The classic use case for a round of venture debt is topping up an equity round to extend the cash runway. First, let’s talk about how startups get funded. A new enterprise SaaS company may need, say, $30 million in funding to get from idea to a profitable self-sustaining company.
But here’s the thing – that $30 million won’t come from one VC and won’t come all at once. Rather, the $30 million in funding will come in stages, or funding rounds. Using multiple funding rounds benefits both the VCs (who get to reduce their risk by introducing multiple yes/no and valuation checkpoints) and the entrepreneur (who reduces dilution by raising successive rounds at higher valuations).
Each funding round is designed to get the company to its next funding round. It will provide the capital needed for the company to reach a tangible milestone of progression in its development. That milestone is critical – it provides the current and new investors with evidence that the company has progressed, is on the right track, is less risky than it was at the prior funding round and is worth a higher valuation.
When funding each round the VCs look at how much cash the company is forecast to use (or, burn) to reach that next milestone. Each round is typically designed to fund 12 to 24 months of operations. For example, if a company is forecast to burn $0.5 million per month for 12 months to reach its next milestone the funding round will typically be set at $6.0 million. The 12 months’ of funding is referred to as the cash runway.
Is 12 months of runway the right number? That’s hard to say. It may take 15 months to get to that milestone. Or 18 months.
That’s where a venture loan can be helpful. Adding a loan of $3-5mm to the funding round will give the company another three to six months of runway. If there’s a delay in development, for example, having the venture loan means the company has up to six extra months to hit that milestone. And the cost will be a lot lower than adding an extra six months’ worth of equity ($3mm) to the round.
If I was the CFO looking to extend runway through a venture loan I would want to model out how much extra time the loan gives me. If the loan comes in with an equity round it could make sense to get a principal payment holiday, also called an interest-only period, for the first part of the loan. This payment holiday will add to the cash runway (or reduce the amount needed to get the same runway).