"Is venture debt the new venture capital?" Tim O'Loughlin Article in Mass High Tech
Is venture debt the new venture capital?
by Tim O'Loughlin, Director Eastward Capital
http://www.masshightech.com/stories/2011/11/07/daily39-Is-venture-debt-the-new-venture-capital.html
Entrepreneurs often get confused as to when to raise venture capital versus venture debt. Their confusion is understandable as the terms of venture debt and venture capital converge at the margin and misconceptions abound.
Equity is permanent and debt must be repaid, right?
The primary difference between venture debt and venture capital is that debt must be repaid. VCs are also very interested in getting their capital back plus a profit. There are some current market-dynamics which make the distinction between the repayment of venture debt and the liquidity needs of venture capital blur.
I can already hear the skeptics squirming in their seats saying, “Whoa!? A VC hoping to get their money back is a lot different than a lender requiring repayment.” To those skeptics, I say three things:
1. We’re hiring! Skepticism is a core requirement course in any venture debt training program.
2. Interest-Only Roulette: Venture debt usually involves an upfront period where the emerging growth company pays just the interest on the debt. In theory, the tech company begins to make principle payments at the end of this interest-only period. In recent months, companies have aggressively negotiated extensions of their interest-only periods; sometimes by refinancing with another lender. Should the company ultimately fail, the last lender holding the bag gets the usual outcome in Russian roulette…hence the name. When debt isn’t repaid, it becomes a semi-permanent part of a company’s balance sheet.
3. Dividend Recaps: Venture capitalists need liquidity events – particularly if they are raising a new fund. If companies are more slowly successful than planned, the VC may propose a dividend recap to get some liquidity. The tech company declares a dividend and pays cash out to the investors. The source of the funds for the dividend? You guessed it…venture debt. When dividends are paid, equity isn’t the ‘permanent’ capital that it originally appeared to be.
If the line between equity and debt is blurred, how does an entrepreneur pick the right financing strategy for the business? Equity should be raised when a company needs a 4+ year financing horizon and when cash flows are highly volatile. Less dilutive debt options can be considered when the business expects future cash flows or liquidity events in the two-to-three year time frame. The entrepreneur should also take care to make sure that debt service payments are no more than 30 percent of their burn rate because future equity investors want their cash used to grow the business – not to repay debt.
So, who do VCs compete with when sourcing investment opportunities? They compete with anyone with a checkbook and increasingly venture debt firms have very large checkbooks.