29. April 2013–
Until recently, venture debt – a type of financing largely for venture-backed, later-stage startups provided by specialised firms and banks – has been a relatively unknown concept in continental Europe. However, it is becoming increasingly popular as more startups are seeking alternatives to fund their growth.
Olya Klueppel, Partner at investment management firm Eso Capital, shares some points on why venture debt could be an option for your company...
In Europe, venture investing is still a relatively young industry and plays a smaller role in the economy compared to the US. After the crisis, private investors devoted less capital to venture capital, partially due to the perception that VC returns in Europe lag compared to other private equity investment stages.
Although governments have partially stepped in – funding by European government agencies account for about 40 per cent of VC funding – the overall amount available is relatively low. An average European VC fund has assets of €50m versus $150m in the US, according to the European Private Equity and Venture Capital Association.
Alternative options for later-stage startups
On the lending side, banks in Europe and the US have traditionally not been very active because they don't like the risk that comes with financing tech companies. However, a number of alternative players providing growth-lending to late-stage startups have emerged in Europe. Although the total amount of such capital is still insufficient relative to demand, debt has emerged as a viable funding alternative for companies.
Debt is driven on one side, by the increased maturity of VC-backed business and a booming startup scene – especially Berlin – and on the other side, by the decrease in available equity to fund later-stage startups.
There are several advantage to debt, like being cheaper than equity and not dilutive. Also, it normally entails a significantly shorter process – about six weeks from signing the term sheet through due diligence and to funding – and does not require board-level control.
While debt is not suitable to every company, here are a few things to keep in mind when evaluating this option:
1. Debt can be an alternative to equity
Most entrepreneurs looking for capital to bring their company to the next level don't usually think of debt as an option. Yet at a certain stage, debt can be a “smart” source of capital.
For companies, venture debt can be attractive because it provides extra capital to the company without significant dilution to existing shareholders and founders. Not only that, it allows the company to achieve growth milestones or to secure its next round of equity funding at more favourable terms. Additionally, it allows the company to diversify its funding sources and to strengthen its balance sheet ahead of a potential funding event.
2. Is my company ready for debt?
Demand for debt is driven by general lack of capital, owners looking to avoid further dilution and ability to obtain customised terms to help the business take off. However, venture debt requires a shift in mindset because it may not be a good fit for all startups.
Growth lending is geared at venture-backed companies with proven a business model, existing revenues in the €10m to €200m range and strong backing from existing shareholders. This is not the right solution for those looking to validate a concept/product or looking for a seed/Series A round.
3. Be honest about your motivations
If you are looking for an alternative – or addition – to the equity round, then debt is the right tool for you. However, if you are only think about a low single-digit interest rate, then your expectations are unrealistic.
Investing in startups, whether through debt or equity, is risky. Period. As they say, “money costs money” – so what should you expect?
One thing to keep in mind is that lenders evaluate companies on conservative growth forecasts. They are focused on the worst-case scenario – while they would be delighted to hear that the company will reach €500m in sales in three years and will be worth a cool billion – unlike equity – they do not get to profit from the upside.
The lender is mostly concerned with whether the company will be able to generate sufficient cash to pay back interest and principal over the life of the loan. Size of loans typically range from €5m to €15m but can be as little as €1m.
The downside to debt is that if the company breaks the conditions of the loan, there is a possibility that the lender takes over the whole company in order to recover the loan.
4. Choosing the right lender
Picking an experienced lender who understands the motivations of your business and has actually gone through a number of restructurings is vital. Unlike equity investors, debt investors do not sit on boards and are not expected to drive strategic decisions. However, if you don't feel that they understand the profitability drivers and incorporate them into the terms but, instead, try to impose “standardised” terms – steer clear.
Your lenders should try to work with the business and owners when things are tough, rather than take over the business at the first sign of trouble (so called “loan-to-own”).
And of course, pick a lender that has sufficient capital and where other existing investments did not go sour because this could hamper the availability of capital for your business in the future.
5. Seek flexibility
Alternative debt providers are not banks and normally do not (and should not) have rigid templates for the terms and conditions of debt. The company should definitely negotiate terms – especially with regards to repayments and interest rate – that match its expected cash flow profile and overall business plan.
6. Read the term sheet
This obviously applies to both debt and equity term sheets, yet it is surprising how few entrepreneurs actually read the term sheets and instead rely on the lawyers to do the job for them.
In the end, the terms and conditions attached to the funding have to match your expectations for the development of the business. So make sure to look for hidden fees and unrealistically tight terms that might not match your business plan. Usually, these are spelled out in the last third of a long document.
7. Make sure you can get out
As your business grows and becomes more profitable, it will gain access to other, potentially cheaper, sources of financing, including bank loans, etc. It is important to make sure that the current loan can be repaid easily and without significant prepayment penalties.
Want to hear more from Olya and other leading VCs and experts from the startup scene? Get your ticket to Vertical Media’s Heureka! Conference on 14 May below:
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