This document discusses venture debt, which provides secured debt financing to venture capital-backed companies. The main purposes of venture debt for growth-stage companies are to defer additional equity financing, build cash reserves, and act as a final bridge to self-sustaining cash flow. Venture lenders typically seek mid-to-high teens annual returns plus warrants. They contrast with venture capitalists, who seek higher returns but tolerate more failures. While venture capitalists generally do not provide debt to their portfolio companies directly due to conflicts, they may be okay with venture debt being involved. Key due diligence considerations for lenders include a company's execution track record and the likelihood of future equity financing.

1. Growth Stage, TechnologyGrowth Stage, Technology
Venture Financing –Venture Financing –
Venture DebtVenture Debt
David LitwillerDavid Litwiller
December 2010December 2010

2. OverviewOverview
 Venture Lender (VL) – DefinitionVenture Lender (VL) – Definition
 Main Purposes of Growth Stage Venture DebtMain Purposes of Growth Stage Venture Debt
 Model Venture Debt ScenarioModel Venture Debt Scenario
 Typical Venture Lender Business ModelTypical Venture Lender Business Model
 Contrast with Venture Capital (VC) Business ModelContrast with Venture Capital (VC) Business Model
 Venture Capital – Venture Debt InteractionsVenture Capital – Venture Debt Interactions
 Why VCs Generally Don’t Extend Venture DebtWhy VCs Generally Don’t Extend Venture Debt
 Due Diligence Questions for a VLDue Diligence Questions for a VL
 Pivotal VL Risk Management IssuesPivotal VL Risk Management Issues
 Board of Directors IssuesBoard of Directors Issues
 References and ResourcesReferences and Resources

3. Venture Lender (VL)Venture Lender (VL)
 Provides secured debt to a Venture CapitalProvides secured debt to a Venture Capital
backed businessbacked business
 Security is typically fixed assets, IP, or receivables,Security is typically fixed assets, IP, or receivables,
and in some cases, sharesand in some cases, shares

4. Main Purposes of Growth StageMain Purposes of Growth Stage
Venture DebtVenture Debt
 Defer or forestall further equity venture capital investmentDefer or forestall further equity venture capital investment
1.1. If further equity venture capital financing will likely be required, to delay thatIf further equity venture capital financing will likely be required, to delay that
event, related dilution and obligations for valuation, and terms negotiationevent, related dilution and obligations for valuation, and terms negotiation
while near-term performance objectives are achieved that will de-risk thewhile near-term performance objectives are achieved that will de-risk the
business and investment thesis. Mid-milestone equity funding negotiations canbusiness and investment thesis. Mid-milestone equity funding negotiations can
be very competitive and tensebe very competitive and tense
2.2. To build cash strength on the balance sheet in advance of an equity fundingTo build cash strength on the balance sheet in advance of an equity funding
round or closing a major customer deal, to show prospective incominground or closing a major customer deal, to show prospective incoming
investors or customers that the company has strength and staying power.investors or customers that the company has strength and staying power.
Inbound investors and customers are often more influenced by assets thanInbound investors and customers are often more influenced by assets than
liabilitiesliabilities
3.3. As a final bridge to self-sustaining cash flow. Especially for later stage entities,As a final bridge to self-sustaining cash flow. Especially for later stage entities,
there can be a lot of earlier on-boarded investors with a seat at the table tothere can be a lot of earlier on-boarded investors with a seat at the table to
make valuation and terms cumbersome to negotiate for a new equity roundmake valuation and terms cumbersome to negotiate for a new equity round

5. Model Venture Debt ScenarioModel Venture Debt Scenario
 Extend the equity funding runway by six to nine months, so goals ofExtend the equity funding runway by six to nine months, so goals of
significance over that time can be achieved to lower the risk profile andsignificance over that time can be achieved to lower the risk profile and
enhance valuationenhance valuation
 Clear milestones during the extended runway, in technology, marketClear milestones during the extended runway, in technology, market
development, revenue, regulatory approval, etc.development, revenue, regulatory approval, etc.
 No “bridge to nowhere” scenariosNo “bridge to nowhere” scenarios
 Entrepreneur, management and earlier-round investors avoid dilution byEntrepreneur, management and earlier-round investors avoid dilution by
delaying the next equity round, maintaining focus on near-term executiondelaying the next equity round, maintaining focus on near-term execution
 VC gets higher returns because they’ve put less capital to work and acquireVC gets higher returns because they’ve put less capital to work and acquire
more information before making subsequent funding decisionmore information before making subsequent funding decision
 VL gets returns from interest and warrants, and recovery of capitalVL gets returns from interest and warrants, and recovery of capital

