October 7 2020 - New York, NY

Venture debt: Michael Tannenbaum

Thomas:
Brex in the Black is a crash course in financial operations, and today we're going to talk about venture debt with Brex- CFO Michael Tannenbaum. So, Michael do you want to just start off the bat with an overview of venture debt and walk us through the play by play?
Michael:
Sure. Basically, in every kind of panel or event that I do I usually get a question about venture debt. So I think it's worth addressing. I think the number one thing to remember about venture debt is its debt. It's not equity. You need to pay it back. And the other thing to remember about most debt, which is sort of true here is that when someone lends to you, the best that they can do is get paid back. So their assessment of whether they want to do the debt is will this person pay me back? Not how big and amazing can this company be? However, venture debt is unique because it typically has an equity life component or warrant, which means that the lender or the counterparty does sort of care how big you can be. And I think that's why venture does unique and why it's popular in Startup land.
Michael:
Otherwise, I had to tell our CEO and regain this a lot when we were out raising traditional debt. I was like look Henrique, nobody cares how great and handsome you are. They just want to know will you pay them back? And so I think that's where this kind of venture debt differs from traditional underwriting. Traditional underwriting is cash flow to pay down debt not so here, it's really the way it's underwritten is somewhat how big will the company be? But primarily it's just will venture debt be... Will the company raise another round. So that makes sense?
Michael:
So you sort of raised venture debt as a way to bridge additional basically to bridge yourself with additional capital to get to your next round typically and you're doing it to take less dilution. So it's unique to the startup ecosystem. The vast majority of business lenders that do commercial loans won't do venture debt, but people like Silicon Valley Bank, Bridge bank, and then funds like triple point in Hercules Capital, they do it.
Thomas:
Do your turns typically look like with what these players you just mentioned?
Michael:
Yes. So, rates which everybody's focused on are usually going to be in the seven to 12% range. So not actually cheap, but traditionally you could look at venture capital cost of equity as being more like 25 to 30%. That's at least what Brex uses today and we're actually relatively big for a startup. So venture... When we talk about venture capital cost of funds, you mean what are venture capitalists hoping to return with the money that they invest in your company that return hurdle or threshold is much higher than it is for debt. And so seven to 12% seems lower and is lower and that's why this requires less dilution. Usually there's going to be some warrant coverage meaning, so warrants are typically penny warrants. And what they mean is they're basically a grant of equity to the venture debt lender at one cent a share.
Michael:
So it's essentially giving away shares to that lender and they typically come in. They're quoted in basis points, which are fractions of a percent. And so, 35 to 150 or 0.35 to 1.5% of the company, 35 to 150 is typically given to lenders in this context. One thing to watch out... so that's one of the way the terms work. It's 24 to 48 months. One thing to watch out for is that typically, these people the lenders will have some covenant. Usually, the covenants are some form of liquidity covenant meaning you have to maintain a minimum amount of cash. And they're sometimes also a tangible net worth covenant which means you can't have losses to your equity or basically cash burn over a certain amount. And then another thing that usually is done is they try to make a lean or suggest that if you don't pay them back they get your intellectual property. That's a tricky one. And so you want to try and make as much as possible and make that a negative pledge, meaning that you can't pledge your intellectual property elsewhere rather than an actual lien.
Thomas:
And is venture debt something worth considering for founders and at what stages?
Michael:
So, I would say yes. It that is definitely worth considering. It can help with runway and avoid dilution. Everyone should probably consider it. So, one thing about venture debt is if you're pre-seed or seed nobody cares about you in venture debt world you're just small. So ,I don't think that if you don't have over, I would probably say three to $5 million in the bank, you or have raised three to five million. So you've done like a million dollar seed round. It's too risky and that's not really where venture debt plays. It's much more larger seed, but really series ABC gate. So, it's much more like you have a business. There's something that venture debt can look at. You have a track record, you have good investors, then they like to comment. Remember lenders, they're still primarily not to lose money.
Michael:
So they want to feel like they're not going to lose money on your company. And the more the easier that becomes when you have more investors, you have more capital and more of a traditional business though so sort of the larger you are, the more you should be thinking about whether venture debt is a way to bridge yourself to the next row. Couple other things you should think about though, is if you have... If you're a SaaS business and you're already booking ARR, right, there are other options out there and venture debt is one of them. And it will be modified to give you the credit for the recurring subscription revenue that you already have. Right? If you're a lender, the fact that you have booked a bunch of revenue each month, that's unlikely to go away because you're a subscription that's valuable to lenders.
Michael:
And so that will make you more appealing in the eyes of venture debt, but will also mean that you could use other alternatives that have sort of sprung up that lend against these revenue streams. Yeah, the way I would treat venture debt in general, it's sort of like the way that I try to approach all of early stage financing. It's like you have milestones that you want to hit. Those are associated with times you're going to raise money because your business has is worth more and we'll be more attracted to investors, and you want to think through venture debt is just being a way you can get from one milestone to another. Typically, not going to bridge the whole thing you're going to need this. It's a supplement to equity, but it is a good thing to pursue.
Thomas:
Thank you for that bullet discussion on venture debt. Thanks Michael.
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