MARKETING

SaaS Founder’s Guide to Venture Debt

How Venture Debt Helps Founders Grow Their Businesses

Founders of SaaS businesses often look only to equity to finance their start-up and early growth. Perhaps they are unaware of or are not appreciative of the value of venture debt financing, which is complementary to venture financing. Using this venture debt guide, we explain the basics, as well as the advantages and disadvantages of venture debt, so you can decide if it is the right decision for your SaaS business.

What is Venture Debt?

In spite of the term venture debt, the terms and mechanics of the financing are similar to loans used today by many businesses to finance growth: term loans wherein the entire principal is drawn down at closing and paid back in periodic installments, and/or revolving lines of credit where the principal is drawn from time to time with interest paid monthly on the outstanding principal. During the term, the principal can be repaid and drawn down again. The traditional term loan and line of credit are typically used to finance working capital and/or capital expenditures for businesses that are cash flow positive. The latter is tailored to businesses burning cash, but with a plan to achieve profitability and fast-growing revenue. Rather than raising capital, which will dilute the founder's share, venture debt can provide a non-dilutive form of financing - or perhaps we should say one that is less dilutive. Occasionally, venture debt will be accompanied by warrants which give the financier the right to purchase equity (we will talk about warrants later). Dilution will occur through the equity purchase, but it will be significantly lower than if we went through another equity round. In addition to equity financing, venture debt financing can be valuable when used in conjunction, but is not always the best option.

When to Use Venture Debt

Almost all early stage, fast-growth businesses utilize both venture capital and venture debt financing. By obtaining venture debt, the founders can defer raising equity, allowing them to improve revenues and move towards profitability. Thus, leading to a higher valuation, and, therefore, a reduction in dilution from fewer equity raises. It is most beneficial for a SaaS company to use venture debt when it needs to build its product, acquire new customers, and grow its subscription base. Generally, commercial/retail lenders won't lend to companies with no free cash flow, and when they do, the credit given for the base (revenue, receivables, subscriptions) against which the loan is calculated is at the lower end, i.e. 2-3x the monthly recurring revenue of a SaaS business as opposed to 7-8x available from a venture debt lender.

The advantage of venture debt is that it can be used to avoid equity financing, increasing the value of the business and limiting dilution to existing shareholders, and:

  • Reaching an important milestone requires funding
  • Fund an acquisition that will add value
  • Revenues are rapidly increasing, cash flow doesn't cover expenses, and break-even is forecasted within 12 to 18 months

When Not to Use Venture Debt

It is not always a good idea for SaaS businesses to take on venture debt. Taking on venture debt might not be beneficial if:

  • The business is in need of cash, but has insufficient backing from existing shareholders, leading a venture debt lender to question the support from shareholders and management.
  • The purpose of this debt is merely to finance working capital
  • The business does not plan to increase revenues to support repayment of venture debt and to break even within 12 to 18 months or to be cash flow positive
  • If a business generates predictable, stable or increasing revenue, as well as profits (FCF), developing a revolving line of credit or a term loan from a commercial or retail lender might make more sense

Advantages of Venture Debt Over Equity

Let's say you're thinking about seeking venture debt. Let's examine some of the benefits of venture debt.

  • Valuations are not required. If, for example, market conditions have temporarily damaged sales and the business is underperforming, it will not negatively impact its borrowing power.
  • Vendor debt will help bridge the gap between available equity financing and what a business needs in order to succeed
  • Prevents dilution of existing shareholders interest in the business
  • Maintains founder's control over strategy and operations
  • Funds are available much sooner than through equity financing
  • A venture debt lender is unlikely to require board or observation seats
  • Increases cash runway between equity rounds
  • Liquidity is enhanced
  • Reduces capital expenditure

Disadvantages of Venture Debt Over Equity

Positives are often accompanied by negatives. Let's consider venture debt's downside.

  • In the event that you default on your venture debt or if the business fails, the lender may attempt to liquidate all the assets of the company.
  • However, venture capital allows the holder (the venture capital firm) to recoup the founder's equity and eventually reduce the other existing shareholders' interest in the business to a minimal amount if the business fails to meet financial and other targets.
  • Although not as expensive as equity in terms of ownership, venture debt does not come cheap.

How to Choose the Right Venture Debt Partner

  • Handling of distressed borrowers, restructured borrowers, or those with unique capital needs in the past. References from past clients.
  • For lenders, the following priority criteria must be met: senior debt funded at 6x MRR or junior debt funded at 18x MRR, or a unitranche loan combining senior and junior debt
  • Willing to subordinate to the senior lender to optimize your borrowing costs
  • The ability to draw funds as needed rather than all at once increases capital efficiency
  • Payments are interest only with repayment of the principal at maturity
  • Prepayment is flexible with reasonable prepayment fees. As well as interest, there are often set-up fees, admin fees, standby fees, prepayment fees, warrants, and an advance fee each time funds are disbursed under a loan facility.
  • Credibility of a lender
  • Negative covenants and/or reasonable financial covenants

What does the Venture Debt Process Look Like?

Step 1: Screening

  • An introductory call between the borrower and the lender.
  • Review of financial information, including historic financial data, forecasts, and economic data.

Step 2: Term sheet

  • Establish and negotiate the substantive terms of the contract.
  • Side note, it’s advised to review the term sheet early in the process.

Step 3: Diligence and Approval

  • Pitch the proposed loan to its credit committee. As part of its diligence, the committee will examine the borrower's business, finances, and operations.

Step 4: Legal and Funding

  • Documentation is prepared for funding and legal purposes. All legal fees, both the borrower's and the lender's, must be paid by the borrower. Once the loan documents have been completed and the security is registered, the funds will be released.

Step 5: Portfolio Management

  • The lender will require monthly financial statements and year-end operations reports that include relevant metrics. It is important to a borrower that a lender understands his or her business and gives appropriate guidance when necessary.

Step 6: Exit

  • The borrower pays down the entire loan in full, perhaps by refinancing or raising capital, or perhaps by selling the business.

Conclusion

Venture debt financing can be an attractive, non or less dilutive source of financing as opposed to an equity raise) for SaaS companies which are burning cash to fuel rapid growth.