How one founder leveraged debt to drive early growth and avoid dilution

Avi Freedman is like any other founder: He wants to build a great company. In this case network analytics platform Kentik, and he needs venture capital to do it. Like pretty much all founders, he doesn’t like the dilution that comes from taking vast sums from VCs in order to grow. There’s always been an alluring solution to this dilemma, but one that comes with its own tradeoffs.


The word has negative connotations, but the reality is that just like equity capital, debt is a key tool in the corporate finance toolbox. Judicious use of debt with the right terms and conditions can cut the cost of capital for a startup significantly, saving founders and early-stage investors from serious dilution as a company scales. Used too heavily or improperly however, and debt can turn a bad financial quarter into a dead company, stat.

Founders, particularly those who run companies with recurring revenues, are increasingly hearing the debt pitch from bankers and peers, leading many to consider debt options much earlier than has traditionally been the norm. Boards are also getting more comfortable with the idea of a startup taking on early debt to extend runways and double down on growth.

Let’s walk through how a founder sees debt today and discuss what the market looks like for debt options. Freedman was helpful in illuminating his recent fundraise, including the range of term sheets he got, and was willing to share his experience and thinking on how he approached his latest financing.

Debt and COVID-19

Some context to get started. Kentik is a six-year-old SaaS platform that has raised more than $60 million in venture capital, according to Crunchbase, including a seed round led by First Round Capital, a Series A led by the now-defunct August Capital (which is still actively managing its investments), and a Series B led by Third Point Ventures (plus the company’s most recent equity/debt round we’re talking about today). Freedman himself has been a long-time entrepreneur, building the first ISP in Philadelphia back in 1992. Kentik was his first true “venture-backed” business in the Silicon Valley startup model.

Starting earlier this year, Freedman was looking at his options for fundraising. He intends to raise an equity round later this year, but had started meeting debt investors at conferences like AGC and KeyBanc who warmed him to the idea of using venture debt as part of a comprehensive funding package. As effects from COVID-19 started bearing down in March, Freedman decided to run an abbreviated search for debt capital.

He got five term sheets in roughly two weeks, one of which came from a SaaS securitization firm which we talked about on Extra Crunch a few weeks ago that I will comment more on later. Two term sheets came from debt funds, and the remainder came from banks.

In the end, he chose Vistara Capital Partners, a debt fund that offered a mixed debt and equity term sheet of $23.5 million. Freedman says he met Vistara as part of an “investor dating” format for 25 minutes “in the waning days of handshakes,” and proceeded to do the negotiation and due diligence online to close the round.

A framework for a positive relationship with debt

Freedman approached debt with a clear intention for getting the terms right and structuring the conversation properly. “Venture debt is all about investor relationships,” he said.

A bank’s relationship is often not with an individual founder or startup, but rather a holistic relationship with a specific venture capitalist and likely even more broadly with that individual VC’s firm. Some banks have multidecade relationships with their VC firm partners, and they can draw on the wellspring of goodwill that has accumulated over a long business partnership when times get rough and debt has to be repaid.

That’s why it is critical that all investors understand the terms of the debt, what it means for their own liquidity positions, and that they are aligned with the debt provider. Debt has the highest seniority in the capital structure of a company, which means that any money that is recovered in a bad situation goes first to the bank before it flows down the waterfall to VCs and common shareholders like founders and employees.

Freedman said that he, David Hornik (who represents August’s interest) and the other investors in Kentik came to an understanding on what “good” debt would look like and what was most appropriate for the company. “Keep your investors informed early and often,” he emphasized.

The key motivation for him was that the company has good growth potential this year and has a strong net dollar retention rate, which means spending for growth today can pay itself back reasonably quickly in the future and provide cover for upcoming debt payments.

Finding the right debt terms

It’s one thing to have a framework and investor alignment around debt. The real challenge is to get the right terms that optimize for the success of a startup while mitigating potential downsides.

