Striking a balance – What’s the right amount of venture debt for your startup?

Typical amount of venture debt

With recent resets of startup valuations, we've been having lots of conversations with founders regarding the role of venture debt—as well as the optimal amount—especially in the Series A phase and beyond. How much is enough? Or too much? What are some of the best ways to secure a venture debt loan? Are there other financing options to consider?

Every Series A situation is different, with a multitude of variables, but there are good rules of thumb to follow to help you use debt as an effective financial tool, especially in a more uncertain market.

One of the advantages of partnering with us is that we've had decades of experience working with growing startups in all kinds of niches and all kinds of market conditions. There aren't many scenarios we haven't experienced first-hand over the last 40 years. With that kind of deep experience comes a unique perspective on how venture debt can be used to propel a startup's success.

Generally speaking, there should be signs of momentum in the business to justify taking on debt. The amount of venture debt, then, tends to be proportional to specific milestones that signify growth or progress in the company. These may include new product releases, clear signs of product-market fit, or entry into a new or expanding market, to name a few.

We should note that companies in the life sciences or pre-Series A have unique dynamics to take into consideration when seeking funding. For the purposes of this article, we're largely focused on technology innovators with at least early product-market fit, that are evaluating their financing options.

There should be signs of momentum in the business to justify taking on debt. The amount of venture debt, then, tends to be proportional to specific milestones that signify growth or progress in the company.

The key to venture debt is to use it judiciously

By the numbers, a typical amount of venture debt for startups is:

• 20 to 40% of the most recent equity round;
• No more than 10% of the startup's durable enterprise value;
• As a percentage of net burn, consider keeping debt service at less than 25%;
• The debt should provide approximately six months of runway—but most lenders expect you to have at least 12 months of organic runway in addition to the debt.

These numbers are in definite contrast to the market in 2021 when equity valuations were inflated, as were the expectations around the debt terms that could be secured. Companies who pushed the envelope to maximize the amount of debt they could secure near the peak of the last cycle, now find themselves with burdensome levels of debt that easily tops 20% of their current enterprise value.

Of course, that's a risky ratio. A healthier one—and a common measurement of debt worthiness—is typically six to eight percent of a company's last valuation (i.e., after its latest round of funding).

It's important to note that there are no hard-and-fast rules about the ratio, however, the six to eight percent range is the most common one we've seen across various company stages, business models and industry sectors. Even so, we've also seen the debt-to-equity ratio weighted more toward debt in later funding rounds, especially when the lender can see increased evidence of enterprise value accretion, revenue traction or actual profitability.

What are the risks of too much venture debt?

Debt is a powerful tool, but like any other tool, it's only as effective as the skills of the person using it.

Having too much debt may impact your ability to raise your company's next round of funding. It could also decrease your valuation if the company has underperformed expectations or failed to accomplish its core goals. Investors, of course, are looking for growth opportunities, but might be wary of providing funds to a company with too many debt obligations—they don't want to see their fresh equity go toward paying off debt. When a company is properly capitalized, most lenders are happy to refinance debt alongside new equity.

Taking on too much debt also runs the risk of shortening your runway once the amortization of the loan kicks in. For example, a company with a monthly operating burn of $250K and a $5M debt facility that amortizes over 30 months will see an increase in their burn rate by more than 50%, once payments begin.

Entrepreneurs lean to optimism and society has benefitted from incredible innovations because of that optimism. It is one thing that sets apart our economic system from much of the rest of the world. But, a healthy appreciation for downside risks can help ensure these game-changing innovations survive and are brought to market. That doesn't mean you shouldn't take on debt, but you should be aware how much burn rates can impact on-plan, as well as off-plan scenarios.

Even more critical, too much debt could limit your company's strategic options and spending decisions going forward. And leaning too much on your equity to service the debt might leave you with a smaller stake in your own company. You don't want to take debt as a replacement of equity, but rather as a complementary source of capital.

Knowing when to harness the power of debt is critical

Another way to look at debt is that it can be like a jet engine strapped onto a train. It can accelerate in the direction you're going, but it becomes problematic if you make a sharp turn.

Having a well-defined roadmap and plan for your business will put you in the best position to manage debt and relationships with lending partners. It's essential to have your financing lined up, financial projections made, business goals outlined and an understanding of how debt fits within that roadmap.

But if you're anticipating a pivot at some point, or if you're lacking strong conviction in hitting your plan, debt may not be the best funding option.

