Last month, the OneEleven community heard from Tony Barkett, Managing Director at RBCx, about venture debt. Tony shared his view on what founders need to know and what RBCx looks for when helping promising businesses achieve scale.
What is the purpose of venture debt?
The purpose of venture debt is to extend the cash runway in order to allow a company to hit additional milestones and raise the next round of equity at a higher valuation. Ultimately, with a longer time horizon to achieve milestones that drive increased enterprise value without necessarily using equity dollars, existing investors retain a larger ownership in an acquisition or IPO by leveraging venture debt.
What are the general market terms for venture debt?
According to Barkett, there are some general market terms companies should be aware of for venture debt.
- Facility Type – Venture debt is a committed amortizing term loan, which means once a lender enters a loan agreement, barring unforeseen circumstances or material degradation of a business, it must fund within the draw period if requested by the company. Venture Debt is collateralized by an all asset lien which will generally have a Negative Pledge on IP (meaning a Company doesn’t have to pledge IP as collateral for Venture Debt, but can’t pledge the IP as collateral to another third party). Typically, venture debt offers 12-24 months of an interest only drawdown period with no requirement to borrow. Whatever is borrowed over that time amortizes over the next 30-36 months.
- Facility Amount – Venture debt typically represents 20-40% of a Company’s most recent equity round and is a supplement to equity, not a replacement. Amounts larger than this typically put unnecessary leverage on a growth-stage company, and the burden of debt service after the draw period may hamper a company’s growth or potentially be an impediment when attracting new investors in the next round.
- Economics – there are multiple drivers of cost on a venture debt facility:
- Upfront fee (typically referred to as a commitment fee) that will range from 10-20 basis points (bps) of the commitment amount.
- Interest rate will generally be mid-single digits (4-6%) depending on the competitive environment and other pricing mechanisms.
- Warrants for equity share – preferred or common (anywhere between 15-30bps of fully diluted ownership (FDO).
- Prepayment penalty equal to 1-2% of the drawn amount to be paid if the venture debt term loan is repaid early, typically within the first 3 years following closing.
- A final payment that can be utilized in lieu of other pricing mechanisms to reduce the up-front costs of putting a debt facility in place (generally 4-6% of total commitment amount).
- Covenants – Venture debt doesn’t typically have financial covenants (e.g. liquidity or leverage). They do have non-financial covenants, which includes Material Adverse Change (MAC) or Investor Abandonment (IA) clauses.
Why leverage venture debt?
By extending a company’s cash runway with venture debt, a Company can hit additional valuation milestones, which could include product development, hiring talent, investing in customer acquisition channels, geographic expansion, capital expenditure of hardware purchases, new product testing, etc. The more valuation milestones achieved, the higher the valuation will be in the next round. In addition, most initiatives take longer than originally planned, so venture debt can also act as an insurance policy, putting a company in the best position when seeking additional investor support.
What does RBCx look at?
Barkett further explains what RBCx looks at when financing companies:
From a financial perspective, they look at high growth rates – fast growing companies with achievable milestones – which better position the companies to raise the next equity round, as additional equity is underpinning the Bank’s underwriting to cash burning companies. RBCx also looks for increasing enterprise value as demonstrated by priced equity rounds or meaningful milestones being achieved given the desire to back growth stories. Strong or improving growth margins and cash runway of over 12 months without debt are also important factors.
On the qualitative side, they look at meaningful TAM (total addressable market), promising market share or brand recognition, significant IP or innovation, disruptive product or service, management team experience, and strong investor backing.
- Investor target profile & diligence
The investor(s) profile and their ability to help companies scale is extremely important, which includes the investor syndicate (number and quality of investors matter), firm expertise, firm reputation, partner expertise, and partner reputation. Companies are looking for more than a cheque when considering the right investment partner and we’re looking to better understand that dynamic to assess their ability to scale. They also look at the investor’s ability to compensate for an inexperienced management team.
For the fund dynamics, they look at size and age of the fund, reserve strategy (how much do they typically reserve), remaining callable capital, do they have the ability to cross-invest if needed, and fund track record to understand the investor’s capacity and willingness to fund.