In Freedman’s case, he had a couple of nonnegotiable terms, and from there, tried to optimize the financials to best help Kentik succeed. “The thing we were really insistent on,” he said, was a “no MAC clause.”

That’s a material adverse change clause, which states that in certain scenarios, a bank can take over a company to protect its debt repayment. For instance, if revenue suddenly drops, or a key executive departs, or a myriad of other potential conditions are triggered, the bank could take unilateral action to shore up the startup or even just liquidate it to recover its capital.

Freedman said that a number of his options had no MAC clause, including the one he signed with Vistara.

The other term to minimize (or eliminate entirely, if possible) is an investor abandonment clause, said Freedman. As I discussed before, a bank’s relationship is often with the VC firms around the table rather than the specific startup under consideration. Therefore, banks often add this clause to protect themselves in a scenario where a VC investor is getting cold feet about a company and refuses to put in more money to help it through a rough patch.

The problem with this clause is that its trigger can be very ambiguous. “If you are going to agree to it, make it clear what the metric is,” Freedman noted. If you have to have one of these clauses in, make sure that it offers a sufficient “cure period” that affords you an opportunity to raise funding or otherwise fix the underlying financial problem before the bank can take over.

The last piece to the terms themselves before we get to the finances is negotiating the covenants — essentially guarantees that a company makes to the debt provider around its operations. There is a huge spectrum of covenants that might be agreed to, such as revenues, revenue growth, operating expenses, profitability (or path to profitability), margins and much more.

Freedman emphasized repeatedly in our conversation the importance of making all covenants as objective and clear as possible (along with every other term of course). “My mother was a tax attorney, and as she told me, ‘if you don’t understand something, a judge won’t understand it’,” he cautioned. Good lawyers obviously help here, as do experienced investors who can help you negotiate, but nothing beats having your own understanding of what you are agreeing to. For instance, Kentik agreed to an ARR-based covenant with Vistara and “they were really reasonable about that,” Freedman said.

Debt is in the financial details

Okay, so let’s get to financials. For Kentik, Freedman saw a path this year for immediate growth and wanted debt that maximized flexibility to spend for that growth. The main financials under consideration were the length of the interest-only payback period, the repayment premium (what Freedman called “penalty”), the drawdown period, and of course, the size of the debt facility and the interest rate.

All of these financial terms range from very startup friendly to very debt provider friendly. The lower the interest rate, the better it is (there, saved you an MBA!). Negotiations are all about tradeoffs. For instance, you might accept a higher interest rate in exchange for more flexibility around drawdown and repayment. Or you might have no drawdown period at all (i.e., you take all the debt immediately upfront), but accept a lower interest rate. It’s important to get alignment on what your goals are with debt and exactly when you want to use it so that you can negotiate a term sheet effectively.

Regarding the specific terms themselves, let’s start with the drawdown period — this is how long after getting debt you have to actually “take” it, which is when interest has to start being paid. Longer drawdowns give startups more flexibility to use debt, but at the cost to the bank that they have to reserve capital for you to use without getting paid interest for it. The more flexibility you want, the higher the cost of capital will be on average.

An interest-only period allows a startup to grow into a debt facility earlier than it might otherwise be able to given its cash flow. If you expect massive revenue growth in the next few quarters, you could take on more debt earlier by avoiding repaying the principal of a loan during the interest-only period, and start making full payments when the startup is in better financial help. Longer interest-only periods often come with more strict time periods for drawing down the debt line.

Another area of negotiation is on the payment structure for the loans. Debt is repaid over a strict period, either linearly (you pay a fixed payment every month for a set period of months) or it balloons over time (you pay less in earlier months and then make it up by paying more in later months). Balloon terms are popular for startups because presumably startups grow quickly and it is easier to repay debt in later years than earlier years. For the bank, a bigger balloon later in repayment is more expensive as well as riskier, and so the more you backload your repayments, the more expensive your debt will be.

