Venture Debt Demystified
Venture debt seems to be en vogue these days. While venture debt as a form of financing goes back over thirty years in Canada, it’s seen a resurgence as of late.
A continued push by Canada’s chartered banks to invest in technology-focused companies, plenty of dry powder in the market and the preponderance of market participations (be they private equity, VC’s, alternative lenders, etc.) chasing a limited number of deals, might be a few reasons for its recent popularity.
Traditionally, venture debt was lent to technology venture-backed companies looking to finance and accelerate growth. Yet today, venture debt is available to both pre-revenue and growth revenue companies, across a spectrum of sectors, not just technology.
As a source of financing, owners and founders may ask “what are the features of venture debt and is this capital source a potential option to help accelerate the growth of my business?”.
To answer these questions, we approached three venture debt lenders and one private lender in Canada to dive into the idiosyncrasies of venture debt and discuss how a company goes about getting funded. As you will read, the options are endless and flexibility nearly unlimited vis-à-vis traditional bank debt.
Question One: Who is the ideal borrower for venture debt, and for your products in particular?
Across all respondents, companies exhibiting strong YoY revenue growth, was noted as a strong determinant for product fit. However, while growth benchmarks varied across venture debt lenders, a minimum annual recurring revenue threshold of $1 million was common, with ticket sizes ranging from $100k to $5 million. Unlike traditional bank debt, positive earnings are not necessarily required. Kutral Veerabadran, Principal at Flow Capital notes “EBITDA and/or cashflow can be negative provided that the current capital raise is sufficient to achieve positive [future] free cash flow with confidence”. Similarly, Garron Helman, CEO of Venbridge Capital, a Toronto-based venture debt firm focusing on SRED and tax credit financing for technology companies further elaborates on this point, stating “lenders who provide SaaS companies
facilities based on their MRR have a different set of criteria for evaluating companies. In general, revenue must show strong growth, high gross margins, low churn, and controllable burn”. Quantius Capital, another Toronto-based venture debt lender is relatively unique in their approach. Aside from the above-noted factors which they too consider, the firm’s CEO Lally Rementilla noted their “wide sector focus allows [Quantius]
to work with companies who may not necessarily have recurring/subscription revenue streams”.
Question Two: What are the typical structural features of venture debt?
Amongst the respondents, flexibility in structuring the perfect loan was noted unanimously as a benefit of venture debt. Lally noted “we will work with the company to come up with a bespoke solution (such as a principal holiday, long amortization schedule and repayment terms) that addresses [the company’s] needs and their targeted financial milestones”. Both Venbridge and Flow Capital offer a unique product, known as a cap rate or royalty-based financing (or “RBF”) loan, that blends these three concepts. Each loan derives its repayment schedule based on a % of a company’s monthly recurring revenues. These products offer ultimate repayment flexibility. Unique to Flow, Kutral notes, “RBF is structured as a perpetuity with no minimal or maximal tenure, thereby giving complete flexibility to the entrepreneur/company to decide timing of exit, not to mention total freedom from the stress of impending maturity/bullet”. We also reached out to Jeff Roth at MidStar Capital, a private lender with offices in Toronto and Vancouver, for a different perspective. Interestingly, while MidStar is not a venture debt lender, they do offer loans with higher leverage covenants and lower amortization (often by utilizing cash flow sweeps), thereby mirroring to some extent the structural features of a venture debt loan. As a final comment, equity kickers and/or warrants were not seen as common deal features especially with venture debt loans below $2 million.
Question Three: What is the average tenor on your loans and how are they typically repaid at maturity?
Across our respondents, tenor ranged from 12 to 36 months on average.
