Emerging companies can be so focused on growth that they neglect to analyze the cash flow implications of raising debt. Such an exercise uncovers the nuanced distinction between traditional, amortizing “venture debt” and a non-amortizing term loan (the “balloon” or “bullet”).
The typical venture debt structure is a three or four year term loan with equal amortization payments starting between months 6 and 18. Once amortization commences, the increase in cash burn can be significant enough to necessitate (a) refinancing of the loan, if possible, or (b) raising an equity round. These outcomes aren’t necessarily detrimental. You have been given cushion to execute your plan and raise your next round of equity at a higher valuation (theoretically at a higher mark than with no debt). Utilized in many cases as “runway extension” capital, venture debt is commonly viewed by early stage companies as complementary to equity.
But what about later stage companies? These issuers must consider another option: the non-amortizing term loan. The bullet or balloon structure has no amortization and typically matures in five years, with underwriting focused on enterprise value and growth prospects.
We detail an example below where a company is evaluating $10 million of debt under two structures: amortizing venture debt and a five-year bullet. With venture debt, the issuer will have returned to the lender over 50% of the principal amount by month 20 (in interest, fees, and amortization). This dynamic can work, especially if the company is close to profitability or a significant milestone; but there is a difference between “working” and providing ample breathing room. The bullet does not breach that 50% threshold until month 53. Talk about runway extension! This structure can truly replace a round of equity.
While a bullet structure might result in more dilution than venture debt, there can be significant value in the extra cash cushion, especially if it eliminates another round of equity. Back to our example, it’s interesting to see that the time value of money from amortization nearly offsets the assumed higher interest rate and dilution under the bullet structure (refer to the cost of capital / IRR calculations).
Comparative Summary - Amortizing Venture Debt vs Bullet Structure
In fact if you assume this issuer refinances its venture debt facility in month 25 in order to avoid running out of cash in month 33, the cost of capital ends up nearly equal to the bullet structure.
Taking this analysis one step further, if we were to make the interest rate and warrant coverage of the two scenarios the same, we can quantify the embedded incremental "cost" of the amortizing structure: 500 basis points.
- Amortization: 250 basis points
- Shorter maturity: 150 basis points
- Refinancing: 100 basis points
When weighing your options, there are considerations other than cost and amortization: (a) governance (such as financial covenants and MAC clauses), (b) distraction and risk of a refinancing in the amortizing venture debt scenario, and (c) a bullet structure can create “repayment overhang” (a refinancing challenge at loan maturity, particularly if the business isn’t performing well).
Ultimately, what’s available and best for you truly depends on your circumstances.
Assumptions and Cash Flows - Amortizing Venture Debt vs. Bullet
A Smarter Way to Procure Growth and Venture Debt
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