Growth Stage, Growth Stage, Technology Venture Technology Venture

Financing –Financing –Venture DebtVenture Debt

David LitwillerDavid Litwiller

December 2010December 2010

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 Contrast with Venture Capital (VC) Business

ModelModel 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 Resources References and Resources

Venture Lender (VL)Venture Lender (VL)

Provides secured debt to a Venture Provides secured debt to a Venture Capital backed businessCapital backed business Security is typically fixed assets, IP, or Security is typically fixed assets, IP, or

receivables, and in some cases, sharesreceivables, and in some cases, shares

Main Purposes of Growth Main Purposes of Growth Stage Venture DebtStage Venture Debt

Defer or forestall further equity venture capital investmentDefer or forestall further equity venture capital investment1.1. If further equity venture capital financing will likely be If further equity venture capital financing will likely be

required, to delay that event, related dilution and obligations required, to delay that event, related dilution and obligations for valuation, and terms negotiation while near-term for valuation, and terms negotiation while near-term performance objectives are achieved that will de-risk the performance objectives are achieved that will de-risk the business and investment thesis. Mid-milestone equity funding business and investment thesis. Mid-milestone equity funding negotiations can be very competitive and tensenegotiations can be very competitive and tense

2.2. To build cash strength on the balance sheet in advance of an To build cash strength on the balance sheet in advance of an equity funding round or closing a major customer deal, to equity funding round or closing a major customer deal, to show prospective incoming investors or customers that the show prospective incoming investors or customers that the company has strength and staying power. Inbound investors company has strength and staying power. Inbound investors and customers are often more influenced by assets than and customers are often more influenced by assets than liabilitiesliabilities

3.3. As a final bridge to self-sustaining cash flow. Especially for As a final bridge to self-sustaining cash flow. Especially for later stage entities, there can be a lot of earlier on-boarded later stage entities, there can be a lot of earlier on-boarded investors with a seat at the table to make valuation and terms investors with a seat at the table to make valuation and terms cumbersome to negotiate for a new equity round cumbersome to negotiate for a new equity round

Model Venture Debt Model Venture Debt ScenarioScenario

Extend the equity funding runway by six to nine months, so Extend the equity funding runway by six to nine months, so goals of significance over that time can be achieved to lower the goals of significance over that time can be achieved to lower the risk profile and enhance valuationrisk profile and enhance valuation

Clear milestones during the extended runway, in technology, Clear milestones during the extended runway, in technology, market development, revenue, regulatory approval, etc.market development, revenue, regulatory approval, etc. No “bridge to nowhere” scenariosNo “bridge to nowhere” scenarios

Entrepreneur, management and earlier-round investors avoid Entrepreneur, management and earlier-round investors avoid dilution by delaying the next equity round, maintaining focus on dilution by delaying the next equity round, maintaining focus on near-term executionnear-term execution

VC gets higher returns because they’ve put less capital to work VC gets higher returns because they’ve put less capital to work and acquire more information before making subsequent and acquire more information before making subsequent funding decisionfunding decision

VL gets returns from interest and warrants, and recovery of VL gets returns from interest and warrants, and recovery of capitalcapital

Typical Venture Lender Typical Venture Lender Business ModelBusiness Model

Seek mid- to high-teens percentage annual returns, plus Seek mid- to high-teens percentage annual returns, plus warrant coverage in the vicinity of 5% to 15% of the loan valuewarrant coverage in the 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 VLs lending to earlier stage enterprises tend to favour amortizing loans, where principal is repaid throughout the amortizing loans, where principal is repaid throughout the term of the loan, reducing exposure over time when investee term of the loan, reducing exposure over time when investee risk is relatively high. Loans are typically in the $500K to $5 risk is relatively high. Loans are typically in the $500K to $5 million range.million range.

VLs lending to later stage entities will more often provide VLs lending to later stage entities will more often provide bullet/balloon loans, where the principal is repaid in a balloon bullet/balloon loans, where the principal is repaid in a balloon payment at the end of the loan, since investees have a payment at the end of the loan, since investees have a relatively lower risk profile for outright failure. Liquidity exits relatively lower risk profile for outright failure. Liquidity exits are comparatively much closer in time. Loans are typically are comparatively much closer in time. Loans are typically above $5 million, with the ability to syndicate much larger above $5 million, with the ability to syndicate much larger amounts.amounts.

