As Maurice Werdegar, Investment Partner and CEO of WTI points out, venture debt can serve a variety of use cases in the lifecycle of early and emerging stage companies. But it also carries inherent risk.
What happens if growth plans don’t go as planned or even worse the business needs to completely pivot? We asked Werdegar to share his thoughts on identifying whether your company is a good fit for venture debt, and the nuances you should understand before, during and after the process of securing debt financing.
How can startup founders ensure their best strategic positioning when pursuing venture debt as a financing strategy?
Werdegar: A company needs to have a sense of the key milestones it’s hoping to achieve. Without a clear plan or sense of how additional capital would be applied, companies shouldn’t take on the liabilities associated with venture debt. We encourage companies to get some operating history under their belts. We also encourage them to spend some of their initial capital that they’ve raised to gain an understanding of how their business plan is shaping up before considering taking on additional capital.
Venture debt is at its most impactful once a use-case has been identified.
WTI is interested in looking at venture debt opportunities for companies at all stages, as long as they have raised at least one seed round of capital. In all cases, venture debt should be used as a compliment to the underlying equity funding strategy of a company, not as a substitute for it. It should not be used as a pure bridge when a company is running low on cash and has failed at fundraising.
Why pursue venture debt instead of a bank loan? How can founders determine which option is the right fit?
Werdegar: There are a few fundamental differences worth considering. Banks are federally regulated institutions that are lending out their own bank deposits. As a result, they may have much stricter policies with respect to limiting loan draws. By contrast, venture debt funds are structured more like venture capital funds with more flexibility to take a long view with a company.
Most of us at WTI have founded companies or have worked at startups. We are empowered to resolve all issues directly with the company, which creates a nice collaborative platform for the relationship between us and the company.
For example, we did our first venture debt deal with Facebook when it only had one employee in California and had raised just its initial $500,000 convertible note from Peter Thiel.
Along these lines, what are some common mistakes you see management teams make when taking on debt financing?
Werdegar: The biggest mistake companies make is to look at venture debt as a form of “rainy day” backstop capital if they fall significantly behind plan and have trouble fundraising. We believe that venture debt is more useful to the companies that want to accelerate growth and spending in advance of raising what will likely be a very successful next round of financing. Using venture debt as a backstop often only adds a burden to the balance sheet and increases a company’s burn rate, making it incrementally less attractive to next round investors.
What role does a lender have in helping resolve these challenges? What should startups keep in mind when times get tough?
Werdegar: A lender can have a very positive impact on a troubled situation. First, an experienced lender can provide advice to a management team on how to work through difficult financings, hiring M&A advisors, contingency planning and even restructuring loans and other costs. If a company does lose the support of its investors, an experienced lender can use strategies to protect a company from other creditors or bankruptcy filings. This can effectively save a company and give it the time to turn their business around, find new financing and live to see another day.
How can founders make sure that they choose a venture debt partner who can effectively mitigate risks and support founders when times get challenging?
Werdegar: Founders should rely on key advisors: law firms, board members, part time CFOs, investors and other trusted mentors. We encourage management to perform back-channel reference checks and ask venture debt providers for the references from companies that have encountered substantial challenges such as missing milestones. It’s easy to be a lender to a good company – it is much harder to be a strong and thoughtful partner to a company that encounters unforeseen challenges.
Any last thoughts on debt financing options?
Be in your strongest possible positioning as a business and work with a debt partner who can empathize with the risks you’re facing. It’s not exclusively about the money—when you’re running a startup, you’re dealing with extreme ambiguity. You need a partner who believes in you, understands the unique challenges you face as a founder and will work with you to land on your feet.