Rethinking Venture Debt During Periods of Economic Headwinds

I began my career at Chemical Bank (now JPMC) in New York and spent my first year going through the well-regarded credit training program. It was not too long after the early 1980s and people still remembered high inflation and high interest rates. We were trained to run financial projections on the ability of a company to repay debt with an assumption of 18% prime rate of interest, even though the rates had fallen to mid-single digits. Banks think a lot about repayment because they make most of their money on the spread of interest between their lending cost and their borrowing cost and thus it takes many good loans to make up for one bad one. The other thing I learned during my time at the bank was how differently a bank can view a business during a strong economy versus a weak economy and how unfair that can feel to the company borrowing the money.

As a venture investor, why am I writing about debt? Over the past decade, venture-backed companies seem to have increasingly used venture debt to extend the financial runway, to raise less dilutive capital, and to increase financial flexibility. Venture lenders – we most often see Square 1, Silicon Valley Bank, and Bridge Bank – have been creative and accommodating in their financing structures, and have put in place lines of credit based on multiples of monthly recurring revenue, a perfect loan structure for a software business with subscription revenue. These lines can grow as a company grows recurring revenue and can be viewed by many entrepreneurs as almost a permanent slug of capital. As long as these lines are annually renewed by the bank and as long as covenants (or bank financial requirements) are met, these lines theoretically never have to be paid back, which is convenient and non-dilutive – but also potentially dangerous.

In 2008, during the last financial crisis, a number of our portfolio companies had venture debt facilities, but most were term loans that required monthly loan payments of principal and interest. I have never been a fan of term debt for cash flow negative businesses because ultimately the bank is relying on the investors to be the ultimate source of refinancing. During the financial crisis, these banks proved to be inflexible in renegotiating or restructuring their terms and payment timing, but generally, as long as payments were current, they didn’t call or accelerate the loan even if financial covenants were not met. The world is different today . . .

In the current environment where companies are using MRR lines of credit, being in default of a covenant can cause 100% of the line to come due very quickly. The bank can also simply choose not to renew a line of credit or alter the terms at the time of renewal for any reason. When this happens, the line is immediately due – AND since the banks require companies to keep their cash at the lending bank, the bank has the right, although it is not often used, to sweep the bank account and take the cash that the company is relying on to run the business. What is more common in the case of a default is that the bank will immediately take away any remaining borrowing availability under the line and then will force the conversation of rapid payback of the line with the threat of the cash sweep. Any of these actions create a huge problem for the company, for its people, and for its investors. Given that covenants on MRR lines often relate to churn, growth, or meeting of board plan – all of which can be hard to manage in a downcycle – the risk of violating a covenant and thus technical loan default becomes much higher in turbulent economic times.

This is not meant as an indictment of venture lenders. These are good people who serve a real need. Remember though, they are not venture investors and their economics do not allow them to take venture risk. They don’t win big when your company wins big – they get their cash back, interest along the way, and maybe have a small warrant. When you make money on interest, you can’t afford many losses, and they run their businesses with that knowledge. Thus, if you run a start-up and you have venture debt and your risk level rises, expect a reaction from your lender.

So, for a start-up CEO, what are the implications?

• When you think about cash requirements for a business, think about it in the context of either an eliminated or meaningfully reduced bank line. If you need $3 million in cash for operations for the next eighteen months and if you have $3 million in debt and $1 million in cash, you need more than $2 million, and you may need up to $5 million to pay off the debt and to fund operating losses for the period.
• Think about raising money sooner if you are worried about the environment and factor in your round size to reduce or eliminate your venture debt.
• Work carefully to negotiate your covenants if you are taking venture debt. Give yourself room to have slower growth or higher churn and not be in default. It is always best to work your deal up front versus trying to renegotiate these terms later when you are in default. Renegotiated terms tend to have to go all the way up the bank hierarchy for approval.
• Think about how terms may be changing during renewal periods; don’t get complacent because you never broke a covenant in the past.
• Remember, loans are not permanent capital and at some point need to be paid back – and, more often than you think, that is before exit.