Debt is a financial instrument that involves a set of promises between the borrower and the lender. For example, for the borrower, it means promising not to divest operations, materially change the business model itself, change the executive team or pay dividends to shareholders. Ultimately, the lender is looking for commitment, consistency and communication on the part of the borrower.

At the same time, well-established lenders understand the risks that they underwrote and expect to take occasional losses. So don't be afraid to surface negative news early. The best lenders will appreciate knowing and early communication may preserve more optionality for a potential solution that helps lead to the best outcome for you, your equity investors and the bank.

Having a well-defined roadmap and plan for your business will put you in the best position to manage debt and relationships with lending partners. It's essential to have your financing lined up, financial projections made, business goals outlined and an understanding of how debt fits within that roadmap.

7 tips on using venture debt to propel your startup's success

In our experience, the most accomplished startups follow these seven tips when taking on debt:

1. Make sure the debt extends your runway—that it doesn't just serve as your only source of runway.

2. Ask yourself if the debt is really needed—be thoughtful, be prudent. Just because a lender offers debt financing doesn't mean it's the right tool for the job.

3. Think of it as a tri-party initiative. Work collaboratively with your management team, your investors, and the lender—more transparency helps you quickly find mutually agreeable terms. This of course includes the deal initiation, but also throughout the life of the partnership.

4. Perform as much or more due diligence on your source of capital as they do on you—choosing the right lender is critical. Critical to your diligence is understanding how a lender reacts in an adverse scenario.

   Some questions to ask yourself include:

   • Are they known as a patient lender?
   • Is their credit framework approved by regulatory bodies?
   • How have they reacted in down cycles? Have they ever been tested by such a cycle?

5. Model out your worst-case scenarios—expect the best, yes … but plan for the worst, especially when it comes to your ability to service the debt.

6. If you're getting close to cash flow breakeven, compare venture debt to other financing options—venture debt can be more costly compared to other debt solutions.
   
   
7. Use a lawyer experienced in venture debt—inexperience in the nuances of acquiring this form of debt can delay the loan closing, creating added costs and unnecessary distraction for the entrepreneur or finance team.

Why we believe venture debt is more art than science

While the tips we list above are good guidance, there are other factors that may influence your decision to take on venture debt.

Our view: it's better to find a lender that understands your business and the natural cycles of the innovation economy. It may make all the difference when unexpected things happen (and they will).

An experienced lender generally looks at more than the last valuation of your company. The company's overall performance is a better measure of venture debt viability. Having a fully vetted forecast, for example, that demonstrates how projected sales and revenue targets can be achieved or having a signed term sheet for the next equity round can go a long way. So can having full sign-off from your board on how the debt is expected to be used.

When the venture capital markets were hot, many lenders entered the market, but they don't have a long history of working through the up-and-down liquidity conditions that are a natural part of life in the innovation economy. It's advantageous to choose a lender that has the credit appetite and a proven track record of working through challenges that many VC-backed companies face.

As advantageous as debt can be to fueling growth, it's important to be cautious about taking on too much. There is a tendency with some lenders to win business simply by providing too much capital without the right kind of structure. A more prudent, patient approach is preferable. It's not just about taking on more debt and hoping things will work out. Mutual commitment by the lender, equity investors and borrower to a venture debt agreement goes a lot further towards making it a successful partnership.

How to evaluate venture debt lenders: the Four Cs

When assessing the viability of venture debt for your business, we think it's just as important to assess the viability of the lender, too. It's not just about taking on debt, it's about taking on a financial partner—one who understands the innovation marketplace, the capital cycles and the events, trends and issues that are affecting your business.

Here's what to look for in the financial partner you choose:

1. Capital: A solid financial foundation is absolutely essential. Can they support you as you scale or is this a one-time transaction?

2. Commitment: It's not just about making a deal and writing a check. It's about sharing your vision and helping you see it through, as well as delivering value beyond the check. That can include connections to other entrepreneurs and introductions to future investors or trusted service partners equally as committed to the innovation sector.

3. Consultative: Taking on debt should always be motivated by solving a specific business challenge. A lender should understand the challenges you face, the nuances of your industry and pinpoint the right amount of funding you'll need.

4. Consistency: A long track record in funding successful businesses— through good times and bad—can make all the difference. Steady appetite by the lender through multiple economic and funding cycles should be evaluated, in addition to the terms. Great deal terms mean little if a lender overreacts at the first sign of challenges.