There are various ways to fund an early-stage, research-heavy startup. Often, grant funding or equity-based investment from angels or VCs makes most sense for quantum technology startups in the beginning. But there can be other options.
Sometimes, taking out a loan in the form of venture debt can be a sensible and logical approach to growing a quantum technology startup. But how, and why?
To find out more about this type of finance, we spoke to Fatou Diagne, Managing Partner at Bootstrap Europe –a provider of venture debt to VC-backed startups across Europe–and Marie Weijler, Startup & Scale-up Banker at Rabobank.
What is venture debt?
MARIE: Venture debt is like a sibling or a cousin of venture capital. They both target startups and scale-ups, but instead of taking equity in a company in exchange for capital, venture debt provides a loan and does not receive equity in return.
Most Dutch startups think they can only come to us for a small ticket, like €150,000, but we can go up to €20 million.
FATOU: Venture debt is a sort of financing for fast growing scale ups, with a structure [FB1] that can be most closely compared to a mortgage on your house. It's a loan that you take from a financing provider, and you reimburse it over a fixed period of maybe three or four years. Usually, you make a monthly repayment towards the original sum and the interest.
The main reason it is used by founders and by their shareholders is to avoid dilution. Startups have key inflection points, and with the debt, you're trying to move the timing of those inflection points. If you know that you're going to raise your next round based on certain milestones of revenue or development, you might want to either push that away further to give yourself time to grow, or you might want to grow as fast as possible before that moment.
Therefore, venture debt complements your cash or your equity-based funding to help you get there faster.
You need to be at a stage where you're out of technology risk, and you have a good view of your cash’s ROI. As an example, you might take €1 of cash, invest it in your business, it results in €10 of revenue, and that €10 is valued at €100. That's a clear ROI, and that's when you should be taking on debt.
You should not take it because you're desperate, or because you can't raise equity, and not when you don't know what to do with the money. It's an expensive tool; it's more expensive than banks, but it's much cheaper than equity as an alternative.
Why would a startup not go for a traditional business bank loan instead?
MARIE: In our case specifically at Rabobank, we offer the Rabo Innovation Loan. In the first two years, there is a grace period in which you do not have to pay back the loan, and most traditional bank loans do not have a two year grace period. You do not always get seven years to pay back the loan, and we do provide that.
And it's an unsecured loan, which is another thing that a traditional bank loan will probably not offer you, because a startup is a relatively risky business for a bank to provide a loan to.
We do like to co-finance funding rounds, too, so it's not a choice of VC or venture debt, it can be both. You can decide to have a €3 million funding round, and, for example, do €2 million in equity through a venture capital fund and €1 million through venture debt. And having a major bank on board can be a stamp of approval for an investor.
FATOU: Often, bank funding is just not available for startups. Because you're not profitable and don't have a long history of cash flows, banks will not touch it, but sometimes the risk is completely overstated.
For example, if you have a company that has a solid contract over three to five years with a blue chip company, that's a risk that normally banks should be able to underwrite and provide funding for, but because you're a startup, you can't access that.
And so that's where venture debt comes in. It still has the spirit of venture backing, and we are together with our founders on the ups and downs of the journey, but it's something that doesn't dilute you on your cap table.
How can venture debt fit into the life cycle of a quantum startup particularly?
FATOU: Yesterday, I was on the phone with a quantum company that told us they don't have a lot of revenues, but they have got a multi-million contract with the government to develop a quantum computer.
That's fantastic for us to finance, because you need the money today while the future revenues are almost 99% certain, so why wouldn't we finance it?
Quantum companies need to think about their funding needs in terms of what they’re funding. If it's technological risk that you're financing, that's probably a good fit for equity or grant funding. But once you've passed that and you need to buy equipment, CapEx financing, lenders love that because they have a collateral.
If you're thinking of customer financing, if you have a contract and you just need to order inventory or materials, lenders would love that if there is no enormous risk in the construction, because you would get paid at some point.
