When should you raise venture debt?
Venture debt should not be seen as an alternative to raising equity, butrather as a complement. Thus, almost no venture debt fund will invest in acompany that has bootstrapped its growth (i.e., has not previously raised an equityround). Indeed, venture debt has been calibrated around the tacit assurance ofsupport from equity investors in case of financial distress. In the absence oftangible assets and on non-profitable business models, the best collateral forventure debt is the equity sponsor. It means that venture debt is conceptuallydesigned to be a complement to equity, not a competitor.
The easiest equity fundraise is to complement an equity round
During an equity round, the founder can complement his round with venture debt. This is the easiest way to raise Venture Debt and results in the lowest interest rates for the company. Indeed, the signal given to the venture debt fund is that equity investors are willing to take the highest risk to finance the business. The interest of an equity complement is to increase the liquidity and thus the runway of the company, by limiting the dilution of the founders. It is also easier to raise money in later stage rounds than in early-stage ones because the former catchment area is larger.
Fund an acquisition
The current rise in interest rates favors company concentrations, because late-stage scale-ups that were able to make large rounds of financing during the cheap equity era will be in a strong position to make acquisitions in order to consolidate their sector. They will have two options: draw on their equity resources, as the fundraising environment has become tougher, or raise debt to avoid draining their most expensive resource, equity. The second option will be the most relevant for companies that are expecting to pursue their high growth following their acquisition since in the long run it will be cheaper than increasing their dilution.
Accelerate international growth
International development can be capital intensive. It is necessary to recruit salespeople, deploy production lines, and pre-empt regulatory issues (operating licenses, etc.) through legal expenses. These expenses can result in the crowding out of previously raised equity round to the detriment of product development or diversification of the offering. This is particularly critical for early-stage companies with limited equity resources. Conceptually, equity, which is the most expensive resource for a company, must be dedicated first and foremost to product design. Therefore, any policy of international deployment funded by equity may be to the detriment of R&D which would help increase client retention and acquisition.
Extend runway to bridge to the next equity round and improve valuation terms
Cash is King! Venture debt funding allows a lot of flexibility by usually being split in several facilities, to support growth over time while containing the debt burden. The frequency of equity rounds is determined by the runway. According to a rule of thumb, a hypergrowth company is considered to raise for 18 to 32 months of operation before the next round and should approach VC funds when the runway dries up. Venture Debt is a solution to extend that runway to pursue even more organic growth before the next equity round improving key metrics and therefore valuation. This strategy was already relevant before today’s unfavorable market conditions, and it is even more so nowadays to avoid down rounds with VC funding tightening.