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May 16, 2024

The Do’s and Don’ts of Venture Debt Financing in Today’s Market

overhead view of charts, graphs, and financial paperwork on a desk

Navigating a challenging market as a startup founder can be daunting, especially when you’re looking for ways to bolster your company’s cash reserves. Venture debt often emerges as a viable option, but for most founders, it’s uncharted territory. As Head of M&A and Capital Markets on Norwest’s Portfolio Services team, I’ve guided many founders through venture debt deals, helping to demystify this financial tool along the way.

In this post, I’ve drawn from my experiences to develop a list of do’s and don’ts across the four pivotal stages of venture debt financing. I offer this advice to empower founders in their financial decision-making.

Stage 1: Considering Venture Debt

✅ Do: Work with your board and, if available, your investor’s debt advisory team throughout the process and proactively reach out with any questions or concerns.

Nobody expects entrepreneurs to be venture debt experts. Your investors and their debt advisory team can assist you with the details. Have these folks on speed dial!

✅ Do: Identify a clear use of proceeds. Why venture debt? Why now?

We typically advise our companies to consider debt on the back of a successful round of equity financing, particularly in a volatile lending environment. Venture debt of this kind can be used to prolong runway and provide additional liquidity to the balance sheet. That said, venture debt should be a “nice to have” and not a “need to have.”

✅ Do: Have a clear plan for how to pay the loan back.

Your potential lender is underwriting your ability to raise your next round of financing. Be sure you understand and discuss with your board how this impacts the timing and sizing of your next raise and your plan to grow the business during the life of the loan. Are you being realistic about your growth and fundraising prospects?

✅ Do: Understand the time commitment required to get a debt deal done.

You will need at least two months from outreach through diligence to get to the end of the process.

❌ Don’t: Pursue debt as a last resort because equity wasn’t available.

Debt is a useful tool in the right situation but it comes with significant risks if you don’t manage it correctly. Most lenders in a tough economic environment won’t consider working with a company with less than 18 months of runway. Keep this in mind.

Stage 2: Meeting Potential Lenders

✅ Do: Rely on your board.

Warm introductions count for a lot. Use the established, long-standing relationships of your board members and their firms to drive your outreach and discussions with potential lenders. Those relationships will help you tell a clear story and enable you to get the best terms available.

✅ Do: Get multiple term sheets to run a competitive process.

The market is always changing and you need a cross-section of lenders to get a sample of terms. We recommend reaching out to enough lenders to get at least 3-5 term sheets to compare.

✅ Do: Have a structure in mind.

Do you want a revolving facility? A term loan? A bullet repayment vs. an amortizing loan? Each comes with its own benefits and challenges. You should understand the differences before speaking to lenders so you can ask for what best suits your needs.

✅ Do: Have projections and diligence items prepared in advance of meeting lenders.

Your projections should capture the base case, upside case,and reach scenarios for your company in a thoughtful way. You want your lender to base their loans off your base case, which should be VERY achievable for your business.

We advise our companies to use a 30 percent cushion on the performance of the business for the base case – meaning the company should be certain they can achieve 70 percent of their projections. This gives room for business/market fluctuations and ensures a high likelihood of compliance and success.

Don’t: Fail to properly prepare for the process.

You should set up a data room with basic diligence items early. This will enable you to run a quick and competitive process and move prospective lenders from introduction to term sheets quickly. Running a slow process can also meaningfully increase legal fees. Being prepared counts for a lot! For example, have your historical and near-term financial projection model ready, along with a solid grasp of key KPIs related to your business. The longer you make lenders wait for your information, the less efficient your process will be.

Stage 3: Selecting a Lender / Closing Your Deal

✅ Do: Carefully model how servicing this debt fits into your financial planning.

Understand any covenants and requirements and how you plan to meet them. The details matter!

✅ Do: Bring your whole management team into the discussion of managing the debt. Make sure the whole team is on board with this new form of financing and that they understand the requirements.

