http://www.paulgraham.com/swan.html); venture debt investors expect to get repaid on every investment. With venture debt investors, repayment is contractually required: every cent must be repaid. Venture debt investors typically tie their investment to business plan milestones, metrics like accounts receivable and revenue, or events, whereas most equity investors allow startups leeway to pivot. Unlike equity investors, venture debt investors are less flexible. These investors are not as concerned with reputational damage: while an equity investor may support a startup that “pivots” to find product market fit, a venture debt investor is less understanding, given the need to get repaid. Venture debt lenders are thus more apt to enforce a contract to make sure their money is returned, even if the company would be killed from such enforcement. These investors are myopically focused on losing as little money as possible; they rarely are interested in any other considerations.</p>\n<h2>Strategy: How to Approach Venture Debt</h2>\n<p>First, founders need to understand basic venture debt terminology. Founders do not need to be venture debt experts, but do need to understand their contractual obligations, particularly because venture debt lenders will rely on these contractual terms to protect their investment<a id=\"footnote1a\"><a href=https://www.ycombinator.com/"#footnote1\"><b>¹</b></a></a>. Founders need to assess which terms are important, and which ones may place their company at risk. At the bottom of this essay is a short glossary and explanation of some key terms that founders will encounter in a venture debt financing.</p>\n<p>Second, after understanding the basics, founders should consider evaluating multiple venture debt lenders in order to make the process competitive. Far too often, Y Combinator founders tell me that they met a venture debt lender, got a term sheet and quickly signed and agreed to terms. A founder would never speak to only one equity investor when raising a Series A round, but in my experience, it is common for founders to speak to only one venture debt investor. Fortunately, there are more lenders and new entrants offering venture debt, and founders now have additional options (more on this topic below). Working with a more friendly lender that you know well can make all the difference in a downside case, but you also should not drag on the venture debt raise process for months – you have a business to run.</p>\n<p>Third, founders must involve legal counsel when entering into a venture debt relationship. Again, the terms and conditions of venture debt financings arguably matter more than equity financings because lenders do not hesitate to assert their rights and will apply assertive tactics to recover every dollar they can. For example, there are important differences in the types of “defaults” that may trigger a loan to be due immediately, and experienced counsel will help protect a company and make sure that it is better positioned if things go awry. Often a startup involves counsel after a term sheet is signed, but it is better to involve counsel earlier in the process, which typically is when a company has more leverage.</p>\n<p>Please note that while venture debt investors need to protect their investment, they also deserve to be treated fairly. There are many instances where venture lenders have complained that companies were not forthcoming about their circumstances and did not provide relevant information such as their cash burn, or the loss of a significant lost contract. It does not help a company to hide from its lenders – the worst possible way to treat your lender is to make them think that everything is going according to plan, and then drop a bombshell on them when it’s too late to course-correct. Because there may be ways to restructure debt, it inures to a company’s benefit to treat its lenders fairly.</p>\n<h2>Good news: New Entrant: Brex</h2>\n<p>I mentioned there are new entrants in the venture debt space, and Y Combinator is glad that our portfolio company Brex is now offering venture debt financings to startup companies. Understanding startups’ financial needs is in Brex’s DNA: the company grew quickly because it understood the challenges startups had with accessing basic credit. Brex knows how to serve startups and young companies with a variety of credit solutions and is a welcome addition to this market. YC has shared our concerns with Brex about the pitfalls of venture debt, and Brex has plans to make its venture debt financing terms simple and transparent. While we are confident in Brex’s ability to compete in any market, we continue to believe that all startups should reach out to multiple parties when accessing venture debt. To learn more about Brex’s offering, see <b><a href=https://www.ycombinator.com/"https://www.brex.com/product/venture-debt//">here.

