Venture debt is a type of debt financing provided to venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses4 min read
2. What are three major types of venture debt?
3. Pros and Cons of Venture Debt
4. The proper time to raise venture debt
5. Important terms when you raising venture debt
What is venture debt?
Raising capital is vital to the survival and long-term success of startup companies, particularly those with the sorts of business models that attract venture capital (VC) investment. These companies are often unprofitable (or pre-revenue). Therefore, they need regular cash infusions to continue funding their operations and growth because little to no founder funds have been infused to finance the business.
All companies raising capital must decide which instrument to issue to their investors. For startups, the choice of the instrument varies depending on the company's stage of development, investor base, and financial position. This article will focus exclusively on providing an overview of venture debt to raise capital for a growing startup company.
Early-stage startups are rarely candidates for commercial bank loans unless the founders are willing to give personal guarantees and have sufficient personal assets to pledge as collateral. However, once a startup has institutional VC investors, there are certain banks and venture lenders that offer commercial lending services, such as Silicon Valley Bank, Square 1 (a division of Pacific Western Bank), Western Technology Investment (WTI), and Comerica Bank. These venture banks and lenders look at VCs as potential backstops if their venture-backed borrowers fall on hard times since VCs are often willing to invest additional equity capital to keep their portfolio companies financially afloat. Venture debt generally consists of 3 to 4-year term loans. These are made available for startup companies, even without any positive cash flow or assets used as collateral. One of the most substantial benefits to founders and early investors is that these shareholders will generally not get diluted by the venture debt (assuming there is no other equity kicker in play). From a practical standpoint, imagine a new startup that has raised a seed round of $1M at a $3M valuation and then raised $10M through Series A at a $25M valuation. In this case, the founders have given away the vast majority of their company to outside investors. Not to mention the fact that if the company needs additional capital in a Series B round and beyond, the shareholders will get diluted even further. Venture debt is a potential alternative non-or-less dilutive financing mechanism in comparison to raising capital from convertible instruments or as part of priced rounds.
What are three major types of venture debt?
Growth capital: It is structured as a term loan and can be used to replace or supplement an equity round, finance mergers and acquisitions (M&A) activity, or provide additional working capital;
Accounts receivable financing: It allows revenue-generating startup companies to borrow against their accounts receivable items (typically 80-85%);
Equipment financing: This is typically structured as a lease and is used to purchase equipment such as network infrastructure, manufacturing, etc.
Pros and Cons of Venture Debt
If you structure appropriately, venture debt can be an attractive financing option for the following reasons:
No or less equity dilution: The beauty of venture debt is that it does not require exchanging equity for capital.
- Extend Cash Runway: Companies may choose venture debt to extend their cash runway. Each company has its goals and milestones, but the ideal runway for early-stage startups is 15-18 months. It gives the opportunity to hit the company’s goals and prepare for the next fundraising round.
Lesser formality: In contrast to the due diligence process of venture capital, venture debt requires less formality. The due diligence process is less exhaustive and companies get funded more quickly than some other methods. This is an opportunity to achieve the company’s next landmark in a shorter period of time.
Possible Dangerous Financial Settlement
The main disadvantage of venture debt is the possibility of a dangerous financial deal. If a company does not meet specific metrics set forth in the loan terms (e.g., negative earnings, the company cannot service its debt when due, etc.), this can lead to the lender calling an event of default. When a company is in default, the loan is accelerated and the is due and payable at that time.
Quarterly Cash Advances
Although venture debt helps high-growth businesses retain equity while extending cash runway, this does mean it creates quarterly cash expenses for the company. Unlike equity financing, this needs to be repaid at some point in the future. If venture debt is used correctly, it can be a helpful financing tool that can boost success for companies who use it in conjunction with equity financing. However, if not negotiated properly, it can become very costly.
The proper time to raise venture debt
Four common use cases when to raise venture debt:
Extending the cash runway of a business to hit the company's next milestone;
Preventing the need for a bridge round or a down round to get through a tough period without creating a negative signal;
Funding large capital expenses, acquisitions, or acting as a bridge to profitability;
Acting as insurance in case it takes longer than expected to hit the next milestone.
Important terms when you raising venture debt
When you are raising venture debt you should keep in mind the following important terms to be included in the agreement:
The size of the loan;
The duration of the loan - time to be repaired the loan;
The amount of fees and interest rates;
Financial and non-financial covenants;
Amortization time - when the repayment starts
Before making a final decision, it is recommended that you work with a lawyer that has venture debt experience to review the documents