You want everyone in the business to understand the requirements associated with managing the debt and the lender relationship. What are the covenants? What are the milestones in the term sheet? Your senior management team should be prepared to be on-board with keeping the company compliant.

✅ Do: Respond to diligence requests quickly.

The goal is to have at least 3 (but hopefully 5!) term sheets to compare and negotiate. This can happen only if you are being responsive to your lenders and pushing them to complete their diligence.

✅ Do: Negotiate aggressively!

A competitive process should see meaningful improvement in terms from the time of the initial term sheet to close. Your investors and their debt team should be able to advise you on best practices and can often assist you directly in negotiations. In some cases, it may even be possible for your investors’ debt team to negotiate on your behalf to achieve the best terms.

At Norwest, we use our many years of experience negotiating with various lenders to thoughtfully push for the optimal terms for our companies. We take our responsibility to our portfolio seriously and work hard to get our founders market-leading terms.

Don’t: Select a lender exclusively based on price.

Focus on these other important factors:

  1. The lender’s relationships with your board
  2. The lender’s market reputation for working collaboratively with growing companies
  3. Terms and pricing.

BE CAREFUL WHO YOU TAKE MONEY FROM. Accepting a loan from the wrong source can endanger your business. You should ask your board or debt advisory team: is this lender well-known for finding solutions if a company trips a covenant or misses a milestone? Do they support startups and engage in helpful dialog in difficult situations and markets? How likely are they to assist in a refinance if needed? All growing companies face challenges. Your lender needs to understand this and have an excellent reputation for collaboration.

Stage 4: Managing Your Debt

✅ Do: Stay on top of your terms.

The terms to keep top-of-mind include your covenants and the relevant dates of your Draw Period and Interest Only periods. Reviewing these key items should become a part of every management and board process. Everyone in the company should understand and actively participate in managing your terms.

✅ Do: Continually invest in your relationship with your lender.

Be collaborative and communicative. Share news – good and bad – early. Schedule regular one-on-one calls with your lender’s relationship manager to catch up on the progress of the business and to get ahead of any challenges or issues.

Keep in mind that lenders can be strict and often inflexible in difficult markets. Before you draw on your existing loan, check in with your lender to share your plans and timing – particularly if you recently missed your projected financial plan. You should confirm that they will honor your existing deal and allow for the draw. Maintaining an active and positive dialog with your lender will help with this transparency.

✅ Do: Be thoughtful and careful about when you pull down your debt (if your terms allow) and how that impacts your runway, your cash expenses related to debt service, and your other terms.

Ideally, you should use venture debt as either a way to drive growth or as an “insurance policy” that provides extra cash runway between fundraising rounds. Think and plan carefully regarding the use of this resource.

✅ Do: Leverage your investors if something goes wrong or needs adjusting. Breached a covenant? Missed a milestone? Need to refinance? Bring your investors into the conversation with your lender. Investors have long-term relationships with lenders and can assist in finding solutions.

Don’t: Wait to share bad news with lenders.

This includes a projected miss of your revenue or profitability targets. Surprising your lender with bad news is never a good idea!

Treat your lender as a partner in your journey. Keep them up-to-date and involved in your growth. As your company scales, you will have the opportunity to raise additional rounds of equity financing and debt. Solid relationships will assist in your efforts and bring another partner to the table to advise you as you grow.

Demystifying Venture Debt with Preparation and Support

Venture debt can extend your company’s runway and infuse cash into the balance sheet, which may be particularly attractive in the current market. But you need to be thoughtful about how to approach venture debt financing and make sure it aligns with your company’s specific needs and circumstances. I hope the do’s and don’ts I’ve shared help demystify the process.

You probably noticed that I listed many more do’s than don’ts. That should be an indicator of how proactive you should be in choosing and managing your lenders. I cannot overstate the significance of choosing your debt partners wisely and fostering enduring relationships. Prioritize the ones who align with your long-term vision and values. With the right guidance and strategy, you will be well positioned to harness the potential of venture debt and steer your company toward sustainable growth.

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