/n

Conclusion:

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Venture debt clearly has many benefits &#8212; it offers startups a less dilutive way to inject capital into a healthy, growing business, a business that most traditional banks ignore today. At its best, venture debt is an effective complement to equity financing, and helps accelerate a company’s growth. But accessing venture debt is not without risks<a id=\"footnote2a\"><a href=https://www.ycombinator.com/"#footnote2\">^<b>2</b></a></a>. Founders should be realistic and ask themselves whether they are taking on a burden that can be repaid. A company is best positioned to assume venture debt when it is confident in its ability to repay the loan, which will eliminate all associated risks.</p>\n<h3>GLOSSARY: BASIC TERMINOLOGY (for familiarity only; counsel needs to be hired):</h3>\n<p><u>Commitment</u>: What type of commitment is your venture debt investor making? How much money is being offered? When can your company access the money? Does the company need to “draw-down” over time? Can the company access all the capital at once?</p>\n<p><u>Term Loan/ Revolver</u>: Term loans are for a set time period (i.e. 3 years) and have a fixed payment schedule. The payment schedule can be “amortized” meaning that both the principal and interest is paid through periodic payments e.g. a mortgage; a “bullet” payment means the interest payment is made throughout and the principal is paid at the end of the term (aka the “maturity” date).</p>\n<p>Revolvers are like credit cards or a line of credit: a borrowing limit is set by the lender. Most venture lenders charge a “commitment fee” – the fee can be a flat fee or a fixed percentage of the commitment and is intended to compensate the lender for keeping open access to the money. Make sure to understand how much money is being paid on fees: venture lenders tend to nickel and dime companies with tiny fees.</p>\n<p><u>Interest Rate</u>: Interest rate is a crucial term and varies on a company’s ability to repay; the rate may vary from ~6-10%. Term sheets often express interest as “Prime rate plus x%”. Many lenders offer an interest only period prior to requiring repayment of principal.</p>\n<p><u>Warrants</u>: Warrants are another critical term and provide the lender with potential upside as a stockholder in a venture backed company. Warrants are typically a percentage of the commitment (i.e. 5% of $2mm). Most lenders ask for preferred stock based on a company’s last round, but an increasing amount of recent term sheets request a set percentage of common stock. Obviously, it is important to speak to multiple lenders when negotiating interest rates and warrant coverage.</p>\n<p><u>Prepayment Penalties</u>: Founders should make sure there are no charges for paying back their loan early (can be very useful if the market improves).</p>\n<p><u>Investor Abandonment</u>: A clause that allows the lender to demand repayment if a company’s investor doesn’t invest in the company’s future round.</p>\n<p><u>Negative Pledge on IP</u>: A clause that prevents a company from pledging its intellectual property to another party while the loan is outstanding. Sometimes lenders ask for a first-priority security interest on a company’s IP &#8212; this is a term companies should not accept.</p>\n<p><u>Field exams/ legal costs</u>: Beware of hidden fees! Look for clauses that allow the lender to conduct on site exams (at the company’s expense). Make sure to cap legal fees and do not pay the lender for documents that have been drafted a hundred times.</p>\n<p><u>Current Ratio/ Quick Ratio</u>: These financial terms measure a company’s liquidity and may impact how large a commitment a lender makes. The “current ratio” measures a company’s assets by dividing the company’s assets by the amount of liabilities. The “quick ratio” only includes the most liquid current assets that can be turned to cash quickly, and does not include inventory, supplies, etc. Venture debt lenders often use these ratios in covenants to monitor liquidity.</p>\n<p><u>Default Provisions</u>: Defaulting on a loan allows the lender to ask for its money back and can kill a company. There are different types of defaults in venture loan contracts: technical default (violating a covenant); monetary default (missing a payment); change in status default (legal judgment); and there are subjective defaults: “material adverse change” or “investor abandonment”. It is important to maintain a good relationship with your lender, especially if there is a subjective default provision that may be triggered. In these circumstances, a lender bank may choose to revise its debt, or make the more draconian decision to send the loan to its bank’s workout group.