Venture debt is widely discussed in startup circles, but often misunderstood. Our partners at Silicon Valley Bank break down five of the most commonly asked questions about venture debt to help explain the fundamentals and help you decide how you can best grow.

What is venture debt?

Venture debt is a catch-all term referring to loans that are tailored to the needs and the risks associated with investor-backed startup companies in technology, life science and the innovation economy. These loans are targeted toward companies that have raised equity from venture capital firms or similar institutional sources as opposed to capital raised from “friends and family.”

Is venture debt available to seed-stage and pre-revenue companies?

Yes, but availability depends largely on the type of investors backing the company. The typical venture debt borrower is a fast-growth company that has raised money from venture capital firms, or similar institutional sources, and has a defined strategy for continuing to raise capital. Many seed-stage companies will not align with this profile because of the composition of their investor base. Venture debt lenders focus their underwriting on the probability and the capacity of the existing “inside” investors to independently close one or more follow-on rounds, should the company prove unable to attract a new “outside” investors. Most seed investors fail to meet this standard either because they lack a committed a capital base or because they don’t intend to participate in follow-on rounds.

Why does venture debt make sense for startups and fast growth companies?

The cost of equity fluctuates significantly in innovation economy business cycles but one thing stays true: debt is cheaper than equity. Thus, the primary benefit of venture debt is that it leverages the equity raised by a startup and reduces the average cost of the capital required to fund operations when a company is “burning” more cash than it generates. A secondary benefit is flexibility, since venture debt can be used as insurance against operational glitches, hiccups in fundraising and unforeseen capital needs, such as performance bond requirements.

Here’s how it works: If a Series A round of $10 million provides the new investor with 20 percent ownership (on a fully diluted basis), then the stake held by the existing shareholders is valued at $50 million. Let’s assume the company has a monthly cash burn of $1 million, meaning the Series A proceeds provide a 10-month runway. A venture debt loan of $3 million in this scenario might require warrants with dilution equivalent to 25-50 basis points (fully diluted). In this example, the venture debt would extend the operating runway by another three months. The venture debt loan, provides roughly 30 percent additional runway but carries only 1/40th the dilution, even with a 50 bps warrant in the pricing.

When is the right or wrong time to raise venture debt?

When you are working on an equity term sheet, you should consider initiating a conversation with a lender about venture debt. Typically, venture debt is synced up to close a few months after a fresh round of equity. Raising debt when the company is flush with cash may seem counterintuitive, but in many cases the debt can be structured with an extended “draw period” so that the loan need not be funded right away. Regardless of when you want to actually fund the loan, your creditworthiness and bargaining leverage are highest immediately after closing on new equity.

Conversely, soliciting venture debt when liquidity is diminished and the operating runway is minimal will inevitably prove more arduous and more expensive. It helps to recall that the venture industry is highly cyclical and venture debt availability is highly correlated to industry valuation trends. The availability of venture debt and the variety of loan structure options will expand and contract in response to venture capital trends, the direction of valuations in your particular sector and the business cycle across the broader economy. Think of yourself as the proverbial “umbrella shopper.” The best time to test the market is when there isn’t a cloud in the sky, and the worst time is when the storm is already lashing at your windows.

What is the biggest mistake entrepreneurs make when taking on venture debt?

Too many entrepreneurs focus their loan selection strictly on price and loan size. There is significant value in developing a partnership with a lender that has the experience and ability to be flexible and calm when companies encounter delays, strategy changes and missed milestones, which are inevitable for startups in the innovation sector.

Clear as mud? For information and to learn more please reach out to our friend Dale Kirkland at dkirkland@svb.com.