The Perils of Taking on Venture Debt

By Geoffrey Moore

Author – The Infinite Staircase: What the Universe Tells Us About Life, Ethics, and Mortality

This post is for first-time entrepreneurs, discussing a topic that is painfully well understood by venture investors and more experienced entrepreneurs.? Here’s the situation:

• Your venture is well underway, backed by one or more reputable venture firms.? The product is coming along nicely, and you have customers already and a pipeline for more, but . . .
• The market is not developing as fast as you had planned, and given your current burn rate, you will be running out of cash earlier than expected.
• While you have not yet hit the milestones you committed to when you raised your prior round of funding, you are confident you just need a little more time, so you are looking for a cash infusion to tide you over.
• Venture lenders are there to help, and the interest rates are acceptable, and with the extra funds in the bank you can keep powering ahead—so why not?

This may be when you hear the phrase liquidation preference for the first time.? It seems innocent enough.? The lender just gets paid back before anyone else.? Totally fair.? And if you do execute as you plan, everyone wins.?

The problem is, more often than not, you don’t.? And the reason you don’t is that you have misunderstood the message the market was sending when it did not develop as fast as you expected.? In addition, you have also misunderstood the dynamics of venture capital, so you don’t see the hole you are digging for yourself.? Let me elucidate on both topics, taking the second one first.

Venture financing is designed to back high-risk, high-reward business plans.? It does so by breaking them up into chunks, each chunk corresponding to a round of funding.? Each round focuses on taking one category of risk off the table.? The first round might be an angel round focusing on technical risk—can you make your magic actually work?? That might be followed by a more formal round to address product/market fit—can you get anyone to buy it?? Subsequent rounds can address market risk, competitive risk, team risk, and eventually exit risk.? Upward changes in venture valuations are tied to risk removals.? When the next investor sees that a material risk has been truly removed, they are willing to invest at a higher valuation than the prior round, thus minimizing the dilution to your current investors as well as to you and your team.??

The problem you face is that you have almost removed the risk you have been funded to address, but you have run out of runway.? Almost is worth, well, sadly, almost nothing.? You can’t raise another round of equity without suffering considerable dilution.? That’s when you hear the siren call of venture debt.? A little money to bridge the gap, no dilution, pay it back with future cash flow—sounds good.? Except now, any future investor is looking at a returns model where the venture lender gets their money back before anyone else.? Still, if you really are crushing it, and your future cash flows look reasonably secure, you’ll be fine.

The problem with this scenario is you only get one bite at the apple.? Should there be another pothole along the way—and this venture, folks, so the road is bumpy—you are now in a real jam.? Equity investors are spooked because any more debt will come with additional liquidation preferences, as in 2X or even 3X the amount lent, all to be paid back before anyone else gets a dime.? And common shareholders, which include you and all your team, are increasingly likely to get zilch.? This represents “working for the man” in the worst possible way.

So, what should you have done?? You should have taken the market signal of slower-than-expected adoption as a yellow flashing light.? It doesn’t say Stop.? It says Slow down.? That means cut your burn rate now.? Take your medicine, bitter, though it may be.? All those planned new hires—not now.? Moreover, that elegant roadmap you had in place—it has to be hacked.? Cut it back to the bare bones to get you to the next milestone.? And as for the people already on board, some must be asked to leave.?

None of this is fun, and if you are a first-time entrepreneur, it may be something you have never done before and have no appetite for doing now.? But if you want to know why most start-ups fail, this is why.? You owe it to yourself, your team, your existing customers, and yes, even your investors, to step up.

Understand one more thing.? You are not going to be good at this, so reach out for advice.? Often, a venture firm will have someone on staff, someone who has been in your shoes before and can help a great deal.? Work with them to draft a get-well plan, and then engage with your board to pressure-test it.? The main thing is to act promptly.? Every day you do not act is another day of excess burn.? Your plan won’t be perfect, you will make mistakes, but you are buying much-needed time and you are protecting the fledgling enterprise when it needs it most.?

No one said it was easy to be an entrepreneur—now you know why.

That’s what I think.? What do you think?

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