</p>\n<hr />\n<p><a id=\"footnote1\"><a href=https://www.ycombinator.com/"#footnote1a\">^<b>1</b></a></a> Venture debt terms and concepts are very simple; the language may seem daunting because it is unfamiliar. The dynamic is similar to equity financings: it is disconcerting for founders when they first hear preferred stock financing terminology (e.g. liquidation preference, broad-based weighted average anti-dilution, right of first refusal and co-sale rights). But all YC founders quickly get up to speed and understand the meaning of these simple concepts. Venture debt terminology may seem unfamiliar, but also can be understood quickly.</p>\n<p><a id=\"footnote2\"><a href=https://www.ycombinator.com/"#footnote2a\">^<b>2</b></a></a> I have not listed all the risks associated with venture debt. It is important to note that unlike equity, venture debt requires a startup to agree to financial “covenants” &#8212; e.g. a startup needs approval before incurring additional indebtedness, selling assets, etc.. More important, in a downside scenario, a venture lender often influences a company’s ultimate exit. That means if a company is running out of capital and has two options, one which employees prefer and one which is better for the bank, the company probably will have to choose the option that is better for the bank. These risks further highlight why founders need to be realistic about their ability to repay. To emphasize, founders should remember that venture debt is a debt that needs to be paid back.</p>\n<!--kg-card-end: html-->","comment_id":"1104897","feature_image":"/blog/content/images/2022/02/BlogTwitter-Image-Template-1--1-.png","featured":false,"visibility":"public","email_recipient_filter":"none","created_at":"2021-08-26T01:59:44.000-07:00","updated_at":"2022-02-03T16:34:50.000-08:00","published_at":"2021-08-26T01:59:44.000-07:00","custom_excerpt":"In this guide, YC Managing Director Jon Levy talks about venture debt. He covers what it is, walks through some of its benefits and risks, and gives advice on how to approach the process of taking on venture debt.","codeinjection_head":null,"codeinjection_foot":null,"custom_template":null,"canonical_url":null,"authors":[{"id":"61fe29e3c7139e0001a7109c","name":"Jon Levy","slug":"jon-levy","profile_image":"/blog/content/images/2022/02/jon.jpg","cover_image":null,"bio":"Jon is Managing Director, Partnerships at Y Combinator. He previously counseled public and private technology companies as an attorney for Wilson Sonsini Goodrich and Rosati.","website":null,"location":null,"facebook":null,"twitter":null,"meta_title":null,"meta_description":null,"url":"https://ghost.prod.ycinside.com/author/jon-levy/"}],"tags":[{"id":"61fe29efc7139e0001a71174","name":"Advice","slug":"advice","description":null,"feature_image":null,"visibility":"public","og_image":null,"og_title":null,"og_description":null,"twitter_image":null,"twitter_title":null,"twitter_description":null,"meta_title":null,"meta_description":null,"codeinjection_head":null,"codeinjection_foot":null,"canonical_url":null,"accent_color":null,"url":"https://ghost.prod.ycinside.com/tag/advice/"},{"id":"61fe29efc7139e0001a7116d","name":"Essay","slug":"essay","description":null,"feature_image":null,"visibility":"public","og_image":null,"og_title":null,"og_description":null,"twitter_image":null,"twitter_title":null,"twitter_description":null,"meta_title":null,"meta_description":null,"codeinjection_head":null,"codeinjection_foot":null,"canonical_url":null,"accent_color":null,"url":"https://ghost.prod.ycinside.com/tag/essay/"},{"id":"61fe29efc7139e0001a71170","name":"Startups","slug":"startups","description":null,"feature_image":null,"visibility":"public","og_image":null,"og_title":null,"og_description":null,"twitter_image":null,"twitter_title":null,"twitter_description":null,"meta_title":null,"meta_description":null,"codeinjection_head":null,"codeinjection_foot":null,"canonical_url":null,"accent_color":null,"url":"https://ghost.prod.ycinside.com/tag/startups/"}],"primary_author":{"id":"61fe29e3c7139e0001a7109c","name":"Jon Levy","slug":"jon-levy","profile_image":"https://ghost.prod.ycinside.com/content/images/2022/02/jon.jpg","cover_image":null,"bio":"Jon is Managing Director, Partnerships at Y Combinator. He previously counseled public and private technology companies as an attorney for Wilson Sonsini Goodrich and Rosati.","website":null,"location":null,"facebook":null,"twitter":null,"meta_title":null,"meta_description":null,"url":"https://ghost.prod.ycinside.com/author/jon-levy/"},"primary_tag":{"id":"61fe29efc7139e0001a71174","name":"Advice","slug":"advice","description":null,"feature_image":null,"visibility":"public","og_image":null,"og_title":null,"og_description":null,"twitter_image":null,"twitter_title":null,"twitter_description":null,"meta_title":null,"meta_description":null,"codeinjection_head":null,"codeinjection_foot":null,"canonical_url":null,"accent_color":null,"url":"https://ghost.prod.ycinside.com/tag/advice/"},"url":"https://ghost.prod.ycinside.com/venture-debt-101-basics-and-approach/","excerpt":"In