6. Typical Venture Lender BusinessTypical Venture Lender Business
ModelModel
 Seek mid- to high-teens percentage annual returns, plus warrant coverage inSeek mid- to high-teens percentage annual returns, plus warrant coverage in
the vicinity of 5% to 15% of the loan valuethe vicinity of 5% to 15% of the loan value
 Capital loss in less than 5% of investmentsCapital loss in less than 5% of investments
 VLs lending to earlier stage enterprises tend to favour amortizing loans,VLs lending to earlier stage enterprises tend to favour amortizing loans,
where principal is repaid throughout the term of the loan, reducing exposurewhere principal is repaid throughout the term of the loan, reducing exposure
over time when investee risk is relatively high. Loans are typically in theover time when investee risk is relatively high. Loans are typically in the
$500K to $5 million range.$500K to $5 million range.
 VLs lending to later stage entities will more often provide bullet/balloonVLs lending to later stage entities will more often provide bullet/balloon
loans, where the principal is repaid in a balloon payment at the end of theloans, where the principal is repaid in a balloon payment at the end of the
loan, since investees have a relatively lower risk profile for outright failure.loan, since investees have a relatively lower risk profile for outright failure.
Liquidity exits are comparatively much closer in time. Loans are typicallyLiquidity exits are comparatively much closer in time. Loans are typically
above $5 million, with the ability to syndicate much larger amounts.above $5 million, with the ability to syndicate much larger amounts.

7. Contrast with Venture Capital ModelContrast with Venture Capital Model
 VL seeks 12% to 20% annual returns from eachVL seeks 12% to 20% annual returns from each
investment, with few outright failures. VL is lookinginvestment, with few outright failures. VL is looking
for return of capital in two to three year yearsfor return of capital in two to three year years
 A game of singles and doublesA game of singles and doubles
 VC seeks 35% to 70%+ annual returns from eachVC seeks 35% to 70%+ annual returns from each
investment, but is able to tolerate failures of 50%+ ofinvestment, but is able to tolerate failures of 50%+ of
investments, and is generally able to stay in itsinvestments, and is generally able to stay in its
investments longer, often four to seven years for aninvestments longer, often four to seven years for an
earlier-stage VCearlier-stage VC
 A game of home runsA game of home runs

8. Why Venture Capitalists are OftenWhy Venture Capitalists are Often
OK with Involving Venture DebtOK with Involving Venture Debt
 Improved calculated Internal Rate of Return (IRR) forImproved calculated Internal Rate of Return (IRR) for
VCVC
 IRRs are typically calculated based upon when funds areIRRs are typically calculated based upon when funds are
dispatched, not committeddispatched, not committed
 Deferring capital draws from the VC fund improves scoringDeferring capital draws from the VC fund improves scoring
and VC compensationand VC compensation
 Buys more time and more information until next VCBuys more time and more information until next VC
funding commitment needs to be madefunding commitment needs to be made
 Supplements VC’s reservesSupplements VC’s reserves

9. Why VCs Sometimes Chafe with VLWhy VCs Sometimes Chafe with VL
 Next stage equity investors will sometimes complainNext stage equity investors will sometimes complain
about paying for the then current enterprise plus debtabout paying for the then current enterprise plus debt
valuation, and discount the value of the debt that itvaluation, and discount the value of the debt that it
took to complete recent milestones and achieve thetook to complete recent milestones and achieve the
valuationvaluation

10. Why VCs Generally Don’t Provide Venture Debt toWhy VCs Generally Don’t Provide Venture Debt to
Existing Portfolio CompaniesExisting Portfolio Companies
 Venture debt target returns are significantly moreVenture debt target returns are significantly more
modest than the target returns of venture capitalmodest than the target returns of venture capital
 Equity investing and lending in the same investee canEquity investing and lending in the same investee can
create conflictscreate conflicts
 Governance and fiduciaryGovernance and fiduciary
 Self-interested transactionsSelf-interested transactions
 Time and difficulty of coordinating loans with otherTime and difficulty of coordinating loans with other
equity investment syndicate membersequity investment syndicate members

11. Some Due Diligence QuestionsSome Due Diligence Questions
about a Venture Lender (1)about a Venture Lender (1)
 Flexibility the VL has been able to provide to past debtors whenFlexibility the VL has been able to provide to past debtors when
there were problems, and payment terms had to be extended orthere were problems, and payment terms had to be extended or
otherwise modified mid-streamotherwise modified mid-stream
 The VL’s track record under foreclosure situations for keepingThe VL’s track record under foreclosure situations for keeping
management in place during the process and shielding othermanagement in place during the process and shielding other
creditors, to buy time to arrange a sale or raise additionalcreditors, to buy time to arrange a sale or raise additional
funding. The probability of a sale is much higher with thefunding. The probability of a sale is much higher with the
incumbent management team in placeincumbent management team in place
 Past exercise of Material Adverse Change (MAC)/subjectivePast exercise of Material Adverse Change (MAC)/subjective
default clauses. These are triggered by setbacks in the business,default clauses. These are triggered by setbacks in the business,
and can give the VL the right to freeze the assets of the business,and can give the VL the right to freeze the assets of the business,
amplifying any down-side technical, execution, or market riskamplifying any down-side technical, execution, or market risk

