I sometimes hear entrepreneurs extol venture debt because it is “free money.” Low interest, non-dilutive capital. In my experience, there’s no free lunch in the capital markets. That’s certainly the case with venture debt. The interest is low for a reason.
Venture debt is simply a loan. There are interest and warrants attached. There are often “material adverse change” clauses that allows the bank to call the loans.
Even if covenants or MACs are absent, debt doesn’t make sense for equity holders in the case of unprofitable companies. That is because the lender requires the investors to guarantee the loan, as Fred Wilson writes here. Before lending, entities will call up the VCs to get them to guarantee the debt. So, the VC is effectively lending money to itself and paying interest to do so.
Two other things to note. First, optics. Debt at an early stage company is a red flag in subsequent rounds with many VCs I know. Many people have been burnt by debt taken on too early and those memories linger.
Second, note that debt will be taken off any acquisition price. The total consideration an acquirer will pay is this:
Exit price = Value of the business + cash on hand – debt outstanding – cost to keep funding the business – retention packages to keep team members
So, debt lowers your exit price dollar for dollar!
Now, debt can be useful, but in the right context. Our firm is OK with debt secured by Accounts Receivable and we are OK with general debt once a company is profitable or has a large and predictable revenue stream (and, can be profitable, if it chooses). We are open to debt if a company has an LOI to be acquired or is on the road to an IPO.
But, our experience has been that debt is dangerous for unprofitable companies, in the same way that unemployed people should not be taking on huge credit card debt. It puts a lot of risk on the company.
Debt has to paid off. It comes from profits, equity investors or an acquisition price. There is no free lunch and it isn’t free money.
If an entrepreneur is concerned about dilution, then there should be a discussion about granting some more options to the team. That is a better way IMO to handle the discussion. And, as always, the best way to control dilution is this: revenues.