All money is not created equal: What raising venture debt looks like

The first step in the process of raising venture debt is a quick, introductory filtering phone call between you and the potential lender that’s an equal amount selling and listening — on both sides.

Think of it like a first date. Should that go well, it should then be followed up quickly with both parties signing an NDA. (VCs don’t like to sign NDAs, but venture debt lenders don’t have a problem with it.)

At this point, we would start our initial due diligence. We typically ask a company for six things:

An investor presentation

If you are looking for investment money, you probably have recently raised equity. The investor deck you would have used for that works for venture debt as well. (There are numerous examples online.)

The 409A

The annual valuation of the equity value of the company, designed to protect employees who are granted stock options so that they can’t later be slapped with a tax for getting “cheap stock.” Usually those valuations come in at a level that makes getting equity attractive to employees. Don’t worry if the value assigned by the 409A valuation firm is lower than what you believe is fair. We know how these valuations work and don’t become fixated on their valuation.

The 409A will include different ways of analyzing the value of the company, the same things we look at: discounted future cash flow; comparables to public companies; comparables to recent M&A. It will also give a really good history of all the funding the company’s ever gotten, and it always includes a five-year projection.

A detailed capitalization table and funding history

This will include everybody who owns any piece of the company, a history of fundraising and a history of any bank financing or external debt used.

Historical financials

Ideally, we will receive five years of historical financial statements. We would love it if they were audited, but it’s not necessary.

Projected financials

For us to do our work, we want a fully linked, three-statement financial model. The three statements are balance sheet, income statement, and statement of cash flow. If there are delays or issues in the process, it’s usually because of a delay in getting linked three-statement projections, which allows us to do “what-if” analyses (e.g., “If things go worse than planned, when do things break? How much does this startup need to reduce their variable expenses to remain viable and able to service our debt?”).

Often we’re lending to companies that sell to big enterprises, so instead of having a million customers, they’ve got a hundred, and we’ll want to understand how they sell, how predictable their sales forecasts are, and how comfortable they are with the coming years. All of that helps us judge how much we believe in their financial projections.

A list of the largest customers, present and past

Detailed customer information allows us to identify customer concentration or churn. Those can be quick disqualifiers, and we don’t want to waste a lot of anyone’s time if that’s the case.

If a potential borrower’s customer base is too concentrated (fewer than 15 total customers or more than 50% of revenue from just a few customers), that’s too risky for us. Or if the startup has a lot of churn — meaning that their existing customers decided they’re not going to renew or stay with them — that’s another red flag/likely disqualifier. There is nuance around this, too. If your product has evolved significantly and in what we would consider a positive, logical direction, then churn could make sense.

With all this information, we can do a desktop analysis that typically takes two weeks. We could do it more quickly if absolutely necessary, but we like to give ourselves two weeks. If the desktop analysis is positive, we would issue a term sheet.

Doing it our way allows us to customize a thoughtful structure and set of terms that are fair for us and appropriate for the borrower. For example, tailoring the loan for the borrower could be around when you actually need the money. Maybe you need it right away, or perhaps it’s a little farther down the road.

Other variations could mean structuring the deal so the interest rate declines as the company gets stronger, or having a longer interest-only period, where the debt isn’t amortizing, because you wouldn’t be in a position to start to amortize until a certain event occurs.

I would estimate that everything I’ve outlined above should take about four to five weeks from our first phone call. That means you’d probably have a term sheet by week 5.

Going to the board

Up until now, you probably only have the CEO and CFO involved. Once you get a term sheet, you’ll want to present the deal to the board.

Some companies will have their board involved from the beginning of the process. I’ve known of deals that got derailed because a board member didn’t want to do a deal with a specific lender. It could be a personal (and one-sided) beef; it could be that a board member knows something specific about the lender. This has never happened to us, which is why I suggest at least letting your board know what lenders you’re talking to early in the process.

How quickly things move from the board presentation step depends on the borrower. They’ll likely be looking over term sheets from different lenders. I would guess 10% of the time we’re the only lender involved. The other 90% of the time there are multiple lenders pitching to provide growth capital. The company may also be considering using some or all equity to meet their needs.

