Which form of venture debt should your startup go for?

Given the surplus of liquidity in the markets, entrepreneurs have access to more funding options than ever before. Venture banks, venture debt funds and venture capitalists are each jockeying to prove how their money is greener.

Nonetheless, each has constraints that dictate their behavior. While a venture capitalist may swing for the fences in each investment they make to get outsized returns, one home run can make up for nine strikeouts. Contrarily, most banks are playing Billy Beane’s Moneyball — they try to get the entire lineup on-base while making as few outs as possible in the process.

Think of capital availability as a spectrum, from low risk and low return (venture banks) to high risk and high return (venture capital), with venture debt funds sitting somewhere in the middle.

It helps to understand how venture banks make a profit: Essentially, they take deposits from one customer and lend them to another. Most banks currently collect a 4% interest rate from loans while paying less than a 1% interest rate to depositors, generating a margin of approximately 3%.

If we assume that a bank must also cover 2% of overhead for costs like employee payroll and rent, then it must collect at least $0.99 of every $1.00 loaned to generate a profit.

Despite the unscrupulous behavior of a few bad actors (see the Great Recession), the banking industry has a profoundly positive impact on economic productivity overall. More economic productivity means more taxes, so federal and state governments have a vested interest in greasing the skids and have instituted agencies like the Federal Deposit Insurance Corporation (FDIC) to help protect depositors and monitor banks.

The FDIC ensures that each bank under its regulatory oversight has a sound lending policy in place and operates within those parameters. That said, there is an exception to every rule, and borrower activity that may be deemed “too risky” by rigid underwriting guidelines may, in fact, be normal (or even desirable) in certain circumstances. For instance, increasing sales and marketing or research and development spend to leverage or develop a sustainable competitive advantage that will bear fruit in the future — even if that means foregoing profit and increasing burn in the short term).

Therein lies the rub: In the process of protecting depositors, rigid credit guidelines, thin margins and low risk tolerances can create challenges for borrowers operating in dynamic and sometimes volatile markets, often leading to undesirable outcomes.

In contrast, venture debt funds raise capital from investors who have a higher risk tolerance and appetite for return. In turn, such funds generally offer larger dollar amounts and more favorable repayment terms, debt availability, collateral arrangements and covenants than venture banks, albeit at higher pricing.

Further, venture debt funds generally want to deploy capital on day one (since loan-related activity is their only source of income), while venture banks may be motivated to provide unfunded loan commitments to attract deposits. Again, banks take deposits from one customer and lend them to another to make a profit.

Depending on the situation, this latter dynamic may or may not benefit a borrower. Here are three cases to illustrate which source of debt capital makes the most sense for a startup at various points in its lifecycle:

Use case 1

Startup X recently raised a $20 million Series A that is expected to provide at least 18 months of runway. The startup doesn’t have an immediate need for additional capital, but its CFO might sleep better at night knowing that he could access more money later if necessary.

In this instance, a venture bank might commit a $5 million loan (representing a 25% debt to equity, a comfortable ratio for most venture banks) available over an 18-month, interest-only advance period. The loan would be repayable over 30 equal monthly payments of principal, plus interest.

Startup A may never draw on the loan and still give up some fees and warrants, which work like stock options, in the process, but it still gains peace of mind and negotiating leverage in advance of a Series B. In other words, the CFO doesn’t necessarily need to raise additional equity dollars in 18 months, because Startup X has access to debt that would extend runway for another six months. This would prevent VCs from taking advantage of the situation with a lower valuation or more onerous terms.

Just remember that you generally get what you pay for. Possession is nine-tenths of the law, and venture banks may not be obligated to lend if the borrower is materially off-plan.

Use case 2

Startup Y has a profitable B2B software business generating annual revenue of $50 million while growing at 25% year over year but needs to redesign its back-end infrastructure to keep up with the competition. Existing debt arrangements with a venture bank have covenanted to ongoing profits to repay outstanding principal, but waiting to invest in a technology overhaul now will likely result in long-term value erosion for management and shareholders.

In this instance, a venture debt fund may be able to refinance the venture bank to provide debt service relief and incremental capital to cover projected engineering expenses until Startup Y can return to profitability. While the interest rate is marginally higher, the enhanced valuation achieved by maintaining market share would likely exceed the incremental cost of capital.

Use case 3

Startup Z is growing at 100% year over year and recently launched a new product that is clearly differentiated from the competition but requires sales and marketing investment to build market awareness.

Venture banks are willing to provide a line of credit to support the working capital needs of the legacy business, and venture capitalists want to preempt the next round to support the emerging business but at a valuation that management doesn’t think accurately reflects its potential.

In this instance, a venture debt fund can partner with the venture bank by providing subordinated debt that is more flexible than the working capital line but less expensive than venture capital such that management and existing investors get to have their cake and eat it too.

Selecting the wrong capital partner at the wrong time can result in excess cost or (worse) material business disruption, so find an experienced lending professional with a track record for operating with a steady hand.