Busting the myths of venture debt: when and how to use it to fuel growth (and why it's not a company killer)

Author: Antony Baker, Principal at Claret Capital Partners

“Venture debt is a killer”, “venture debt should not exist”, “companies should not draw venture debt…”

Recently, there have been various public, blanket, statements on venture debt, mostly by investors and management of companies that have become insolvent after taking it on.

What these statements neglect is that it is not the debt itself that can be problematic: it’s when, where and how it is deployed that can be detrimental. Both the investment timing and structure – where lenders, investors and companies all play a part – can be the issue.

At its core, the scenario is as follows: (1) entrepreneurs dislike dilution and will take steps to avoid it, (2) lenders are incented to lend money.

In the middle you have venture debt, which when used at the right time and in the right quantity, is a powerful tool that can make a big difference to the dilution suffered by founders and early-stage investors when used to fuel organic growth and finance M&A.

At the same time as lowering the cost of capital, venture debt allows management and shareholders to optimise the timing of future capital raises, maintain governance and control, and benefit from the lenders’ extensive network.

Used the in wrong way debt can hurt a business. It’s pretty difficult to damage a company with the capital injected via equity (although of course what is done with that funding could do so!). But what is the “wrong way” to apply venture debt?

Too soon

Companies that are very early in their journey - whilst exciting, high growth and great equity investments - might not always be the best home for venture debt.

Without scale, a solid (ideally repeatable and growing) customer base to validate the product, pricing power and product market fit, the company is likely to have the wrong risk profile. There may not be enough data points to suggest the business will scale and reach a level of maturity or steady state to service the debt comfortably.

Too much

Debt is not equity and should not be treated as such. Too much debt becomes problematic when repayments kick in – and even more so if the business loses momentum and growth, or cannot maintain efficiency.

Repayments will be out of kilter versus revenues and the company’s cost base. So whilst bumper cheques in comparison to revenues might seem appealing on closing days’ bank balance, they might look like an ugly balance sheet burden 12 months later.

Whilst it is cheaper, debt is not as flexible as equity (it needs to be paid back!) – so the pathway to repayment should be given just as much focus as how much should be raised (the two are linked in any case).

Common routes to repayment are through cashflows (or at least manageable payments versus monthly revenues and OpEx), proceeds from equity fundraising, refinancing or M&A (the achievability of which are all generally dictated by scale, growth, and efficiency). Understanding how, and how much can be repaid, and what cash burn will be, should be key considerations. 

Too risky

The benefits of anti-dilution and maintained governance from using venture debt are most enhanced in the strongest performing businesses. On the contrary, companies that are ex-growth, flat or shrinking, and/or companies with very high burn, might not be suitable candidates. And structurally loss-making businesses? Not suitable for venture debt. It will only make a weak situation worse.

It should be well noted that venture debt is not the capital of last resort (as it may have been incorrectly assumed to be in years gone by) – for example, it should only be used in situations where a business could raise equity, but either chooses not to, or opts to compliment part of an equity round with some less dilutive capital. 

So two things are important when structuring a debt deal: one is quantity and the other is timing. Too much debt and you have a problem. Take it on too early and you have a problem. The lender offering you more debt may no longer be your friend and may not be around when the deal becomes difficult. But the debt will be.

So when should it be used?

Deployed responsibly into the right situations, venture debt is an excellent tool to help fuel organic growth or M&A in a less dilutive way. And when used correctly it should enhance enterprise valuations at a much lower cost, and result in a positive outcome for all stakeholders. 

There are multiple use cases in which venture debt suits. Often it is used to support organic growth, funding the burn of a business so that it grows its revenues as quickly as possible, and therefore scales the enterprise valuation of the company.

In other situations, it might be used to fund M&A, where the leading tech players in a market look to consolidate others and finance the acquisition of such targets without raising equity. To date, at Claret Capital Partners, we’ve backed over 180 companies – including the likes of Butternut Box, Quantilope, Deciphex, and Paysend - supporting each one in various situations like this. 

The slightly more nuanced bit – and where a lot of focus is pointed – is in selecting the right timing. There is typically a time in every growth tech or life science business where it should have access to alternative forms of capital aside from equity, to support its growth before turning profitable or exiting. 

Most companies will have multiple events along the way where they need to raise capital – and at certain points, they should be able to unlock alternative, less dilutive financing options to equity – either reducing their dependence on equity or substituting an equity round entirely. 

At a high level (although there are exceptions) businesses that are the right fit are those that are revenue generating, with a track record of sustained revenue growth, and have good business models with strong margins and ideally a decent level of forecastability.

The majority – but not all – of these companies are VC or equity-backed.

Sensible amounts, at the right time, in the right companies - that is the path to lower dilution, and where venture debt is not a killer.