Such short loan durations were borne out of historical precedent. Traditionally, venture debt acted as a financing bridge between one equity round and the next. A common goal was to use venture debt to accelerate the company’s growth, allowing it to raise a subsequent equity round at a higher valuation. With the exception of some RBF loans, which may be repaid in perpetuity, shorter tenors are common today when compared with traditional bank debt. Across all our respondents including MidStar, loans are typically repaid upon achieving one of three financial milestones, including a subsequent equity or debt raise, a buyout of the firm or a refinance via bank debt. Because of Venbridge’s focus on financing SR&ED and digital media tax credits (“DMTC”), average loan duration is 9 months as tax credits refunds are collected, and proceeds [typically] applied to repay the loan. With respect to early repayment, business owners should be aware of any early repayment penalties, if any. Lally noted Quantius does not employ make-whole provisions in their contracts, while Kutral explains “in terms of [Flow’s] RBF, the company pays a royalty buyout premium whenever the decide to exit”. So, it’s emptor caveat, i.e. read the fine print as features vary greatly between venture debt lenders.
Question Four: What information is key for a borrower in preparing a strong package to a venture debt lender in order to obtain financing?
This is question is near and dear to our hearts as poorly written or incomplete data packages is one of the primary reasons Kaeros Capital Advisors is engaged as a corporate or M&A advisor. If a company is seeking to take on venture debt (or any debt for that matter!), a well-prepared, cogent and intelligible information package needs to be prepared.
All our respondents used phrases like “keep the process simple” and “very little to prepare” to sum up their typical application submission process. Of course, and what I often explain to our clients, is that the clock doesn’t start ticking until all materials are received. As Garron at Venbridge succinctly puts it “be responsive, comprehensive and accurate and [we] will be able to process your application quickly”.
The most important materials that should be compiled and submitted include:
1. Business plan or presentation deck (known as Confidential Information Memorandum or CIM) summarizing the business, management, industry, competitive position and growth strategy
2. Financing amount requested and how money will be invested in the business
3. Historical financials including monthly income statements, balance sheet and cash flow statements for the past two years
4. Financial forecast (preferably by month) over the next two years
Venture debt lenders may have specific information requests based on the type of business they are providing financing to. For example, given Quantius’s focus on IP-rich technology-focused companies, seeing a list of your IP portfolio and pending patent submissions, might be relevant to their approval process.
In cases where the loan is secured by the recurring revenues of the business, detail on the nature of said recurrence would be important. For example, if you’re a SaaS-based business, answers to questions like how many customers do you have, what is your average churn rate, how much money do you spend to acquire one new client and how long does it take to recoup that investment, would be very helpful.
And finally,
Question Five: Can you identify a few reasons why you’d decline an application for financing?
Poor information packages, specifically a lack of externally prepared financials (Reviewed or better are typically preferred) and a financial forecast, as well as poorly defined industry &/or external market risk factors, were noted as the most common reasons a loan would not get funded. It’s also important that companies are proactive in seeking alternative forms of capital before cash runs out. That’s why I really enjoyed Garron’s response to this question, where he answered “I like to say we do bridge financing, not pier financing. If a company has run out of cash and this would be their last attempt to revive the company, it is unlikely they would be funded”. On a similar vain, Lally notes Quantius does not lend to pre-revenue companies, targeting borrowers with top line revenue of $1 million and above. Given MidStar’s focus on companies with EBITDA north of $5 million, it is not surprising that Jeff says a poorly prepared quality of earnings report (or lack thereof) will negatively impact a borrower’s ability to obtain financing.
As a final thought, I would say that honesty is always the best policy when it comes to applying for any type of funding, including venture debt. Disclosing such things as bankruptcies, lawsuits, nature of intercompany loans and company ownership at the outset will always bode well for the borrower. If the lender uncovers things about the business while completing its own due diligence, that weren’t disclosed as part of the original submission, chances of getting funded drop materially.
At this point in your read, you might well ask but what about the risks and disadvantages of this type of financing? To this question, I will only say to stay tuned for an upcoming post that addresses these very questions.
In closing, we believe venture debt has a place in the capital structure of Canadian businesses, due to its inherent flexibility and myriad structural features. When other capital providers restrict the amount of debt they can lend, including traditional banks, that becomes an opportunity for alternative financing sources to step and fill that gap.
If this type of financing is something you’re considering, please send us an email to trevor.palmquist@kaeroscapital.com and we’d be happy to explore some options with you.
Cheers, Trevor
Founder and Managing Director