The coupon, the fees, the final payment and the warrants on one schedule, and the exit prices at which the loan is cheaper than equity.
Venture debt costs the coupon plus three things the coupon hides: an upfront fee, a final payment and warrants. On an illustrative 5,000,000 loan at 11.0 per cent with a 1.0 per cent fee, a 4.0 per cent final payment and 10 per cent warrant coverage, the cash cost alone is 13.91 per cent a year, and with the warrants exercised at an exit price of 5.00 the all-in cost is 18.91 per cent. That is still well below the 25.74 per cent the same 5,000,000 of equity would have cost at that exit.
Worked in full in The Venture Capital Associate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A founder comparing a venture debt term sheet with an equity extension usually looks at two numbers: the interest rate and the dilution. Both understate the price. The fees are paid on the full commitment but spread over a balance that starts amortising after a year, and the warrants are an equity kicker whose cost depends on how well the company does. An associate asked to review a debt offer for a portfolio company should compute the lender's internal rate of return, because that is the borrower's cost, and should compute it with and without the warrants.
| Term | Value |
|---|---|
| Loan, drawn in full at closing | 5,000,000 |
| Coupon, paid monthly | 11.0% |
| Interest-only period | 12 months |
| Then straight-line amortisation over | 24 months |
| Upfront fee, deducted at drawdown | 1.0% |
| Final payment at maturity, on the original loan | 4.0% |
| Warrant coverage, on the loan amount | 10% |
| Warrant strike, the last round price | 2.00 |
| Fully diluted shares before the warrants | 30,000,000 |
| Exit, when the warrants are exercised | month 48 |
The terms are illustrative, not a market survey. The company is post-Series A, valued at 2.00 a share on 30,000,000 shares.
Lender's cash flows: −(loan − upfront fee) at month 0, then interest + principal each month, then the final payment at maturity, then the warrant gain at exit.
Warrant gain = MAX(0, exit price − strike) × coverage × loan / strike
All-in cost = (1 + monthly IRR)12 − 1. In Excel: =(1+IRR(B2:B50))^12-1 on a column of monthly flows, with zeros in the months between maturity and exit.
Step 1, the coupon. 11.0 per cent paid monthly is 45,833 a month during the interest-only year and compounds to 11.57 per cent a year. From month 13 the principal falls by 208,333 a month and the interest falls with it. Total interest over the 36 months is 1,122,917. Because the balance amortises, the average life of the loan is only 2.04 years.
Step 2, the fees. The company receives 4,950,000, not 5,000,000, and pays 200,000 on top of the last instalment. Neither is large in isolation, but both are charged on the full loan and recovered over two years of average life. The upfront fee takes the cost from 11.57 to 12.19 per cent; the final payment takes it to 13.91 per cent. Total cash cost: 1,372,917, or 0.275 for every unit borrowed.
Step 3, the warrants. Coverage of 10 per cent gives the lender the right to buy 500,000 of stock at the last round price: 250,000 warrants at 2.00, which dilute the company by 0.83 per cent. They cost nothing until the share price rises. At an exit price of 5.00 in month 48 they are worth 750,000 to the lender, and adding that flow to the schedule lifts the all-in cost to 18.91 per cent.
| Exit price | Warrant gain | Total cost of the debt | Per unit borrowed | All-in cost of debt | Cost of equity raised at 2.00 |
|---|---|---|---|---|---|
| 2.00 | 0 | 1,372,917 | 0.275 | 13.91% | 0.00% |
| 3.00 | 250,000 | 1,622,917 | 0.325 | 15.70% | 10.67% |
| 5.00 | 750,000 | 2,122,917 | 0.425 | 18.91% | 25.74% |
| 8.00 | 1,500,000 | 2,872,917 | 0.575 | 23.10% | 41.42% |
| 12.00 | 2,500,000 | 3,872,917 | 0.775 | 27.85% | 56.51% |
The equity column is the annual rate at which 5,000,000 raised at 2.00, that is 2,500,000 new shares and 7.69 per cent of the company, grows into what those shares are worth at the exit. At 5.00 they are worth 12,500,000: the company gave up 7,500,000 of value to raise 5,000,000, against 2,122,917 for the loan. Debt costs 0.28 of what equity costs in that outcome.
The comparison flips when the company does not grow much. The two costs are equal at an exit price of 3.74, at 16.93 per cent a year; below that, equity is the cheaper money. At 3.00 the debt costs 15.70 per cent against 10.67 per cent for equity, and at 2.00 or below equity cost nothing while the debt still cost 13.91 per cent in cash, paid from a balance sheet that was already short of it. Venture debt is cheap capital for a company that succeeds and expensive capital for one that does not, which is the opposite of how it feels when the term sheet arrives.
| Warrant coverage | Exit at 2.00 | Exit at 5.00 | Exit at 12.00 |
|---|---|---|---|
| 5% | 13.91% | 16.54% | 21.77% |
| 10% | 13.91% | 18.91% | 27.85% |
| 20% | 13.91% | 23.10% | 37.26% |
Coverage matters more than a point of coupon in any outcome worth having. Doubling it from 10 to 20 per cent adds 4.18 points of cost at a 5.00 exit and 9.41 points at 12.00, while cutting the coupon by a point would save roughly a point in every case. Negotiate coverage first, the final payment second and the coupon last. For how to put a fair value on the warrant itself before anyone knows the exit, see how to value warrants in a private company.
Treating the debt as runway at no dilution. The loan adds months, but from month 13 it also takes 208,333 of principal a month out of the bank, plus interest, so the net runway gain is far smaller than 5,000,000 divided by the burn. Run the debt service through the monthly cash model before agreeing that the loan "extends runway by ten months": the method is in how to calculate a startup's cash runway. The second mistake is ignoring covenants and material adverse change clauses, which have no rate but decide whether the lender can call the loan exactly when the company most needs it.
The book treats portfolio support, including runway and follow-on decisions, as arithmetic an associate should be able to run; the free workbooks for the book carry its reserve and unit economics models.
The value of stock the lender may buy, expressed as a percentage of the loan, at a strike usually set at the last round price. Ten per cent coverage on a 5,000,000 loan at a 2.00 strike gives 250,000 warrants, 0.83 per cent dilution. They cost the company nothing unless the share price rises; at a 5.00 exit they are worth 750,000 to the lender.
More than its size suggests, because it is charged on the full loan but the balance amortises. In the illustrative case a 4.0 per cent final payment, 200,000 at maturity, lifts the annual cost from 12.19 to 13.91 per cent, since the average life of the loan is only 2.04 years.
Only if the company grows enough. At an exit price of 5.00, 5,000,000 of equity raised at 2.00 is worth 12,500,000, a cost of 25.74 per cent a year, against 18.91 per cent for the loan with warrants. The two are equal at an exit of 3.74; below it equity is cheaper, and at the round price equity has cost nothing while the debt still cost 13.91 per cent in cash.
This article is one calculation from The Venture Capital Associate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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