Venture debt:

An alternative growth
financing option
Table of contents
Introduction................................................................................................. 3

The truth about venture debt................................................................. 6

Venture debt demystified..................................................................... 10

Finding the right mix of venture equity and venture debt.............12

Is venture debt the right choice?.........................................................13

The way forward.......................................................................................14

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Introduction
Among the many worries that keep founders and CEOs up at night, raising capital is usually one of the most
pressing. That’s because capital is essential for driving growth as a company evolves from a great idea into a
thriving business. Unfortunately, all of the media hype about venture-backed companies reaching astronomical
valuations only adds to the pressure. In fact, it can make founders and CEOs see raising huge rounds as a sign
of success, even when it’s not always in their best interest.

To be clear, there’s no question that equity has a critical role to play in helping founders and CEOs meet their
business goals. But it’s important to recognize that equity isn’t the only source of capital to fund a fast-growing
company. Using debt to complement your equity funding can be a smart move for stakeholders in a variety of
situations, including when they want to:

Achieve a higher valuation. The higher the valuation you Common scenarios where
get when you raise equity, the better it is for your business. you might use venture
Companies often use venture debt to extend their runway debt include:
so that they have more time to grow their business before
their next valuation. Achieving a higher valuation

Securing greater upside

Maintaining control
Secure greater upside. Dilution is a serious consideration
any time you raise equity. By using venture debt to meet Bridging to equity
a portion of their financing needs, founders and CEOs can
minimize the dilution they suffer and ultimately see more Taking advantage of
upside when the business eventually exits. acquisition opportunities

Maintaining strategic flexibility

Maintain control. Using venture debt results in less dilution,

providing founders with greater economic and strategic
control over the business they worked so hard to build.

Bridge to equity. Sometimes founders and CEOs find

themselves in a position where they want to achieve
certain operational or financial milestones before raising
equity, or where they could simply use additional funding
leading up to an equity raise. Using venture debt can help
companies accelerate momentum and maximize liquidity
thereby optimizing their negotiating position going into an
equity raise.

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 Take advantage of acquisition opportunities. Acquisitions
can help companies drive growth, expand into new
markets, or secure complementary technologies or
solutions. But financing them can be challenging. Venture
debt can often be secured more quickly than other forms
of financing, enabling companies to take advantage of
strategic opportunities. “During our last financing round
we tried to strike a balance
between raising enough capital to
supercharge our growth and not
Maintain strategic flexibility. Bringing on a new investor often
suffering too much dilution. Once we
means re-setting the clock and committing to a plan (and time
learned about venture debt, adding
horizon) that promises to deliver the investor’s target return.
it into the equation became a no-
Using venture debt can help founders maximize their flexibility
brainer. With a mix of debt and equity,
when it comes to deciding when and how to exit.
we were able to raise the full amount
we needed to accelerate our product
roadmap and invest in our back-end
While companies must always plan to be well capitalized, CEOs processing capabilities. The result
and founders need to find the right combination of capital was a broader addressable market
sources. The goal should be to optimize the company’s cost and a more valuable business,
of capital while enabling them to maintain more control over all while minimizing dilution and
their business longer. We believe that the key to doing so retaining more upside.”
is by blending equity capital with debt capital. As we’ll see,
incorporating debt into your overall capital mix is a simple, Eric Green
efficient, and cost-effective way of growing a business without Co-Founder and CEO, Askuity
the downsides that come with relying exclusively on equity.

In this white paper, we will take a closer look at venture debt

and how it works. We’ll then explain how it can be used in
conjunction with equity capital to help businesses grow and build
enterprise value.

So what exactly is venture debt?

Venture debt is a form of non-dilutive financing that complements equity. More specifically, it typically takes the
form of a term loan or line of credit that companies can use to proactively fuel growth by, for example, investing
in sales and marketing, accelerating product development, enabling more hires, funding acquisitions, or simply
providing basic working capital.

For fast-growing companies that don’t have significant assets or positive cash flows and that therefore often don’t
have access to traditional bank loans or material amounts of bank financing, venture debt can be a powerful debt
financing tool.

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The implications of
raising equity
While the idea of raising a large equity round can be very appealing — not least because of the attention
that comes with it — the fact is that using equity alone to grow a business has some important implications.
In simple terms, raising equity:

Leads to dilution. Too much dilution too early results in a loss of control over the direction of the
business. Meanwhile founders, CEOs, and other investors all stand to see a smaller payout if and
when the business is acquired or goes public.

Equity-only One-third venture debt

80%
73%
67%
57% 59%
54%
47% 42%

Series A Series B Series C Series D

Requires you to give up board seats. That means that you have to obtain your equity investors’
consent on important decisions such as the strategic direction of the business, staffing and
compensation, and product roadmap, among others.

