Note
- Venture debt is not venture capital, but plain old bank debt that needs to be repaid with cash, and entrepreneurs need to understand the details before signing on the dotted line.
- Entrepreneurs should ask themselves five questions before taking on venture debt: how much will it cost, how will it be repaid, can solvency be maintained, what happens if it can’t be repaid, and is the debt worth the value it will bring?
- Venture debt can lead to insolvency and loan recalls if covenants are not met, and banks have the legal right to demand immediate payment if the company becomes insolvent. Entrepreneurs should be cautious and fully understand the risks involved.
Highlights
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2025-01-10 15:19 Let’s start by clearing up what venture debt actually is. Many entrepreneurs hear the term and think it must be something similar to venture capital.
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2025-01-09 22:44 The term venture debt says seems to have been coined by Silicon Valley bank in the 1980s. SVB made their mark in their early days by being the banker of choice for venture backed startups.
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2025-01-10 15:19 They believed that lending to venture backed startups was a safer bet than lending to just any old startup because they figured that we VCS did a lot of diligence before we invested and we tended to pick the winners. Plus the money that we VCS invested would ultimately be junior to their bank debt, meaning that the VCs wouldn’t make anything until the bank got paid back first. So the bank believed that if the company got in trouble, the VCs would put more money in to support it, making that bank loan even less risky. And they were often, though not always, right about that. Although we VCs would have no direct obligation with respect to bank debt given to portfolio companies.
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2025-01-10 15:19 The bank also wanted at least verbal assurance from us that we would be there to support the company if things went sideways. They’d call the VC investors as part of their diligence process and ask us not only lots of questions about the company, but also about our commitment to the company, including how likely we were to invest more money and even what kind of financial reserves we had earmarked to do so. But again, just to be crystal clear, the actual debt contract was between only the startup and the bank, and its terms were that of debt, not of venture capital.
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2025-01-10 15:18 This is where that insolvency test comes into play, because almost all debt comes with a condition that it can be recalled, that is the bank can demand immediate payment if the company enters balance sheet insolvency, which occurs when the total liabilities of company exceed its total assets. And here’s the inherent catch 22 about using debt to extend your Runway. The debt itself is a liability on the balance sheet. So if you Have a million dollars in the bank and then you borrow $2 million thinking you can extend your Runway with it. Well, as soon as you spend the million you already had, and unless some other money came in in the meantime, you become technically insolvent. Entrepreneurs who think that they can get away with this are almost always wrong. And sadly, they often don’t realize that until the moment the bank tells them. That’s because they usually borrowed the money when they still had other money. And they didn’t realize that once they crossed into balance sheet insolvency, they wouldn’t be able to keep or use that borrowed money anymore.
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2025-01-10 15:17 And then because the revenue came in lower than plan, the debt service ratio or some other covenant dependent on revenue gets tripped and the bank can then call the loan. And if you don’t have enough cash to pay the loan back, the bank could even seize other assets or force you into bankruptcy. But banks wouldn’t actually do that, right? Uh, again, banks are not in the risk business. They can, and sometimes they do call those loans and they’re not being evil. That’s just their business model and their legal right to do so.