this guide, YC Managing Director Jon Levy talks about venture debt. He covers what it is, walks through some of its benefits and risks, and gives advice on how to approach the process of taking on venture debt.","reading_time":8,"access":true,"og_image":null,"og_title":null,"og_description":null,"twitter_image":null,"twitter_title":null,"twitter_description":null,"meta_title":null,"meta_description":null,"email_subject":null,"frontmatter":null,"feature_image_alt":null,"feature_image_caption":null},"mentions":[],"related_posts":[{"id":"61fe29f1c7139e0001a7191b","uuid":"395e6c97-7acc-49bb-9d6d-f833e439e99b","title":"What’s the Second Job of a Startup CEO?","slug":"the-second-job-of-a-startup-ceo","html":"<!--kg-card-begin: html--><p>Successful startups go through three broad phases as they scale, and a startup CEO’s job changes dramatically in each phase. A CEO’s first job is to build a product users love; the second job is to build a company to maximize the opportunity that the product has surfaced; and the third is to harvest the profits of the core business to invest in transformative new product ideas. This blog post describes how to become a great Phase 2 CEO by focusing on the highest leverage tasks that only the CEO can accomplish. As YC’s Continuity team, we’ve seen many Phase 1 CEOs transition successfully into Phase 2, and some who have not. The future of your startup depends on which kind you are.</p>\n<p><strong>Your First Creation is a Product, Your Second Creation is a Company</strong></p>\n<p>A CEO’s first job is to build a great product and find a small group of people who love it and use it enthusiastically.<sup id=\"footnoteid1\"><a href=https://www.ycombinator.com/"#footnote1\">1</a></sup> A Phase 1 startup CEO is the Doer-in-Chief. You must be deeply involved in both building the product (observing/interacting with users, writing code, designing product specs) and acquiring users/customers. Delegation should not be a word in your vocabulary. If you succeed, it’s because your deep involvement and unique vision give the company a perspective and drive that few others have. The other imperative for a Phase 1 CEO is to conserve money in order to extend the time to iterate and improve the product.</p>\n<p>Most startups fail because they are not able to create a product that users love enough to abandon existing alternatives. Success in this first phase means discovering more demand for your product than your small team can handle. When this happens, you have to shift your focus as CEO to building a company that can capture and maximize the demand that your product has surfaced. Company-building becomes the CEO’s primary job in a Phase 2 startup. The company you build is your second creation and will be your lasting legacy as a founder.</p>\n<p>As a Phase 2 CEO, you need to transition from “Doer-in-Chief” to “Company-Builder-in-Chief.” This is how you scale as a CEO, and CEO scaling is the first step in company-building. For most founders, this is very difficult. When you’ve been a successful Doer-in-Chief, it’s hard to stop. It’s hard to stop coding, designing product specs, and interacting with customers on a daily basis. It’s hard to stop answering support tickets, doing all the product demos, and debugging the latest build. It’s even hard to delegate the random and sometimes menial tasks that you’ve accumulated over the years because they were “no one’s job.” But you have to stop doing all of these things so that you can safeguard your time for high leverage tasks that only CEOs can do.</p>\n<p>This transition can cause confusion and even friction with your team, who can suddenly wonder what you are doing if you’re no longer committing code or why you’re suddenly delegating a bunch of menial tasks that you’d been doing for years. But once your startup reaches 20-30 people, you’ll have to spend more time leading (i.e., directing the activities of others). And since time is finite, the only way to lead more is do less. Without delegating, you simply won’t have time to focus on company-building and you’ll end up slowing everyone else down.</p>\n<p>It may seem impossible at first, but you can eventually delegate day-to-day responsibility for everything you did in Phase 1, even Product. You obviously can’t drop everything overnight, but your job is to replace yourself by hiring people better than you into leadership positions. As David Rusenko, the co-founder and CEO of Weebly has said, “Often, the first time I find out about a product feature is reading about it on our blog. It shocks most founders to hear this, but I know I’ve done my job well because I’ve yet to see a feature that was built poorly. You should aspire to build a team that’s so good that you don’t have to be involved in the product details.”