Tony Barkett, Head of Banking and Thomas Bird, VP, Credit Advisory on what Canadian founders should be thinking about
For venture-backed startups, getting the right financing to grow quickly is essential. Venture debt is an option more companies are considering in 2023 as they navigate challenging economic times. As part of our commitment to power Canada’s boldest startups, RBCx Banking offers this valuable financial instrument. But how do you know if venture debt is right for your business?
RBCx recently hosted a webinar to answer that question, led by Tony Barkett, Head of Banking and Thomas Bird, VP, Credit Advisory.
Tony leads our full technology and innovation banking practice, providing strategic oversight of product and market development, and heads our national relationship management and credit advisory teams.
Thomas administers venture debt and working capital facilities to leading Canadian technology companies and manages a portfolio of clients ranging from Series A to late stage.
Speaking to about 200 attendees, Thomas and Tony unpacked the meaning of true venture debt, its benefits, and how to know if it’s right for your business. If you missed this informative webinar, read on for a recap of what our experts covered.
What is venture debt?
Simply put, venture debt is growth capital for venture-backed companies that’s designed for early to growth stage companies. “We’re seeing it’s most effective at series A, B, and C level,” explains Thomas, “when companies are getting into the product market fit and beginning to scale.”
The main purpose of venture debt is to send a cash bolster to your balance sheet. “This, in effect, lengthens your company’s cash runway,” Thomas says, which is ideal for venture-backed companies that are typically in cash-burning mode. Three to six months is the common length of runway extension with venture debt.
Venture debt is best used as a supplement to an equity raise, and is meant to support expansion and scaling initiatives. “If a company has raised an equity round of financing and has milestones you need to hit in a specific timeframe, that clock starts ticking immediately,” says Thomas. Venture debt comes in to lengthen the amount of time to reach those goals.
Alternatively, venture debt can be used as operational insurance if a venture chooses not to draw the whole amount—a rainy day fund or initiative capital to get to the next round, explains Tony.
To clarify the definition of venture debt as it pertains to the RBCx presentation, Thomas explains: “True venture debt is non-covenanted and non-margined.” The startup is working with a lender that provides a non-covenanted, growth capital facility that is structured as term debt.
Just as important to understand is that venture debt is not predicated on revenue. “The precursor to getting venture debt is being venture-backed,” Tony says. In fact, a venture-backed company can access venture debt even at zero revenue.
“We’re looking at the wherewithal and scalability of a company in combination with the investors and the amount of money they’re putting in at the same time,” he adds.
As such, venture debt is structured to be as friendly as possible to startups that need to grow quickly. Offered without any liquidity or financial covenants, it can fund growth without heavily impacting the cap table.
How to know if venture debt is right for your company
There are a variety of factors to help determine if venture debt is the right instrument for your startup. The top considerations are:
There’s been a recent venture capital equity raise. This is the most important consideration for RBCx and co-exists well with the venture debt model. “We’re looking for an institutional level of capital,” Thomas explains.
Existing cash runway. “We’re looking to come at the back of an equity raise,” Thomas says. “We want to see that there is already a cash runway of 12 months or more.” Venture debt is meant to be a supplemental runway; it’s not meant to replace what you already have.
Leverage existing investor diligence. A benefit to businesses that have done an equity raise is that RBCx can leverage the existing investor diligence. “We’re not adding to that list in terms of getting fundamentals of your company or new information investors don’t already have,” says Thomas.
A high existing (or planned) growth rate. Along with high growth, the company should have a meaningful market sizing and a scalable business model that is IP- and innovation-based.
Looking “under the hood”
An in-depth look at the recent equity round is part of the venture debt review process. This typically considers the following:
The lead investor on the last equity round. Our lead investor analysis will “hone in on who you raised that round from,” says Thomas. “For venture debt, we’re talking about working with financial VCs.”
Size of the fund. There is more confidence when raised capital comes from a large fund.
Lifecycle of the fund. When did the business receive the investment in that fund’s life cycle? “If the fund is about to close, that might bring into question how that next funding source works versus a fund that just opened,” Thomas says.
Reserve strategy and follow-on capacity. Usually the fund reserves 100 per cent of the first investment to re-invest in the business. Consideration will be given to the lead investor’s intention of follow-on.
How venture debt is structured
Venture debt is term debt that’s structured as senior secured debt (first ranking GSA), putting it at the top of the capital stack. Its size is typically a function of the business’s equity raise—around 20 to 40 per cent of the latest equity round size. “This emphasizes how closely tied the equity round is to getting venture debt,” Tony says.
While venture debt is interest-bearing, it’s at a margin above prime rate. The average term length is four years which includes the draw period and amortization period. However, Tony emphasizes interest is only paid on what’s been drawn. “If you have $10 million secured but actually only need $2 million, you will only pay interest on that amount withdrawn.”
Venture debt includes a nominal warrant position. The benefit to this is it ties the lender’s interest to the startup’s interest and that of the equity investors. In this scenario, “your financial institution has gone from just a lender to having a vested interest in the growth and valuation appreciation of your company,” explains Thomas.
With the understanding that most startups are cash-burning, there is no financial covenant in venture debt. However, a material adverse change (MAC) clause is included (a last resort clause to protect the lender, if need be).
Setting up for success
For startups that choose to pursue venture debt financing, these best practices can help improve chances of securing venture debt and having a smooth experience.
Timing is everything, and the best time to qualify for venture debt is when you don’t need it. “Get venture debt when you don’t need it, rather than when you do,” suggests Tony. The ideal time to talk to an investor is when you have more than 12 months’ cash. Therefore, you should secure venture debt shortly after raising equity.
“If you wait until six months, then you’re looking more for bridge financing,” Tony explains, which is not the purpose of venture debt.
Tony recommends working with a lender that has a broad platform. “You want to stay with your lender provider as long as you possibly can.” That means asking plenty of questions: Is your lender able to scale with you? Will your long-term needs and the lender’s capabilities match?
“Really think about who you’re partnering with,” Tony says. “What is the process? How often will we talk? What are expectations of communications going forward?” Understand your lender’s approval process to know how they get their deals done. Businesses should get as much information as possible on what happens if things go sideways.
Lastly, find a law firm that’s done venture debt before. It’s different from other debt instruments and an experienced lawyer will be of great value.
Five key takeaways:
- The main purpose of venture debt is to send a cash bolster to your balance sheet, and is best used as a supplement to an equity raise.
- True venture debt is non-covenanted and non-margined. The startup is working with a lender that provides a non-covenanted, growth capital facility that is structured as term debt.
- The precursor to getting venture debt is being venture-backed. It is not predicated on revenue.
- The best time to qualify for venture debt is shortly after raising equity – you should have more than 12 months’ cash.
- Venture debt is structured to be as friendly as possible to startups without any liquidity or financial covenants, so it can fund growth with minimal impact on the cap table.
Gain more valuable insights from RBCx
If you missed our webinar on venture debt, we’ve got good news. Additional RBCx webinars are scheduled for 2023. These valuable sessions will allow you to tap into some of the tech and finance industry’s top minds from the comfort of your own home or office.
To get invites to future webinars, reach out to your RBCx Banking VP today.
This article offers general information only and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or its affiliates.