Typical venture lending schemes (sometimes called – Venture Debt or Term Loans) have very different DNA and investment criteria than those of other popular schemes of financing which are based on the revenue stream or cash flows of the borrowing tech company.
The basic assumption behind a classic venture lending deal –
As a creditor the lender holds priority rights for repayment of the funds it invested over equity investors. The equity tranche is de-facto a safety cushion for the non-equity investor.
Therefore, the lenders’ logic is simple: if a reputable VC has recently invested in a tech company (i.e. the tech company successfully went through due diligence of professional equity investors) – then I as a lender can feel safe enough to provide debt money to that tech company after it closed the equity round. This is why lenders prefer to extend this debt soon after the equity round (not more than 12 months later). Of course lenders run their own due diligence (underwriting) on the business performance and financial status of the borrowing company, but it mainly relies on the VC equity injection and its decision to invest. This is a classic piggyback investment situation.
This means – if you do not have a reputable VC which has invested in the last 12 months in your company – it would be very difficult to raise money by venture lending. Some smaller venture lenders stretch the notion of “reputable VC” and for them also unknown/small VCs or just institutional non-VC equity investors are sufficient to extend their venture debt.
This also means – the size of the venture lending check is very much linked to the size of the VC investment (and not to the actual revenues or profit of the borrowing entity). This is why, if a VC has invested $7M, the venture lender may often add $1-2M in debt even if the company has no revenues at all. The venture lender believes that the company can raise more equity money in the future and if worse comes to worst – the VC will support the company and inject money to pay back to take out the debt provider (which usually holds liens and rights over the company’s assets and IP).
Revenue Based Financing (sometimes called - Revenue Based Investment, RBF or RBI) has a completely different approach and hence it fits different situations and business profiles. RBF relies on the ability of the borrowing company to serve and payback the debt by the revenue it collects (and not by future equity rounds). Therefore, RBF is agnostic to the quality of the cap-table and which VC and when it invested.
This means – that the entire investment criteria and due diligence for RBF deal is around the quantity and quality of existing and future revenue streams. Examples for considerations in order to measure the revenue streams include:
- Is there a large customer base? Is there enough diversification of customers (no concentration, different geographic or sector exposures)?
- Can we assume that the company will continue growing? How can the company survive in a no-growth situation (runway, cost-cutting possibilities, stress analysis)?
- How sticky is the product for its customers – can they easily switch to a competitor or is it a “system of record” situation where switching is hard to implement.
- Is the product’s pricing reasonable – otherwise the revenues might drop due to price competition, even if the number of customers remain unchanged.
- Are the revenues recurring or a collection or one-off transactions? Of course recurring revenues are easier to predict.
- This also means that the RBF check size is directly linked to the revenues of the company. RBF check size will typically be in the range of 3-5 times of the company’s monthly revenues.
To summarize: venture lending and RBF are very different schemes by nature and as result they suit different types of companies and financial situations. A startup or tech company should first understand its own fundability profile before pursuing specific non-dilutive financing. In the same family of RBF we can also find other financing schemes like Cohort Based Finance or Merchant Cash Advance (MCA) which also rely on the cash inflows of the company and less on the identity of its shareholders or its probability to raise more equity money in the future, like in venture debt.
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