The 7 Venture Debt Pitfalls and "Gotchas" to Avoid in 2023
While venture debt is one of the most popular forms of financing for startups, it can also be one of the most dangerous. Breaking a covenant, provision, or clause can cause a premature default, which can be detrimental to a cash-strapped startup. Being overleveraged or underleveraged, misjudging the repayment terms, and failing to plan for market volatility may also be detrimental to cash-strapped startups. Suffice it to say, there are a ton of things that can go wrong, and that’s why we wrote this guide! Below you’ll find the seven most common “gotchas” and pitfalls associated with venture debt and how you can steer clear of them. Let’s dive in!
Venture debt pitfall #1 - being overleveraged or underleveraged
Generally speaking the term “overleveraged” refers to situations where a startup borrows too much money and cannot satisfy their debt, while underleveraged refers to situations where a startup should have borrowed more money and missed out on opportunities because they failed to do so.
In venture debt, the term overleveraged refers to situations where the startup qualified for and drew down too big of a facility when they could have pursued cheaper or more flexible alternatives, like equity financing. It also refers to situations where startups can financially able to satisfy debts today (thanks to the interest-only period) but cannot do so in the future when the loan amortizes. Being underleveraged in venture debt is the same as mentioned above: the startup is unable to hit all of the goals or targets they set out to achieve simply because they did not draw down enough of the facility during the redemption period.
To avoid this pitfall, startups should stress test their models and assumptions and add a buffer of at least 25% to account for unexpected outcomes. More specifically, you’ll want to model out what growth targets you need to hit until you reach your next equity raise, then factor in your current conversion rates, to determine the CapEx, and S&M spend you will need to get there. Obviously, if you’re an early-stage startup and you don’t know what your conversion rates are, what your LTV to CAC is, or what your ideal CPMQL is, this is going to be a challenging exercise. In that case, buffer in at least 50% to all of your assumptions—meaning a 50% lower conversion rate from MQL to SQL, SQL to SQO, SQO to opportunity…etc, a 50% higher CAC, and so on.
Venture debt pitfall #2 - misjudging repayment terms and schedules
If you haven’t had a chance to dive into our guide on comparing and negotiating venture term sheets or raising venture debt in 2023, you’ll want to start there. This pitfall is directly related to the timing, use case, and structure of the venture debt facility. Startups who misjudge the repayment terms and schedule either didn’t fully understand what they were signing up for or didn’t use venture debt for its intended purpose.
Essentially they either figured that they wouldn’t have to pay anything until the loan matured (bullet) even though the terms specified the interest-only period or milestone event, or they invested heavily in R&D which they thought would generate significant revenues but ultimately did not generate enough revenues to cover the amortization of the facility (overleveraged), or they assumed that they could raise equity capital to satisfy the loan once they hit certain milestones even though they had negative unit economics, and weren’t able to do so.
To avoid this pitfall, negotiate terms that align with realistic expectations around your future cash flows and growth projections. Also, push for clauses that enable you to restructure or extend the payment terms of the deal in case things don’t go as planned.
Venture debt pitfall #3 - fail to plan, plan to fail
Unfortunately, the age-old adage of “if you fail to plan, you plan to fail” applies to venture debt raises as much as it does in life. When raising venture debt, founders must account for market volatility in their assumptions and models. One of those factors is the stage of the economic cycle in which the startup is operating. Others include the impact of new technology or regulations on a startup's business model (e.g. SAFE Banking Act of 2012) and the impact of new entrants into the market (Uber’s impact on taxis or Airbnb’s impact on hotels.
Let’s take 2021 for example. Startups were raising equity capital hand over fist at all-time-high valuations. Some took the new capital and raised more via debt, which subsequently led to them being overleveraged. They assumed that they could continue to raise capital, but they were wrong. When the market flipped less than one year later, these same startups were caught completely off guard, and could not afford the ballooning monthly payments, along with their payroll, benefits…etc. The result was a slew of defaults, layoffs, and ultimately bankruptcies.
While it's impossible to predict when a bubble will burst or a black swan event will occur, the very possibility of them should be considered. These startups should have taken a step back, slowed their roll, and realized that the music was going to come to an end at some point. They should have modeled for and created a plan for potential downside scenarios to avoid catastrophe. Because they did not, their so-called “rocket ships” crashed down to earth and they never reached the moon.
To avoid this pitfall, always plan for the worst and hope for the best! Add a buffer of at least 25% (or 50% if you’re really conservative) to all of your assumptions, build cash reserves, and diversify your revenue streams. Note: The second item is crucial, as you can only cut your expenses so much, but you can always generate more revenue. Finally, make sure that you’re actually qualified for venture debt before you kick off the process.
Venture debt pitfall #4 - underestimating the impact of covenants, clauses, and provisions
As they say, the devil is in the details, and pitfall number three highlights exactly why that is the case. Covenants, clauses, and provisions protect the interests of the lender. As such, they give lenders the ability to force startups to take certain actions, not take other actions, and penalize startups if they fall out of compliance with the terms they have outlined. Ultimately, they can restrict startups’ ability to operate (and grow) if not properly structured, that’s why it's so crucial that you understand what you’re agreeing to. The TL;DR on each of these items is below, for a more in-depth look, check out out the venture debt covenants, clauses, and provisions to avoid.