Forces a valuation of the business now. While not necessarily a bad thing, there are cases, such
as when the company is growing quickly or is about to achieve certain key milestones, where it’s
better to defer a valuation until a later date when the business will likely be worth more.

Eats up precious time. Raising equity generally isn’t a fast or simple process. Even in the best
scenario it will divert management’s attention away from what should be their primary focus:
growing the business.

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The truth about
venture debt
“When I was raising capital for
Debt is a common tool that can be used to accelerate the impact Achievers I wanted to be backed by
of equity. In traditional business sectors such as manufacturing or the best VCs in the world because
retail, securing your first loan — typically from a bank — to grow that meant that I was in the same
your business is a well-accepted milestone. Indeed, using debt is a
league as Steve Jobs and Larry
very common way for traditional businesses to acquire equipment
Page. Unfortunately, that led to a
or machinery, expand production capacity, and finance inventory,
suboptimal outcome for the people
among other things.
that mattered most to me — my
And yet, founders and CEOs in the technology sector have failed family, my management team, my
to apply the same logic to their businesses. Instead, the generally employees, my friends, and my other
held belief was that the only way to raise the capital needed to early investors. Had I used venture
grow a technology business was to partner with angel investors debt as part of my long-term funding
or a venture capital firm to raise equity. While this approach was strategy, this group would have made
historically driven in part by the lack of debt-funding alternatives $30 million more at exit. And that’s
for technology companies (these days, by contrast, there are many only part of the picture. Raising all
debt-funding options), the allure of being backed by top-tier VCs that equity also meant I lost control
also plays a role. That’s because in many cases founders and CEOs of the business too early. That meant
see VC funding as a proxy for success, even when that’s not always that we didn’t always make the right
the case. decisions and that we ultimately sold
the business far too soon.”
The data for debt provided to technology companies is not as
well documented as data for equity venture capital, but by some
estimates venture debt accounts for at least 10 percent of all venture
Razor Suleman
Founder, Achievers
capital deployed.1

Had I used venture debt, this group would

have made $30 million more at exit.

1 Connie Loizos, “Yep, more later-stage companies are taking on venture debt.” March 28, 2017.

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Senior vs. mezzanine venture debt
In this whitepaper, we refer to venture debt as the debt that is used to fund growth. In most cases, it will be the
junior or mezzanine layer of the debt portion of the balance sheet. While senior bank facilities are sometimes
characterized as venture debt, it's important to understand the differences.

Bank facilities, generally structured to support a company's working capital needs, will carry lower interest
rates and offer less lending capacity than venture debt. In many cases, senior bank facilities are put in place
concurrent with the company completing an equity raise. They also might be subject to amortization and
include other covenants designed to minimize the lender's risk.

Adding venture debt as the junior or mezzanine layer of debt capital ranking behind a senior bank facility can
therefore be an attractive option. Combining senior bank facilities with mezzanine venture debt structures
enables companies to maximize their debt funding while minimizing their blended cost of debt capital, diversifying
funding sources, and avoiding dilution.

Unitranche loans
Unitranche loans combine senior and mezzanine debt into a single loan, with a blended interest rate that sits
between senior loan and mezzanine loan rates. Unitranche loans are attractive to borrowers because of a number
of key features and benefits. These include:
• The convenience of dealing with a single lender
• One loan agreement and one set of loan covenants, simplifying negotiation and increasing
the certainty of closing
• A single reporting obligation, reducing administrative complexity
• No need for intercreditor agreements, allowing for faster closing, reduced legal expenses,
and less complexity in managing the loan
• Non-bank lenders offering unitranche solutions will generally have a greater risk appetite,
offer less restrictive covenants (on the entire loan), and be able to provide more “patient” capital

Cost of capital

30% Equity

25% Royalty
loans
Growth 20%
capital Mezzanine
debt
15%
Unitranche
10% loans

Working Senior
5% debt
capital
Risk of loss to the lender

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Considering venture debt?
Here’s what to look for

While there’s no shortage of lenders that provide venture debt, it’s important to keep in mind that they don’t
all work the same way. Companies need to do their homework to understand the structure and terms of any
potential debt financing to ensure it’s the best solution for their business and fits with their longer term capital-
raising strategy. Where possible, partner with a lender that:

Offers capital efficiency. Being required to draw down the entire amount of the loan up front can mean
the company is paying interest on excess capital it cannot invest effectively, which is inefficient. Instead,
consider loan structures that allow the company to draw down capital as required.