Contrast with Venture Contrast with Venture Capital ModelCapital Model

VL seeks 12% to 20% annual returns from each VL seeks 12% to 20% annual returns from each investment, with few outright failures. VL is investment, with few outright failures. VL is looking for return of capital in two to three looking for return of capital in two to three year yearsyear years A game of singles and doublesA game of singles and doubles

VC seeks 35% to 70%+ annual returns from VC seeks 35% to 70%+ annual returns from each investment, but is able to tolerate failures each investment, but is able to tolerate failures of 50%+ of investments, and is generally able of 50%+ of investments, and is generally able to stay in its investments longer, often four to to stay in its investments longer, often four to seven years for an earlier-stage VCseven years for an earlier-stage VC A game of home runs A game of home runs

Why Venture Capitalists are Why Venture Capitalists are Often OK with Involving Often OK with Involving

Venture DebtVenture Debt Improved calculated Internal Rate of Improved calculated Internal Rate of

Return (IRR) for VCReturn (IRR) for VC IRRs are typically calculated based upon when IRRs are typically calculated based upon when

funds are dispatched, not committed funds are dispatched, not committed Deferring capital draws from the VC fund Deferring capital draws from the VC fund

improves scoring and VC compensationimproves scoring and VC compensation

Buys more time and more information Buys more time and more information until next VC funding commitment needs until next VC funding commitment needs to be madeto be made

Supplements VC’s reservesSupplements VC’s reserves

Why VCs Sometimes Chafe Why VCs Sometimes Chafe with VLwith VL

Next stage equity investors will Next stage equity investors will sometimes complain about paying for the sometimes complain about paying for the then current enterprise plus debt then current enterprise plus debt valuation, and discount the value of the valuation, and discount the value of the debt that it took to complete recent debt that it took to complete recent milestones and achieve the valuationmilestones and achieve the valuation

Why VCs Generally Don’t Provide Why VCs Generally Don’t Provide Venture Debt to Existing Portfolio Venture Debt to Existing Portfolio

CompaniesCompanies Venture debt target returns are significantly Venture debt target returns are significantly

more modest than the target returns of more modest than the target returns of venture capitalventure capital

Equity investing and lending in the same Equity investing and lending in the same investee can create conflictsinvestee can create conflicts Governance and fiduciaryGovernance and fiduciary Self-interested transactionsSelf-interested transactions

Time and difficulty of coordinating loans with Time and difficulty of coordinating loans with other equity investment syndicate membersother equity investment syndicate members

Some Due Diligence Some Due Diligence Questions about a Venture Questions about a Venture

Lender (1)Lender (1) Flexibility the VL has been able to provide to past Flexibility the VL has been able to provide to past

debtors when there were problems, and payment debtors when there were problems, and payment terms had to be extended or otherwise modified mid-terms had to be extended or otherwise modified mid-streamstream

The VL’s track record under foreclosure situations for The VL’s track record under foreclosure situations for keeping management in place during the process and keeping management in place during the process and shielding other creditors, to buy time to arrange a sale shielding other creditors, to buy time to arrange a sale or raise additional funding. The probability of a sale is or raise additional funding. The probability of a sale is much higher with the incumbent management team in much higher with the incumbent management team in placeplace

Past exercise of Material Adverse Change Past exercise of Material Adverse Change (MAC)/subjective default clauses. These are triggered (MAC)/subjective default clauses. These are triggered by setbacks in the business, and can give the VL the by setbacks in the business, and can give the VL the right to freeze the assets of the business, amplifying right to freeze the assets of the business, amplifying any down-side technical, execution, or market riskany down-side technical, execution, or market risk

Some Due Diligence Some Due Diligence Questions about a Venture Questions about a Venture

Lender (2)Lender (2) The VL’s involvement with invested VCs in other The VL’s involvement with invested VCs in other

businessesbusinesses If they are working together elsewhere, it often helps If they are working together elsewhere, it often helps

encourage good behaviourencourage good behaviour Sometimes though, relationships between involved VLs and Sometimes though, relationships between involved VLs and

VCs in other companies can lead to reciprocity equalizations VCs in other companies can lead to reciprocity equalizations between them being settled up in your companybetween them being settled up in your company

Whether the VL has its capital from its investors, or Whether the VL has its capital from its investors, or only commitmentsonly commitments

Whether the VL is levered, relying on its own debt Whether the VL is levered, relying on its own debt facility to fund dealsfacility to fund deals

