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Venture Debt

When times are tough, look to nonbank lenders for venture debt.

This story appears in the July 2008 issue of Entrepreneur. Subscribe »

Today's topsy-turvy capital market is changing the rules of company financing. As banks restrict their lending, traditional loans are increasingly difficult to obtain. At the same time, the uncertainty and confusion surrounding the in general makes every a bit riskier than in recent years. Faced with more market uncertainty and less capital, entrepreneurs are turning to nontraditional lenders for . As its name implies, venture debt is a hybrid between a term loan and . Like a traditional loan, the debt is meant to be repaid, generally over a period of several years. Like venture capital, however, it is often provided to high-growth companies without any real collateral.

After backing away from a venture loan last year, Ned Moore has decided to take a second look. The CEO of Portico Systems Inc., Moore is caught in a whirlwind of hypergrowth. Portico sells software to insurance companies to help them track their networks of health-care providers. Between 2005 and 2007, sales for the Blue Bell, Pennsylvania, company tripled to $10.2 million, with $14.2 million in sales projected for this year. It takes a lot of cash to feed that kind of growth, and Moore has already raised two rounds of venture capital.

The company's first opportunity for a venture loan came late last year. "Based on our performance, we thought we could fund [our growth] with debt," says Moore, 39. "But in the middle of the raise, we changed our pricing model, and we thought there was some risk associated with that." That additional risk left Moore uneasy with the thought of paying back a loan--even a venture loan--during a period of transition and uncertainty. Instead, he opted for a pure equity investment.

The transition has run its course, and now Portico needs cash for less risky investments, such as marketing, sales and staff. Because he feels his risk of default is lower and the business will earn enough to pay back the investment sooner, Moore is happy to consider a loan. "It's a cost issue at the end of the day," he says. "Equity is more expensive than debt."

But Portico is not so low-risk that traditional banks are willing to extend much credit, so Moore also faces the issue of flexibility. Fortunately, venture lenders are willing to give Moore the kinds of flexible terms that asset-based lenders and traditional banks simply cannot offer.

Of course, venture debt is not free of restrictions. If you accept a venture loan, be prepared to meet stringent covenants, says Marty Secada, founder of The Ivy Plus Alternative Investment Network, which has more than 7,000 members who work in the investing and lending industries. "Everything is milestone-driven: You have to reach a milestone in revenue, in funding, in exposure, whatever," he says. "If you don't hit your milestone, you'll get ratcheted down." If that sounds ominous, it's because "ratcheted down" is financespeak for giving up stock.

Secada says that while venture debt can be more flexible than other kinds of financing, not every company will qualify. "You'd want to have revenue of a couple million dollars," he says, add-ing that profits are helpful but not always mandatory. Qualifying high-growth companies should start the search for venture debt through existing banking contacts, corporate lawyers and, of course, the venture capital and private equity community. Many private equity funds will have an associated lending firm, says Secada. Moore has hired an intermediary to introduce him to venture lenders and help him evaluate their offers. He's expecting about 40 percent growth again this year and hopes to have a few competing loan offers. "Since the equity round was done, our balance sheet is much stronger and we are looking for better terms," he says.

For Portico, the key to venture debt is in the timing. But the real lesson, says Moore, is timeless: "It's best to get debt when you don't need the money."

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