</p>\n<p>In practice, Phase 2 usually begins when a startup has around 20-25 employees and ends when it reaches 400-500 employees. At the end of Phase 2, you’ll have a leadership team that you’ve “road tested” to the point that you can confidently delegate everything you did in Phase 1. Your direct reports should be experienced leaders who can perform at a high level with minimal involvement from you, provided that you have set direction well. You can then shift the burden of company building to your leadership team so that you can start working on Phase 3: taking profits from the core business and investing them in new, transformative products. As an example, Facebook built its senior management team in Phase 2 while running the business at roughly breakeven. In Phase 3, it began to generate huge profits in its core business thanks to more lucrative in-stream ads, so it could allocate significant resources towards Messenger as a separate product and buy Instagram, WhatsApp, and Oculus.</p>\n<p><strong>Three Tasks That CEOs Can’t Delegate</strong></p>\n<p>Stated simply, your job as a Phase 2 startup CEO is to delegate everything you did in Phase 1 in order to create time to focus on three critical operational tasks that only the CEO can do <sup id=\"footnoteid2\"><a href=https://www.ycombinator.com/"#footnote2\">2</a></sup>:</p>\n<p><strong>1&#46; Hiring a Leadership Team and Making Sure They Work Well Together</strong></p>\n<p>Only the CEO can hire the company’s senior leadership team and make sure that they work well together. You can get help and feedback from others as you hire, but when you bring leaders like a VP of Engineering, VP of Sales, and CFO on board, the ultimate hiring decisions must be yours. You can’t hire by compromise, looking for someone who everyone around you likes. The choice has to be yours because the consequences are yours as well.</p>\n<p>Recruiting senior executives takes an extraordinary amount of time. If you are doing it for the first time, meet lots of people so that you can develop good judgment about the skills, experiences, and personality traits that you need. Patrick Collison, co-founder and CEO of Stripe, made it a point to meet with the “best-in-the-world” in each field so he could get a sense of what a great candidate looks like. Because executive hiring takes so much time, you should stage these hires rather than trying to hire everyone at once. Our recommendation is to hire a good executive search firm to help you run your first couple of searches. It will cost you an arm and a leg, but if it helps you hire the right person, it’s worth every penny.</p>\n<p>YC teaches founders to manage their startups using weekly milestones to ensure rapid iteration and progress. That’s great for a small company trying to find product-market fit, but it’s not the way to manage senior executives. You manage senior people to longer term outputs rather than week-to-week tasks. To do this well, you first have to set the right quarterly and annual milestones for the company and for each executive. It’s also your job to acclimate new executives to the culture of the company. As you build your senior team, expect to spend extra time with new executives individually and as a team on culture and teamwork. You should insist that new executives take the time to build relationships across the organization rather than pressuring them to come in and start changing things immediately.</p>\n<p>Learning how to evaluate the performance of senior executives is also a challenge, partly because your face-to-face interactions do not provide much of the information you need. You have to evaluate how well they are building their organizations, how productive and happy their employees are, and how well they are working with other teams and executives. You should expect that at least 25% of your leadership hires don’t work out. For most startup CEOs, it’s very difficult to fire their first executive, and most CEOs take too long to do it. But it’s better to act quickly and leave a void in the organization than to leave an ineffective senior executive in place for too long. The longer you leave an under-performing executive in place, the more credibility you lose with everyone else on your team.</p>\n<p>Your job is done when your entire leadership team has been hired, you’ve coached them to work well together, and they can operate at a high level with minimal involvement from you. Don’t be surprised if 50% of your time goes to hiring and managing your senior team; it’s time well spent.