Venture Debt is a rather complex topic, so I need to break this down into two different parts. This is the first of those parts and has to do with Valuation. Now, as I have said the actual valuation of a startup is a problem. There is little to no revenue and there will be ongoing losses for some time. Uniqueness and IP Value are in the eye of the beholder, so one way out is a form of Venture Debt. The point of this post is actually to help you get a handle on some other terms, so our financial example is going to be pretty simple.
Now let us imagine a company where you have been able to pull together a modest amount of Friends and Family money. You are on your way, but struggle to raise Angel money because their is a disconnect on valuation. If you don't get some money pretty quick, you will need to stop or nearly stop the company. This loss of momentum is bad and most times is unrecoverable.
Now if the company was more advanced you would go to a Venture Capitalist (VC) or 12 and raise what is called a Series A Round (aka an A Round). The problem is that the company may not be mature enough for this to happen. In today's world, a software application needs to have a somewhat functional prototype to get this money. It is different in hardware or bio technology, but all of them have some points to get started.
So, is there a solution to bridge this situation? Well, yes there is. It is a strange form of Convertible Debt with step-up preferences. The notion here is that a lender provides some cash (in this case let us say this is $250,000). There are two points going forward: the company either gets to an A Round or it does not. If the company does, then the Debt can be converted to equity or paid off in the A round with a Step Up. This is a percentage that the loan gets as a fixed "interest" payment. It works something like this. Let us say you gave the lender a 10% Step Up. That means that the investment is counted as $275,000 instead of $250,000 when the A round gets completed. Remember the Creditor here is taking on significant risk. The company may not reach an A Round, at which point all the money is lost. So, you can expect these to have a significantly higher value to the Lender than a Bank Loan.
This Loan will also have a preference to it. That means that it gets dealt with first over everybody else. They provided funding when nobody else would so that is fair. The other good news for the Lender is that he/she has a relatively early liquidity event. They can get paid off if the company is successful in raising an A Round or they can get an extra bump to the money that they put in. And this is true regardless of the Valuation of the company in the A Round. Thus, they get significant risk reduction for providing very early stage capital.
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