Doesn’t require amortization. Rather than being strapped with the burden of immediately having to
pay back a loan, look for lenders that offer the option of interest-only loans over the entire term, with
the principal due in full upon maturity.

Is flexible. You want the ability to increase funding as your business grows and to prepay your loan without
penalty. Most venture debt facilities are fixed in their size, leverage ratios, and term. A lender with rigid
policies and large prepayment penalties could impede a business’s ability to execute on its strategic plan
and its ability to raise additional capital in the future.

Has a transparent all-in cost structure. Different venture debt providers take different approaches to
pricing deals. In addition to an annual interest rate, that may include upfront fees, administration fees,
standby fees, early prepayment fees, and warrants, among other costs. When it comes to venture debt,
transparency and simplicity trumps opaqueness and complexity.

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Doesn’t have excessive or highly restrictive covenants. What you need to know
True venture debt should generally have fewer
covenants than traditional senior or working capital loans about warrants
as it’s meant to work as growth capital and bear more risk If you’re looking at venture debt that
(and should be priced accordingly). In addition, venture includes warrants, pay attention to:
debt covenants should be appropriate for companies
that are using capital to fund growth and that are often The formula for calculating the
generating no operating cash flow. Beware of senior number of warrants the lender will
loans masquerading as venture debt with excessive get, and the strike or purchase
covenants that increase the risk of defaults and restrictive price for the warrants
covenants that reduce the capital that’s actually available
How long the warrants will remain
to be drawn down.
outstanding

If the lender has an option to

force the borrower to redeem the
Understands the venture growth journey and has a
warrants or the shares purchased
proven appetite for risk. The right venture debt provider
by exercising the warrants (known
should have a proven track record of being borrower- and
as a put option)
founder-friendly, and of behaving well when things don’t
go according to plan. While the lender has a fiduciary Any anti-dilution clauses
responsibility to safeguard the capital it has loaned, a associated with the warrants
seasoned and rational lender will work with the company or underlying shares
to overcome challenges and help ensure the optimal
outcome for all business stakeholders.

Finding a venture debt partner that’s

able to provide a loan structure that meets
your particular needs and objectives is
critical for ensuring a successful financing.

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Venture debt demystified
Now that we know what venture debt is and what to look for in a venture debt provider, let’s look at how the
venture debt process works as well as some of the key benefits of using venture debt.

As a company evolves through different stages of growth, it can access different sources of capital. Early
on, founders and CEOs might use their own personal funds, turn to friends and family, or rely on angel
investors. As the company grows, develops its product market fit, and establishes a steady track record of
growth, other options such as venture debt become viable alternatives.

Securing venture debt should be a quick and straightforward process that can be completed in a matter of
weeks. Here’s how the process should look:

Investment screening. The process usually begins with an introductory call between the borrower
and the lender. If there’s a potential fit, the company will be asked to provide financial information
so that the lender can conduct a preliminary review and pre-diligence on any items of note.

Term sheet. In step two, it’s time to sign a term sheet. Term sheets should clearly outline all material
terms of the transaction so that there’s no confusion later on in the process. Asking the lender
for a term sheet early in the process will also provide you with a better sense of the terms of the
financing and help you quickly determine if the offer is right for you before you invest significant
time in due diligence.

Diligence and investment approval. Next, the lender’s diligence team will examine the borrower’s
business, financial, operational, and legal situation in detail to determine the borrower’s
creditworthiness. Upon completion, the file will be submitted to the lender’s credit committee for
review and approval.

Legal and funding. Following approval of the loan, the lender will provide its legal and funding
documentation. Legal documentation, and the associated legal expenses, can vary widely between
lenders. Borrowers should confirm expected legal costs in advance and look for streamlined legal
and funding documentation to drive speed and cost efficiencies. Once any legal issues that may
have been identified during diligence have been addressed, the funds should be ready for release.

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 Portfolio management. Borrowers should be prepared to remit monthly reporting to facilitate loan
monitoring. A good lender will proactively engage with the borrower as needed, provide detailed
unit metrics and operational analysis, and leverage its network to help support and accelerate the
company’s growth.

Investment exits. Finally, at the end of the term, the borrower repays the loan in full via a refinancing,
capital raise, or other liquidity event. In some instances, companies will re-engage with their venture
debt lender multiple times, initiating new facilities as their capital requirements evolve and grow.

