Startups Beware: Venture Debt May Not Be for You

Fred Wilson is right about venture debt, says an experienced entrepreneur who has used the funding mechanism in the past and is setting up a similar deal now.

Wilson, of Union Square Ventures, wrote in a recent blog post that so-called venture debt, where companies borrow money and pay it back—usually at high interest rates—rather than taking on equity investments like venture capital, is not for early-stage startups.

Andrew Spanswick, CEO of psychiatric care operator White Rabbit Partners, Inc., of Los Angeles, who has 20 years as an entrepreneur in the health care field, agrees. He’s in the middle of raising money (he wouldn’t say how much) through venture debt for an acquisition (he wouldn't say which one).

Spanswick says companies should only take on such debt if they’re sure they’ll have an almost-immediate revenue boost, so they can pay off the high-interest loans quickly.

“It really depends on how much cash flow you think you can generate,” he said. Spanswick, 42, said he's raised $500 million in equity and debt through private equity firms and institutional investors like banks.

The mysterious world of venture debt came to light earlier this week when Triple Point Capital announced it had raised $1 billion from institutional investors to invest in such deals. It’s not clear exactly how much players in the industry lend, but it stretches into the billions of dollars, as Kirsten Grind of Portfolio.com reports.

But, said Spanswick, that kind of debt is really of more use for an established player looking to make an acquisition that will translate to immediate increased cash flow.

That’s because interest rates are high with venture debt, and there are often balloon payments involved down the road. You either want to be able to pay off the debt quickly through cash flow or show more traditional lenders you have the revenue necessary to pay back a more conventional, lower-interest loan and get the money to pay back your venture debt that way.

“The main advantage of venture debt is it allows the founding team to retain the equity,” Spanswick said. But because startups don’t necessarily expect to generate big cash flow quickly, he advises most of them to stay away. “For your traditional startup, it’s a disaster pretty much.”

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Kent Bernhard Jr. is News Editor of Portfolio.com