Finally, debt often has an early repayment premium if you pay back debt before its actual due date. These terms are critical for venture debt funds but less so for banks, because coupled with an interest-only payment period, it would be possible for a startup to essentially take the dollars from their next VC round, wash out their debt and then get a new debt line while paying minimal interest — essentially a free loan.

So what did Freedman and Kentik end up doing?

First, Kentik already had two loan products with Silicon Valley Bank (SVB): an equipment line and an ARR-based balloon loan product. The equipment line covered the buildout costs of Kentik’s cloud infrastructure. Freedman wrote in an email follow up that “the board treated [it] as less toxic because it was just an alternative to leasing.” He said that the terms were simple amortizing over a set period of months. The ARR-based loan was “shorter term and smaller in magnitude than debt funds would offer.” He said that “it allows us to get — I know, a dirty word — profitable.”

With the new package from Vistara, the firm did a paired equity investment, which allowed them to be “aligned” with the startup. From there, Kentik did a standard debt line as a single product. Across his five term sheets, he had offers of up to five years of interest-only payments, although he demurred about the specific terms of his loan with Vistara.

Could SaaS securitization be a future model of debt for startups?

Let’s move on to a bit more of an avant garde debt option: SaaS securitization. As SaaS startups have grown in popularity, new options have emerged that are designed to finance startups based on underlying metrics like churn, cohort, attachment rate and more, rather than just general risk profiles. The dream for entrepreneurs building these financial products is to lower the cost of capital for the strongest revenue companies, since they also have lower risk profiles.

Freedman looked at two options here for Kentik: One from Lighter Capital, and another investor he didn’t want to disclose due to confidentiality. Lighter had too low of a loan max for Kentik, and so while he said they had a “good reputation,” it wasn’t an option that could be truly considered given the startup’s capital needs.

He said that SaaS securitization models are interesting in the sense that the underlying debt was more closely tied to actual performance. In the models he looked at, a company could draw down their debt line each quarter based on a calculation of their ARR, with an adjustment for the company’s net dollar retention rate. That drawdown had a six month interest-only period and would be amortized over 18 months. As the startup made payments on the debt, new dollars would be made available again in the facility, and so it constantly revolved with the startup.

However, when compared to more traditional forms of debt, these newer options didn’t seem to match up well. One challenge was just the sheer complexity of the models, but the other issue is that when the financial terms were fully calculated, they just weren’t all that competitive with traditional debt. The SaaS securitization products he looked at “didn’t have as good characteristics as minimally more expensive but much longer interest-only period options that we saw” in the traditional venture debt space.

Maybe the underwriting will get better and more competitive over time. But given my personal enthusiasm in these products, I thought it was interesting that a reasonably well-informed founder looking at these products today was less inclined to go in that direction.

Debt is interesting (or at least, interest-bearing)

Debt is a tool, with stricter rules than traditional venture capital and more edge cases that can lead to disaster. On the other hand, it is nondiluting — and can be really valuable in recurring revenue businesses with more predictability.

Freedman made a good point in our conversation: “If you don’t have the right metrics, it doesn’t matter.” The deal terms you get are fundamentally derived from the strength of your business. If you have more ARR, better NDRR, lower churn, etc., you will get better terms and debt makes more and more sense. That’s the magic of running a winning company — financing becomes cheaper for the winners, which means the winners can win all the more while their founders, employees and investors take even less dilution.

If you have the option, the timing is right and your investors are on board, consider looking through some debt offers and how they might align with your startup. The process tends to be a bit more accelerated, and there aren’t a huge number of places that offer debt in the first place, so the search is typically briefer than a venture fundraise. Ultimately, debt can be an iterative process — you generally don’t have just one shot to get everything you want. If the fundamentals are still good, you can always head back to your banker and add on more debt or try other products.

As for SaaS securitization, there is still a lot of excitement there, but time will tell if the dreams of Excel models match the cold reality of startup financial math.

Updated August 22, 2020: Changed the wording of Kentik’s loan products to make clear which were from SVB and which were from Vistara. Also made it clear that repayment premiums tend to be demanded by venture debt firms and not from banks.