delaying the next equity round, maintaining focus on near-term execution

 VC gets higher returns because they’ve put less capital to work and acquire
more information before making subsequent funding decision

 VL gets returns from interest and warrants, and recovery of capital

 Typical Venture Lender Business
Model
 Seek mid- to high-teens percentage annual returns, plus warrant coverage
in the vicinity of 5% to 15% of the loan value

 Capital loss in less than 5% of investments

 VLs lending to earlier stage enterprises tend to favour amortizing loans,

where principal is repaid throughout the term of the loan, reducing
exposure over time when investee risk is relatively high. Loans are
typically in the $500K to $5 million range.

 VLs lending to later stage entities will more often provide bullet/balloon
loans, where the principal is repaid in a balloon payment at the end of the
loan, since investees have a relatively lower risk profile for outright failure.
Liquidity exits are comparatively much closer in time. Loans are typically
above $5 million, with the ability to syndicate much larger amounts.
 Contrast with Venture Capital
Model
 VL seeks 12% to 20% annual returns from each
investment, with few outright failures. VL is looking
for return of capital in two to three year years
 A game of singles and doubles
 VC seeks 35% to 70%+ annual returns from each
investment, but is able to tolerate failures of 50%+ of
investments, and is generally able to stay in its
investments longer, often four to seven years for an
earlier-stage VC
 A game of home runs
 Why Venture Capitalists are Often
OK with Involving Venture Debt
 Improved calculated Internal Rate of Return (IRR) for
VC
 IRRs are typically calculated based upon when funds are
dispatched, not committed
 Deferring capital draws from the VC fund improves
scoring and VC compensation

 Buys more time and more information until next VC

funding commitment needs to be made

 Supplements VC’s reserves

Why VCs Sometimes Chafe with VL
 Next stage equity investors will sometimes complain
about paying for the then current enterprise plus debt
valuation, and discount the value of the debt that it
took to complete recent milestones and achieve the
valuation
Why VCs Generally Don’t Provide Venture Debt to
Existing Portfolio Companies
 Venture debt target returns are significantly more
modest than the target returns of venture capital

 Equity investing and lending in the same investee can

create conflicts
 Governance and fiduciary
 Self-interested transactions

 Time and difficulty of coordinating loans with other

equity investment syndicate members
Some Due Diligence Questions about
a Venture Lender (1)
 Flexibility the VL has been able to provide to past debtors
when there were problems, and payment terms had to be
extended or otherwise modified mid-stream
 The VL’s track record under foreclosure situations for keeping
management in place during the process and shielding other
creditors, to buy time to arrange a sale or raise additional
funding. The probability of a sale is much higher with the
incumbent management team in place
 Past exercise of Material Adverse Change (MAC)/subjective
default clauses. These are triggered by setbacks in the
business, and can give the VL the right to freeze the assets of
the business, amplifying any down-side technical, execution,
or market risk
Some Due Diligence Questions about
a Venture Lender (2)
 The VL’s involvement with invested VCs in other businesses
 If they are working together elsewhere, it often helps encourage good
behaviour
 Sometimes though, relationships between involved VLs and VCs in
other companies can lead to reciprocity equalizations between them
being settled up in your company
 Whether the VL has its capital from its investors, or only
commitments
 Whether the VL is levered, relying on its own debt facility to
fund deals
 Whether the VL has investment decision authority, of whether
its investment committee seats are held by its investors
Pivotal VL Questions about Risk
 For earlier stage enterprises: Are the VCs that already invested
likely to fund the next equity round?
 If they are, the risk of the VL being repaid is substantially lower than
without
 As well, the VL typically leans significantly on the due diligence
already performed by the VC
 For later stage enterprises: Does the company and its
management have a track record of execution success and
meeting projections?
 If they do, the risk for the VL is much reduced than if recent execution
has been patchy
 If the business has to be sold for assets, are there assets and an
identifiable marketplace where sufficient funds can likely to
be recovered to repay the VL?
 Highlight Board of Directors Issues
 If a business reaches the zone of insolvency, the
obligations of fiduciary management and the board of
directors begin to shift from protecting assets to
paying creditors
 Many growth stage businesses are in the zone of
insolvency much of the time, since the classic test of
solvency, that is being able to pay obligations as they come
due, can fluctuate widely and quickly
 A more relevant test for earlier stage businesses is often if
the chances have diminished of being able to access
additional VC financing
 Reference and Resources
 “Debt as Venture Capital”, Darian Ibrahim, University of Wisconsin Law School, paper 1081
http://www.bus.wisc.edu/INSITE/events/seminars/documents/IbrahimDebtasVentureCapitalS
ept2009.pdf

 www.wellingtonfund.com

 “Venture Debt: Device Financing Lifeline or Anchor?”, Stephen Levin, In Vivo, March 2008,
article 2008800052
http://www.westerntech.com/news/Venture%20Debt%20-%20InVivo%20April%2008.pdf

 Silicon Valley Bank

 About the Author
Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise software
developer in Waterloo region.

He most recently was in progressively more senior R&D, marketing and M&A
executive roles with DALSA Corp. Published in 2008, Mr. Litwiller is the author
of “Rapid Advance - Mergers & Acquisitions, Partnerships, Restructurings,
Turnarounds and Divestitures in High Technology”

http://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/
dp/1439200874/ref=sr_1_fkmr0_1?ie=UTF8&qid=1290108813&sr=1-1-fkmr0