If you’re a quantum company and you need to have a lot of prototypes out in the market, to convince your clients with multiple pilot projects before they convert into product orders, you can finance that with debt.
If a quantum company is providing compute power to their customers as a service, and they have to front all that cost, that's something that that debt can provide also, based on the contracts they have.
Also, maybe you’re negotiating with a very big customer. They're not so sure that as a startup you'll be around the next five years to service them, so you need to show very strong balance sheets. It might make sense to use debt instead of equity, even with the interest rate.
What are the risks around venture debt that founders should be aware of?
MARIE: You will have to pay back the loan eventually, and that's different from an equity investment, where you don't have to pay back the capital received. On the other hand, the advantage is that you do not lose your equity, you maintain more control over your company, so there is no dilution of shares.
FATOU: The main feature of venture debt is that you have to reimburse it. You need to make sure that you understand your KPIs and make sure they're repeatable, so you don’t risk your business.
We never convert into equity, because we don't want to dilute the equity investors and the founders. So you have to make sure you have multiple ways to reimburse your lender no matter what, if you want to keep your business. So don't take too much debt. Maybe start slow, see how you deal with the business and have the discipline to reimburse that debt.
Don't take too much debt, because if you're going to go and raise the next funding round and new investors see a wall of debt that their money is going to pay back, they're not going to be interested. They want to finance growth, not debt. So you want to show that you already have financial discipline.
You want to make sure you work also with a lender that understands startups. Banks can be great to have as a financing partner, because they're really cheap compared to venture debt or equity, but they’re a different type of partner. They might not be able to understand all the ups and downs that you're going to face. If you have an issue, you might end up with a restructuring department, and that's another type of dialogue you don't want to face in your business.
So choose a lender that you're comfortable with. All have very similar pricing, and you should choose the one that you feel comfortable with, that you trust, and that has a track record of good behaviour with their startups, even in hard times.
How should startups prepare to apply for venture debt, and what is the application process like?
FATOU: It’s not very difficult to raise venture debt. It's a much shorter process than equity, if you are the right fit for it.
It might seem like an easy step to take, but you want to do it when you have the right financial maturity. Venture lenders generally don’t sit on your board, and we might not have a lot of covenants, but we are interested in getting clear financial information. So make sure your internal systems and reporting are up to scratch. Make sure your board is on board with this, because it's a long term partnership.
MARIE: What we ask for at Rabobank is not much different from what venture capitalists or other venture debt providers want to see. We want to see a balance, a profit and loss statement, preferably with a three-year prognosis.
We want to see an organogram of the company holding structure, we would like to see resumés of the co-founders, we want to see a document from the chamber of commerce that proves that you're actually incorporated so the company is real, we want to see a pitch deck. And we ask startups to give us their milestones that they have set themselves; what are your goals in the upcoming six to 12 months?
FATOU: Ideally when we lend we want to lend multiple times to the same business. On average, we lend two or three times to each business. So we'll be with you for the next 10 years. We'll be with your board for the next 10 years. It's a personal story before everything. So be ready for all the financial information we’ll require, and to embark on a personal relationship that's going to last a long time.
The information we require is very similar to what an equity investor asks for. We need your financial plan, we need to understand your cap table, we need to understand your historical financials. We need to understand your strategic vision for the next 18 to 24 months. And then the process is quite easy. It takes four to six weeks for you to get a venture loan.
Do your homework and talk to several venture lenders. We come in very different flavors. Some only do revenue-based lending, some do asset-based lending, some are multi-geographic. If you're going to be in multiple countries, make sure you take one that can come with you in those countries.
For the legal documentation, make sure you hire a lawyer who understands venture debt, to save you time and money.
After that, keep a relationship of trust with your lender. It will make every subsequent discussion much easier. And when you're ready for more, most venture lenders are really well connected and can help you with fundraising, because we spend the whole day speaking to the VCs, so we'll know exactly which one is right for you for your next stage, and can make very helpful introductions.