If there are three or four term sheets to work through and compare, you will probably take about a week to get through those. While a deal itself may be relatively straightforward, that doesn’t mean that every deal will be the same. Not only do lenders differ regarding the stage at which they will lend money, but some will also specialize by industry. Terms will, of course, vary from lender to lender.

For example, if you are looking at a lender, a key question to ask is, “What is your ratio of term sheets to closed deals?” This should give you a sense of how seriously you should take any overture. (A sample term sheet — a mostly nonbinding agreement outlining the basic terms and conditions surrounding a potential investment — that we would use is in the Appendix.)

There are lenders who will offer term sheets just to get their foot in the door. We don’t do term sheets unless we’re pretty confident that we’re going to do the deal. For example, in 2022 we signed 15 term sheets and closed all but two. One remains in process as of publication and the other decided not to use debt because their board wasn’t confident in the company’s ability to predict its business and achieve its plan.

Some lenders blow hot and cold or will issue term sheets that don’t really amount to anything. The issuing of a term sheet doesn’t come with legal obligations on the lender’s part, but we like companies to know that if we’ve gone to the trouble of doing the work required for a term sheet to be issued, chances are really high that we want to do business with them.

This has worked to our advantage in building our reputation as being a steady hand in choppy waters, and about being more than merely transactional. VCs and board members are looking for money (and partners) they can count on.

There are only two aspects of the term sheet that are binding, as term sheets are pretty standard throughout the business. The first is a period of exclusivity — say 30 days — where it says that the potential borrower won’t work with any other lender while we do our due diligence.

The other binding part is that the potential borrower is required to make a deposit with us, usually ranging from $50,000 to $100,000. Our guarantee is that if we walk away in due diligence, we’ll refund all of the money except for what we spent on due diligence. Such expenses are usually minimal. If the borrower pulls out, they forfeit their deposit.

That puts it at week 6 for a signed term sheet. All that’s left from there is what we call “confirmatory due diligence” and legal documentation. The variability in the legal documents versus the variability in term sheets is very minimal. (Almost all of the legal documentation around term sheets can be traced back to the work of one lawyer, John Hale. Most people probably haven’t heard of him, but his work has had a big impact on deal-making in Silicon Valley.)

The number of negotiating items is relatively small, so getting through that part should be fairly quick. If you are planning to use venture debt, you will want to make sure you’re using an attorney with experience negotiating venture debt loan agreements. They aren’t very complex, but they are very specific, and much time and money can be wasted if one side of the table is being educated on the job.

As part of the final due diligence, most lenders will do an on-site visit. At Runway, it’s mandatory that we spend one to two days at the company and meet the entire senior management team. In my mind, looking the team (especially the CEO, CFO, and head of sales) in the eye and going through their customer base line by line is critical. I’m proud to say that we maintained this process throughout the pandemic.

As the final phase of due diligence, the last thing we do is reference checks with the company’s customers. We’ll call maybe 10 to 15 customers to confirm what the company has told us. If we can, we’ll do reference checks with customers that the company has lost. This isn’t about playing gotcha. We just want to do everything we can to try to get a feel for the company’s reputation in the marketplace. If the company is non-sponsored — meaning they haven’t raised any institutional money — we’ll do a full background check on management as well.

These last two stages — after week 6 — can take another four to six weeks. And then, if all goes well, we’ll close and the borrower will have the money wired to their account on the day of closing. In total, expect the process to last from 10 to 12 weeks from the first meeting to cash in the bank.

How much?

At Runway, we’re enterprise value lenders — enterprise value being how much the company is worth. We’ll lend a company up to 25% of its value. From our perspective, the durability of enterprise value is more important than the potential for a big upside. It’s also important to know that we tend to ignore (or at least underweight) the value of the company defined in the most recent round of equity funding, especially if the round was priced by existing or strategic investors or was more than a year earlier.

For us, the most important definer of value is relevant and recent M&A comps. We will also look at public comps, DCF (discounted cash flow) analysis, sum-of-the-parts, and other mechanisms of ascribing value, but the most important is M&A comps (because the most likely means of exit for venture-backed companies is M&A).

