Understanding and Utilizing Forward Commitments in Venture Debt for Startups

Venture debt can be a valuable financing option for startups looking to gain additional funding, extend their runway, or bridge to the next financing round. One effective way to strategically utilize venture debt is by arranging a forward commitment.

A forward commitment is a type of contract in which the lender defines the terms and timeframe of the debt use and repayment. For a startup with venture debt, this means coming to an agreement on the period of time the startup is able to draw down the venture debt for different uses. This time frame is usually between 9 to 15 months, as lenders don't want to go out too far for fear the startup may start burning the cash they just raised.

One of the key benefits of venture debt is the optionality it provides to startups. For example, startups will typically raise 18 to 24 months worth of cash. When the startup applies for a venture debt loan, the venture debt provider will then structure a forward commitment to draw down the debt capital within 9 to 15 months. This allows the startup to have the option to draw down the money, but if the startup is doing well, it may not need to draw down the venture debt and can instead raise more equity.

There are multiple scenarios in which having a forward commitment will benefit the startup, but the best time to put one in place is as soon as possible after raising equity. When the startup has just raised a big equity check and has money in the bank, it's in the best interest of the startup to set up a venture debt loan and include a forward commitment.

The forward commitment also benefits the lender by providing them with a usage-based component of a warrant, which allows them to make money on interest and get paid for providing a service. The lender reserves funds for the startup to draw down, and if those funds are never drawn down, the lender may not make much money.

On the other hand, if a startup is running out of cash and trying to put a venture debt loan in place with only three to six months of cash left in the bank, it may be difficult to secure a loan. Lenders will ask themselves why the startup hasn't raised enough money already and why they are coming to the lender with only three to six months worth of cash instead of going to their equity holders, such as their venture capital partners.

In summary, arranging a forward commitment for venture debt can provide invaluable optionality for startups and help them avoid the potential pitfalls of venture debt. By putting a forward commitment in place after raising equity, startups can bet on their own success while also ensuring they don't miss out on the benefits of venture debt.