12. Some Due Diligence QuestionsSome Due Diligence Questions
about a Venture Lender (2)about a Venture Lender (2)
 The VL’s involvement with invested VCs in other businessesThe VL’s involvement with invested VCs in other businesses
 If they are working together elsewhere, it often helps encourage goodIf they are working together elsewhere, it often helps encourage good
behaviourbehaviour
 Sometimes though, relationships between involved VLs and VCs in otherSometimes though, relationships between involved VLs and VCs in other
companies can lead to reciprocity equalizations between them beingcompanies can lead to reciprocity equalizations between them being
settled up in your companysettled up in your company
 Whether the VL has its capital from its investors, or onlyWhether the VL has its capital from its investors, or only
commitmentscommitments
 Whether the VL is levered, relying on its own debt facility toWhether the VL is levered, relying on its own debt facility to
fund dealsfund deals
 Whether the VL has investment decision authority, of whetherWhether the VL has investment decision authority, of whether
its investment committee seats are held by its investorsits investment committee seats are held by its investors

13. Pivotal VL Questions about RiskPivotal VL Questions about Risk
 For earlier stage enterprises: Are the VCs that already investedFor earlier stage enterprises: Are the VCs that already invested
likely to fund the next equity round?likely to fund the next equity round?
 If they are, the risk of the VL being repaid is substantially lower thanIf they are, the risk of the VL being repaid is substantially lower than
withoutwithout
 As well, the VL typically leans significantly on the due diligence alreadyAs well, the VL typically leans significantly on the due diligence already
performed by the VCperformed by the VC
 For later stage enterprises: Does the company and itsFor later stage enterprises: Does the company and its
management have a track record of execution success andmanagement have a track record of execution success and
meeting projections?meeting projections?
 If they do, the risk for the VL is much reduced than if recent executionIf they do, the risk for the VL is much reduced than if recent execution
has been patchyhas been patchy
 If the business has to be sold for assets, are there assets and anIf the business has to be sold for assets, are there assets and an
identifiable marketplace where sufficient funds can likely to beidentifiable marketplace where sufficient funds can likely to be
recovered to repay the VL?recovered to repay the VL?

14. Highlight Board of Directors IssuesHighlight Board of Directors Issues
 If a business reaches the zone of insolvency, theIf a business reaches the zone of insolvency, the
obligations of fiduciary management and the board ofobligations of fiduciary management and the board of
directors begin to shift from protecting assets to payingdirectors begin to shift from protecting assets to paying
creditorscreditors
 Many growth stage businesses are in the zone of insolvencyMany growth stage businesses are in the zone of insolvency
much of the time, since the classic test of solvency, that ismuch of the time, since the classic test of solvency, that is
being able to pay obligations as they come due, can fluctuatebeing able to pay obligations as they come due, can fluctuate
widely and quicklywidely and quickly
 A more relevant test for earlier stage businesses is often if theA more relevant test for earlier stage businesses is often if the
chances have diminished of being able to access additionalchances have diminished of being able to access additional
VC financingVC financing

15. Reference and ResourcesReference and Resources
 ““Debt as Venture Capital”, Darian Ibrahim, University of Wisconsin Law School, paper 1081Debt as Venture Capital”, Darian Ibrahim, University of Wisconsin Law School, paper 1081
http://www.bus.wisc.edu/INSITE/events/seminars/documents/IbrahimDebtasVentureCapitalSept2009http://www.bus.wisc.edu/INSITE/events/seminars/documents/IbrahimDebtasVentureCapitalSept2009
 www.wellingtonfund.comwww.wellingtonfund.com
 ““Venture Debt: Device Financing Lifeline or Anchor?”, Stephen Levin, In Vivo, March 2008,Venture Debt: Device Financing Lifeline or Anchor?”, Stephen Levin, In Vivo, March 2008,
article 2008800052article 2008800052
http://www.westerntech.com/news/Venture%20Debt%20-%20InVivo%20April%2008.pdfhttp://www.westerntech.com/news/Venture%20Debt%20-%20InVivo%20April%2008.pdf
 Silicon Valley BankSilicon Valley Bank

16. About the AuthorAbout the Author
Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise softwareDave Litwiller is the COO of Prinova Inc., a growth stage enterprise software
developer in Waterloo region.developer in Waterloo region.
He most recently was in progressively more senior R&D, marketing and M&AHe most recently was in progressively more senior R&D, marketing and M&A
executive roles with DALSA Corp. Published in 2008, Mr. Litwiller is the author ofexecutive roles with DALSA Corp. Published in 2008, Mr. Litwiller is the author of
“Rapid Advance -“Rapid Advance - Mergers & Acquisitions, Partnerships, Restructurings, TurnaroundsMergers & Acquisitions, Partnerships, Restructurings, Turnarounds
and Divestitures in High Technology”and Divestitures in High Technology”
http://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/dp/143http://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/dp/143