The interest-only period

Almost all venture-debt deals come with an interest-only (IO) period. It is an important structural element of a growth loan because it provides the borrower with more cash to use to fund growth (compared to if the loan required amortization — principal payments — from day one). As you can imagine, most borrowers prefer as long an IO period as possible. It provides the most flexibility and the most access to capital. To accommodate this desire, most of our deals include provisions for automatic extension of the IO period if the loan and borrower are performing as planned. From our perspective, if we have a borrower we like, we’re going to work to keep them, which usually means extending the interest-only period.

Unfortunately for borrowers, many lenders have a very different philosophy — “We get in and we get out” — and view the velocity of debt as a good thing. They generally couch it by saying something like, “Technology changes so fast. It’s just our way of managing risk.”

To me, that’s an excuse. It’s one thing if a borrower’s risk profile changes dramatically, but very often that’s not the case. Beware of lenders with a reputation for being rigid about amortization. It is probably an indication that they expect you to refinance them at the end of the IO period.

Covenants are your friend

Borrowers could save themselves a lot of pain if they worked with their lenders to develop properly structured covenants. Too often borrowers view themselves as having scored a big win if they have no covenants: “We got a deal at prime plus one with no covenants.” Covenants — agreements between two parties about what each will and will not do — protect both borrowers and lenders. Be very wary of a lender who doesn’t have covenants. They pretty much say, “Here’s the money. We don’t care what you do with it, but if things go wrong, remember, we’re first money out.”

Communication protocols are another way of making the relationship a strong, positive one for both parties, which is why we build them into our covenants. We normally have a performance covenant that is designed to lead to a discussion if you are not achieving a specified percentage (typically 85%) of a mutually agreed upon financial plan.

If you have a loan with Runway or any other lender, at the end of every month your CFO will be required to file a compliance certificate, stating that there are no defaults and no fraud and indicating how the company is doing relative to its goals. Let’s say at the end of August we get the certificate for July, and it essentially says, “We’re in default” (compliance certificates are typically due 30 days after the end of the month). Our normal response would be to set up a call with the CEO and CFO to find out what’s going on. We might hear something like, “Oh, a couple of big accounts slipped from July. Wait until you get the August certificate, and you’ll see that we’ll be back on plan.” Very often, the slip fixes itself and we waive the default and move on.

However, if at the end of September, we were to get the August certificate and it was the same story, we would have another conversation — this one a little more serious. We might have a conversion with the company and include the VC sponsors. We might suggest that we recalibrate everyone’s expectations and establish a new official plan for the company. We might also ask the VCs to invest some additional capital to maintain the liquidity profile (runway) on which we based our underwriting.

When companies have missed projections for two months, putting the quarter in jeopardy, it’s not uncommon for the CEO to declare “all hands on deck” to make sure that September results are spectacular. There’s every chance that September won’t be spectacular. In that case, we might have a conversation about making some amendments to the loan and/or hiring a banker to sell the company. Selling the company prematurely is nobody’s desired outcome, so the communication protocols (defined in the covenants) would ensure that there will be no surprises after the first missed month. Without such protocols and covenants, it’s too easy for things to slip under the rug — often without malicious intent and with the sincere belief that things will pick up. The lender might realize too late that the borrower has missed their revenue for six months and is now in dire straits.

Those kinds of circumstances usually mean there is not enough time to sell the company in an orderly process that maximizes value for all constituents. Too often in this situation, lenders, in shock from the revelation that a borrower they thought was doing fine was actually in crisis, will panic, foreclose on the company, and attempt to sell the assets in a fire sale, which isn’t good for anyone’s reputation.

At Runway, we have built our reputation on not panicking. Instead, we pride ourselves on being a steady hand in rough seas and doing everything possible to be patient and a good partner. We may not always agree, but we will always listen and work tirelessly to find a mutually workable solution.

Key takeaways

• Borrowing is a fairly straightforward process, but each lender may offer different terms.
• It is wise to involve your board from the beginning of your process to consider debt.
• Covenants and communication protocols will protect both parties.

---

This post is an excerpt from the author’s book, All Money Is Not Created Equal.