With that understanding of how venture debt works,

let’s consider the main advantages of using it.
These can be summarized as follows:

• Founders and their teams maintain control over their business longer. Maintain
Maintaining control enables founders and their teams to drive the strategic control
direction of the company they are working hard to build. That’s important
not just because of the impact it can have on morale, but also because it
typically leads to better business outcomes. In fact, according to a study
by Purdue University, companies where the founder still has a significant
role, whether as CEO, chairman, a board member or in some other
capacity, tend to perform better longer.2 It’s non-
dilutive
• It’s non-dilutive. As part of a long-term financing strategy, venture debt
allows companies to create greater economic value for co-founders,
employees, friends and family, and other early supporters.

• It’s flexible. You can combine venture debt with senior debt from a bank to
reduce your overall cost of debt capital, draw it down when it makes sense It’s
for your business, and, unlike equity, repay it when you want.
flexible

2 Joon Mahn Lee, Jongsoo Kim, and Joonhyung Bae, “Founder CEOs and Innovation: Evidence from S&P 500 Firms,” Purdue University,
February 17, 2016.

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Finding the right
mix of venture
equity and
venture debt
“When used right, venture debt is
When it comes to developing an overall capital-raising strategy, an important alternative source of
companies need to give careful thought to their options and find capital for venture-backed growth
ways to incorporate a balance of debt and equity. That’s because companies. For founders and CEOs,
it’s impossible to build a successful business using debt alone. At it’s an opportunity to raise money in a
the same time, founders and CEOs can quickly get squeezed if they way that’s fair, unobtrusive, and that
just rely on equity. By combining the two types of capital, however, doesn’t create dilution. Right now,
it’s possible to achieve a capital structure that not only optimizes about a quarter of the companies in
the company’s cost of capital but also provides founders and early my portfolio use venture debt. I will
shareholders with maximum flexibility and control.
continue to encourage more to do so
Figuring out what the ideal mix of capital should look like depends because it’s a win-win for everyone.”
on the specific business. A company that can predict with confidence
how investment will directly drive revenue growth (and how much)
Rob Antoniades
or otherwise create value in their business, will generally be better
General Partner and Co-Founder,
suited to using debt capital than one that struggles to do so.
Information Venture Partners
Fundamentally, a company’s capital efficiency will determine how
much debt it should use.

Venture debt is an important alternative

source of capital for venture-backed
growth companies.

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Is venture debt the
right choice?
Venture debt is one of many viable options to consider when raising capital, but it’s not necessarily a one-
size-fits-all solution that’s suited for every company. For example, raising venture debt isn’t a good idea if:

The business isn’t growing fast or efficiently enough. Venture debt is best suited to fast-
growing companies for which the value created through capital investment (e.g., in the form
of revenue growth) meaningfully exceeds the cost of that capital. Borrowing at 15 percent
makes no sense if you’re only growing at 10 percent. Likewise, if customer lifetime value is
too low due to high churn or low margins, or customer acquisition costs are too high, then
venture debt probably doesn’t make sense.

There’s no clear plan in place for using the capital. It’s critical that any funds borrowed are
actively put to use to create value. Having excess debt capital on your balance sheet simply
represents another cost with no benefit. The same can be said for raising excess equity
capital except that the cost takes the form of unnecessary dilution. In that case, the cost is
borne by the founder and early shareholders rather than the company.

The company hasn’t figured out its product market fit. This is an essential step in a company’s
evolution. Companies that haven’t reached it are generally too early stage for most forms of
venture debt and can likely
be better financed with equity.

Remember
Venture debt is an obligation that involves a fixed interest payment every month as well as capital
being repaid at the end of the term. If a business isn’t confident that it can meet its obligation, it
shouldn’t take on venture debt.

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The way forward
Although the pressure to raise capital is real, it’s important not to fall into the trap of associating raising a big
round of equity with success. Founders, CEOs, and boards should take the time to evaluate all of their funding
options. As part of that, they should consider the near- and long-term financial and operational consequences
for the company and its early investors. In many cases, that will mean finding ways to raise capital from a
combination of sources, including equity and debt. The key is to build the necessary foundation for the
company to grow, but in a way that minimizes dilution and cost, and enables founders and early investors to
retain the greatest control of their business.

By partnering with the right venture debt lender — one that understands the business and offers the flexibility to
meet a borrower’s individual needs — companies can quickly access the capital they need to proactively grow
their business. And they can do it in a way that doesn’t come at the cost of dilution or control for them or any of
their investors. For fast-growing companies looking to further accelerate their growth, it makes a lot of sense.

To learn more about venture debt, visit www.espressocapital.com.

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About Espresso Capital
Espresso empowers companies with innovative venture debt
solutions. Since 2009, we’ve helped more than 270 technology
companies and their investors accelerate growth, extend runway,
and increase strategic flexibility with non-dilutive capital. Learn more
at www.espressocapital.com.