Whether the VL has investment decision authority, of Whether the VL has investment decision authority, of whether its investment committee seats are held by whether its investment committee seats are held by its investorsits investors

Pivotal VL Questions Pivotal VL Questions about Riskabout Risk

For earlier stage enterprises: Are the VCs that For earlier stage enterprises: Are the VCs that already invested likely to fund the next equity already invested likely to fund the next equity round?round? If they are, the risk of the VL being repaid is substantially If they are, the risk of the VL being repaid is substantially

lower than withoutlower than without As well, the VL typically leans significantly on the due As well, the VL typically leans significantly on the due

diligence already performed by the VCdiligence already performed by the VC For later stage enterprises: Does the company and For later stage enterprises: Does the company and

its management have a track record of execution its management have a track record of execution success and meeting projections?success and meeting projections? If they do, the risk for the VL is much reduced than if If they do, the risk for the VL is much reduced than if

recent execution has been patchyrecent execution has been patchy If the business has to be sold for assets, are there If the business has to be sold for assets, are there

assets and an identifiable marketplace where assets and an identifiable marketplace where sufficient funds can likely to be recovered to repay sufficient funds can likely to be recovered to repay the VL? the VL?

Highlight Board of Highlight Board of Directors IssuesDirectors Issues

If a business reaches the zone of insolvency, If a business reaches the zone of insolvency, the obligations of fiduciary management and the obligations of fiduciary management and the board of directors begin to shift from the board of directors begin to shift from protecting assets to paying creditorsprotecting assets to paying creditors Many growth stage businesses are in the zone of Many growth stage businesses are in the zone of

insolvency much of the time, since the classic insolvency much of the time, since the classic test of solvency, that is being able to pay test of solvency, that is being able to pay obligations as they come due, can fluctuate obligations as they come due, can fluctuate widely and quicklywidely and quickly

A more relevant test for earlier stage businesses A more relevant test for earlier stage businesses is often if the chances have diminished of being is often if the chances have diminished of being able to access additional VC financingable to access additional VC financing

Reference and ResourcesReference and Resources ““Debt as Venture Capital”, Darian Ibrahim, University of Wisconsin Law Debt as Venture Capital”, Darian Ibrahim, University of Wisconsin Law

School, paper 1081 School, paper 1081 http://www.bus.wisc.edu/INSITE/events/seminars/documents/IbrahimDebthttp://www.bus.wisc.edu/INSITE/events/seminars/documents/IbrahimDebtasVentureCapitalSept2009.pdfasVentureCapitalSept2009.pdf

www.wellingtonfund.comwww.wellingtonfund.com

““Venture Debt: Device Financing Lifeline or Anchor?”, Stephen Levin, In Venture Debt: Device Financing Lifeline or Anchor?”, Stephen Levin, In Vivo, March 2008, article 2008800052 Vivo, March 2008, article 2008800052 http://www.westerntech.com/news/Venture%20Debt%20-%20InVivo%20Ahttp://www.westerntech.com/news/Venture%20Debt%20-%20InVivo%20April%2008.pdfpril%2008.pdf

Silicon Valley BankSilicon Valley Bank

About the AuthorAbout the AuthorDave Litwiller is the COO of Prinova Inc., a growth stage Dave Litwiller is the COO of Prinova Inc., a growth stage enterprise software developer in Waterloo region. enterprise software developer in Waterloo region.

He most recently was in progressively more senior R&D, He most recently was in progressively more senior R&D, marketing and M&A executive roles with DALSA Corp. Published marketing and M&A executive roles with DALSA Corp. Published in 2008, Mr. Litwiller is the author of “Rapid Advance - in 2008, Mr. Litwiller is the author of “Rapid Advance - Mergers Mergers & Acquisitions, Partnerships, Restructurings, Turnarounds and & Acquisitions, Partnerships, Restructurings, Turnarounds and Divestitures in High Technology”Divestitures in High Technology”

http://www.amazon.com/Rapid-Advance-Acquisitions-Partnershiphttp://www.amazon.com/Rapid-Advance-Acquisitions-Partnerships-Restructurings/dp/1439200874/ref=sr_1_fkmr0_1?ie=UTF8&qis-Restructurings/dp/1439200874/ref=sr_1_fkmr0_1?ie=UTF8&qid=1290108813&sr=1-1-fkmr0d=1290108813&sr=1-1-fkmr0