Covenants - These are contractual obligations that help the lender minimize potential default risks, ensuring that the borrower maintains strong financial health & operational efficiency. There are three types: affirmative, negative, and financial.
- Affirmative covenants - require the borrower to take specific actions, such as submitting regular financial statements, and complying with applicable laws and regulations.
- Negative covenants - impose restrictions on the borrower's actions, such as not taking on additional debt, or making major changes to the ownership structure.
- Financial covenants - set out the financial ratios and performance metrics that startups must abide by and maintain compliance with.
Clauses - are similar to covenants in that they can trigger a default event. The investor abandonment clause, for example, gives lenders the right to declare a loan in default if they believe a startup’s investors will no longer continue to support them in future funding rounds.
Provisions - You can think of provisions as the consequences that follow a default event. The cross-default provision, for example, causes you to default on all other debt obligations if you default on just one of them.
To avoid this pitfall, ensure that you understand exactly what the lenders expect of you.
Venture debt pitfall #5 - not heat mapping the key terms prior to the negotiation
The single most important factor in a successful venture debt negotiation is the leverage that a startup has. This leverage can come from a variety of places, such as the timeframe to close, financial need, access to information…etc. If you fail to heat map the key terms across your term sheets, you’re likely missing out on information and improperly comparing the offers, thus there is less leverage at your disposal.
To avoid this pitfall, you’ll want to dive into the details and categorize all of the factors you’re considering the moment you receive a term sheet.
Start with the basics: headline interest rate, amount, term loan availability, interest-only period length, structure (amortizing vs. bullet), milestone events…etc. These are the items you can compare directly from provider to provider. Once you have those noted down, then move on to the covenants, clauses, and provisions. Finally, check out how the lender defines specific items, like default events and the subsequent events that follow. By heatmapping all of these items, you can come into the negotiations prepared with the information you need to push for better terms.
Venture debt pitfall #6 - not nailing the negotiation
Nailing the negotiation process isn’t as difficult as you might think. If you’ve done your homework, you know exactly what you’re looking for, you’ve identified the non-starters and heat-mapped the key terms that you care about, then the rest is easy. Remember to bring your legal counsel into the mix early in the process, and remember that “winning” isn’t getting every single thing you want. Check out the guide we pulled together on comparing and negotiating venture debt term sheets, we’ve included a TL;DR below.
Start the negotiation by discussing the basics: sizing, interest rate, and structure. Then move on to your non-starters: if the lender won’t budge on these then you either need to accept it and continue on, or exit the negotiation. Pro-tip: Sometimes you can leverage your semi-negotiables to unlock flexibility on your non-starters. Lastly, agree on the outcome of a default and, if possible get the lender to bake in a restructuring clause.
We’re of the opinion that it's better to select the lender with the better reputation, a cleaner term sheet, and a higher headline cost than the lender that offers a slightly lower headline cost of capital and a worse reputation.
Venture debt pitfall #7 - ignoring alternative financing options
At the end of the day, capital to startups is like tools to a carpenter—you shouldn’t use a hammer to attach screws to the wall. Sure you’ll get the job done, but you’ll likely make a mess, and the screw won’t have as much holding power as it would’ve if it was drilled into the wall. The same applies to capital: Sure, you can use venture debt for most things, but it’s probably not the most cost-effective, flexible, or scalable option.
Venture debt is great for startups that need a bridge between equity rounds, those looking to invest in R&D or product development and those looking to preserve their equity while securing long-term capital. Venture debt might not be the ideal option for startups that don’t plan to generate revenues in the near future, or startups that have highly cyclical cash flows.
Some of the alternative financing options to venture debt include:
- Revenue-based financing - a form of funding in which a startup secures capital by selling rights to their future projected revenue streams at a discount. Check this out for more information on revenue financing.
- Mezzanine financing - a hybrid form of debt and equity financing, similar to a SAFE or convertible note, except that it gives the lender the right to convert its debt position into an equity interest in the event of default. Check this out for more information on mezzanine financing.
- Crowdfunding - is a form of financing in which non-accredited investors can pool together their resources and invest in a startup.
Final thoughts on avoiding the common venture debt pitfalls and “gotchas”
Congrats on making it this far! If this is your first time raising venture debt, and you’ve read through this guide (and the other guides linked above) you’re already doing better than 90% of founders who go into the process blind. Raising venture debt, like raising capital from VCs, is a lot like riding a bike—it's a bit challenging on your first time around, but once you get the hang of it you’ll almost certainly keep going. As we mentioned above, there are some pitfalls and “gotchas” that can be detrimental to the outcome of that process.
To avoid them, make sure that you properly forecast your capital needs, and account for market variability so you don’t overleverage or underleverage your startup. Also make sure that have a plan coming into the process, understand what the covenants, clauses, and provisions included in the term sheet mean (and which to avoid), and that you can stay on track with the required payments. Finally, make sure that you heat map the term sheets, so you can compare apples to apples, that you nail the negotiation, and that venture debt is the best option for your needs.
We’re by no means legal professionals, and this guide is by no means legal advice, but if you’d like an extra set of eyes (or hands) reviewing your term sheets, or if you have additional questions on the common pitfalls or “gotchas” we’d be happy to help out. Send us an email at firstname.lastname@example.org and we’ll be in touch within 48-72 hours.