</p>\n<div id=\"creating-purpose-and-alignment\">\n</div>\n<p><strong>2&#46; Creating Purpose and Alignment</strong></p>\n<p>The second task that CEOs cannot delegate is creating purpose and alignment at the company. When your startup has less than 10 people who all sit together, you don’t need to work very hard to keep people aligned. Everyone can easily hear what’s going on, understand how their work fits into the broader goals, and have a say in every decision. Communication is simple and creating alignment is easy.</p>\n<p>But when you start hiring more people, soon in different offices and from broader backgrounds and functions (e.g., sales, finance, etc.), creating alignment becomes a lot harder. Your team no longer sits within earshot. You aren’t able to interview or even meet everyone who joins the company. And you may not even able to attend employee onboarding sessions. As an example, there was an 18-month period at Twitter where the company was hiring 50 people per month in offices all around the world. There was no way the CEO or any one executive could meet everyone who was joining the company.</p>\n<p>As a Phase 1 CEO, you are the lead rower on the boat. But in a Phase 2 startup, your job is no longer to row. Instead, it’s to define the purpose of the voyage, set the direction of the boat, and measure the pace and performance of a much larger number of rowers. In business speak, the CEO’s job is to define the Mission (purpose), Strategy (direction), and Metrics (pace and performance). These three elements provide the essential context that a growing company needs to be able to perform.</p>\n<p>One of the best examples of “Mission-to-Metrics” alignment comes from a friend who visited the manufacturing floor at SpaceX. Seeing a SpaceX employee assembling a large part, he stopped to ask him, “What is your job at SpaceX?” He answered, “The mission of SpaceX is to colonize Mars. In order to colonize Mars, we need to build reusable rockets because it will otherwise be unaffordable for humans to travel to Mars and back. My job is to help design the steering system that enables our rockets to land back on earth. You’ll know if I’ve succeeded if our rockets land on our platform in the Atlantic after launch.” The employee could have simply said he was building a steering system for landing rockets. Instead, he recited the company’s entire “Mission-to-Metrics” framework. That is alignment.</p>\n<p>Can you define the Mission, Strategy, and Metrics for your startup in a way that’s clear, simple, and inspiring? Most Phase 2 CEOs can’t readily do this. And, when they sit down to define it, they find it harder than they thought. The diagram below captures the task at hand:</p>\n<p><a href=https://www.ycombinator.com/"https://ycombinator.wpengine.com/wp-content/uploads/2016/11/Artboard-2white_wborder.png/">How To Start A Startup</a> and <a href=https://www.ycombinator.com/"http://www.paulgraham.com/ds.html/">Do Things That Don’t Scale</a>.<a href=https://www.ycombinator.com/"#footnoteid1\">↩</a></p>\n<p><b id=\"footnote2\">2</b> The focus of this essay is on a CEO’s operational responsibilities. There are certain non-operational responsibilities such as building/managing a Board, raising money, interacting with the press, etc., that are also part of a CEO’s job, especially when a startup is small. Generally speaking, the less time a Phase 2 CEO spends on these types of non-operational tasks, the better, because they come at the cost of running the company.<a href=https://www.ycombinator.com/"#footnoteid2\">↩</a></p>\n<p><em>Thanks to Daniel Yanisse, Patrick Collison, David Rusenko, Ben Holzman, Michael Seibel, Ed Catmull, Sam Altman, Leore Avidar, Tyler Bosmeny, and the YC Continuity team for reading drafts of this essay.</em></p>\n<!--kg-card-end: html-->","comment_id":"1096555","feature_image":"/blog/content/images/wordpress/2016/11/businessman-standing-in-office-looking-out-picture-id150220735__1024%C3%97768_.jpg","featured":false,"visibility":"public","email_recipient_filter":"none","created_at":"2016-11-29T00:00:11.000-08:00","updated_at":"2021-10-20T13:17:53.000-07:00","published_at":"2016-11-29T00:00:11.000-08:00","custom_excerpt":null,"codeinjection_head":null,"codeinjection_foot":null,"custom_template":null,"canonical_url":null,"authors":[{"id":"61fe29e3c7139e0001a71078","name":"Ali Rowghani","slug":"ali-rowghani","profile_image":"/blog/content/images/2022/02/Ali.jpg","cover_image":null,"bio":"Ali is Managing Director of YC Continuity, where he invests in & advises growth-stage startups. 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We asked founders to shoot a 30-second video describing theirbusinesses and open roles. 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