Venture Debt – Check your security blanket!
Many venture backed companies take on debt at some stage of their life borrowing money from a bank or specialized venture debt lender. This money is far from being "cheap" carrying high interest rates, transaction fees and warrant coverage (usually in the form of a stock option for preferred stock).
Debt can make sense in an environment where customers are buying and next round valuations are expected to be significantly higher than previous rounds. The premise is that venture debt can lengthen the amount of time a company can operate before having to raise a new round of financing. In an "up" environment, more time can translate to a higher valuation and hence less dilution to existing shareholders (especially important for common shareholders who generally don't invest in rounds of financing to protect their ownership).
Debt can also make sense when a company is expanding sales – debt in the form of a line of credit can be used to supply working capital to cover the time from shipment/invoicing to cash collection. The line of credit allows a company to borrow some percentage of its account receivables – generally with a better rate than pure venture debt.
In addition to high interest rates etc., one of the other attributes of venture debt is that it typically requires either a UCC-1 filing (Uniform Commercial Code, article 9 public filing perfecting a security interest in underlying assets) or a Material Adverse Conditions (MAC) clause. Either of these conditions allows the lender to "call" the debt due under certain conditions. The lender also requires that you either place all your funds (existing and borrowed) in their bank (where the lender is a bank) or execute an account agreement that provides the lender with account control over all of your funds.
In todays "down" environment where revenue growth is uncertain and credit is tight, venture debt can give a company a false sense of security about the remaining cash runway it may have before raising the next round.
Remember that the debt lender has an obligation to protect their asset and so keeps a close eye on the company's current cash balance and compares it to what is owed on the loan. As the cash balance gets close to the outstanding loan, the lender will call the CEO and investors in the company to determine the plans for the next round of financing – basically looking for a "guarantee" that the investors will continue to finance the company (thereby insuring the loan doesn't default).
Any hesitation or lack of conviction in the certainty of the "next round" may cause the lender to invoke the UCC-1 or MAC clause and cause the note to come due. The lender then sweeps the accounts to recover their outstanding principle and the company is immediately out of cash.
Given the current climate and challenges facing financial institutions of all kinds, cash is just a much "king" for them as it is for startups. You can pretty much guarantee that lenders will protect their cash as the first priority and worry about business relationships or possible legal challenges later. We saw this exact scenario unfold many times in 2002-2003 as the business environment was challenged by the aftermath of the Dot Com bubble, 9/11 and the pull back in telecommunication capital spending. 2009 is unfortunately shaping up to be worse…
So, if your company has a venture debt line and you forecast your cash balance going below the outstanding amount of the loan, take a long hard look at whether that cash balance is going to be real at the time you need it most. Chances are the cash will be swept.
Confront the issue now while you still have plenty of time – consider the possibility of the accounts being swept and talk the issue through with your investors. Get a contingency plan in place - perhaps getting a small "top-off" round and immediately paying off the loan (thereby saving interest expense) or figuring out other ways to stretch your remaining cash either to the point of break even or getting a new round of financing closed earlier.
Don't hold on to venture debt as a security blanket – you may get caught out in the cold!!!