Venture Debt: Down Round Protection Without Triggering Downside Provisions

There is increasing chatter in the startup and investor space surrounding venture debt. It is not at all surprising that as the availability of ready capital has contracted considerably over the past two years, debt and debt-like items have come to the front of mind. It is tempting to think that it is only venture-backed software companies falling on hard times that would consider looking to new debt to help them stem their burn rate. This however, would be a mistaken view. Putting aside that even established private equity leaders have been recognizing the value of increasingly moving into the private credit space (both as a lender and as a borrower), debt has always been a useful tool in the corporate context. Venture debt in particular, if used correctly, can be a very effective tool for startups in today’s environment for one very specific reason: avoiding down rounds.

Why Venture Debt is Unique and Valuable

To illustrate why venture debt can be so useful to startup companies in today’s market, let’s first take a step back and look at what makes venture debt its own category of leveraged finance. Venture debt is a kind of debt instrument offered by specific finance institutions and private lenders to venture-backed startup companies. The instruments are usually short-term (with a repayment term of 2-3 years) and typically have a higher interest rate than other types of debt (such as bridge loans or mezzanine financing). In addition to obvious drawbacks associated with debt instruments, such as covenants placing potential restrictions on operations and the ever-present risk of default if a borrower runs into financial difficulty, venture debt carries a unique (and rather ironic) element that can make companies hesitant to utilize it. That’s because venture debt is usually only available to companies that can raise a certain amount of venture capital, and those very companies may not want to leverage venture debt offerings because of the optics involved. Does the need for more capital indicate financial distress? Additionally, does the turn toward debt financing mean that the company’s VC backers are losing faith and unwilling to put in additional capital?

This is an interesting quandary that more than a few companies are encountering. However, it really shouldn’t be a source of consternation, because the strategic use of venture debt can actually help preserve a company’s relationship with VCs by avoiding down rounds.

As any transactional attorney who worked on growth equity deals in 2022 can attest, investors are particularly sour on the concept of down rounds. Down rounds can send negative signals regarding an investment’s growth trajectory (and therefore prompt talk of exit options), result in diluted equity value for the VC and even send ripples of unease among its limited partners. There is a reason why some investment documents can contain 200+ pages of downside protective provisions. Investors are not fond of catching the falling knife.

When Venture Debt is the Best Debt Financing Option

The above scenario is one reason why venture debt can be so useful. When a company hits a headwind, the need for capital does not slow down, yet the capital needed to steer the company through that headwind can be difficult to raise from equity financing. Venture debt offers companies a way to extend their runway and invest in the resources needed to continue growth, while also buying them the time needed to make the operational changes necessary to right the ship. All of this is done without having to raise the potential ire of existing investors, or trigger any of the anti-dilution provisions they likely have baked into their preferred share protections.

Of course, venture debt is not a simple “Get Out of Jail Free” card. It is a tool, and is only as helpful as the way with which it is employed. Venture debt products usually have higher interest rates and quicker turnaround times than other traditional debt products. This means that it is very much a “break glass in case of emergency” financing tool, as it can put immediate pressure on a company’s cash flow. As such,  venture debt is best used as part of a larger strategy that will improve operational efficiencies and increase revenue, all with the ultimate goal of continuing healthy growth rates. With a good strategy in place to get through a period of financial difficulties, venture debt is one way to help a company weather the storm without the risks associated with down rounds, keeping current investors happy, which is always a desired outcome.

Conclusion

Though there are valid reasons to be hesitant when considering venture debt, the facility can be a very helpful tool that can allow cash-strapped companies to get an injection of much-needed capital in difficult economic conditions without having to resort to a down round. But remember that venture debt is best used amid a grander plan that leads to future growth and financial success.

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