Venture Debt: Everything You Need to Know
Venture debt is a form of business loans to supplement money gained through investors to reach milestones or to avoid diluting company ownership.10 min read
What Is Venture Debt?
Venture debt is a form of business loans. Companies often apply for venture debt to supplement money gained through investors. This could be because equity through investors is not enough to reach milestones or business owners want to avoid diluting company ownership.
Venture debt provides flexibility not found with investors and is ideal for businesses that are already equity-backed but need additional funding to complete a project. Ideal uses for venture debt include acquisitions, as a cushion leading up to expansion, or as interim funding used until money starts flowing from a new venture.
As a company is growing, it may run into some growing pains that could be eased by additional funding. Business owners can work with either banks or venture debt funds to secure venture debt funding.
Venture debt, also known as venture lending and venture leasing, can be split up into two categories: equipment financing and growth capital.
With equipment financing, companies use the loan to purchase equipment, and the financing can only be used for that equipment. If a company decides to buy less or gets a good deal on the equipment, it can't use the rest of the money on something else. The amount borrowed uses the equipment itself as collateral.
Growth capital can be used for almost any purpose within the company and relies on the company's assets to secure the loan. Business owners can use this capital to get to the next milestone that they need to meet to grow their business.
Why Is Venture Debt Important?
It's been estimated that since 1999, the time for startups to grow to the point where they are profitable takes 3.5 years longer than before. This has caused the need for a better way of getting funding that is an alternative to venture capitalists and allows companies to get over that extra hump.
Venture debt has become that way — providing companies the money they need to keep up the momentum in order to succeed. Venture debt lending has only really been around since the 1990s. Although it went through some growing pains back during the dot-com era around 1999 to 2001, it's become a very accepted and useful tool utilized by entrepreneurs and seasoned business leaders.
Here are some reasons why venture debt is an essential tool for businesses looking to expand and grow:
- Decreased dilution. Venture debt allows business founders to finance their business without further diluting the ownership of the company.
- No valuation is required. This is very helpful if your company has been underperforming or market conditions have caused lower-than-average sales, and you want to avoid having your company valued in its current state.
- Bridges the gap. When there's a gap between traditional equity from investors and what is needed to reach goals, venture debt is the best option to fill that gap.
Reasons to Consider Not Using Venture Debt
Though venture debt does have many positives, there are some reasons why it might not be the best for you and your business:
- If you don't have a clear plan on how the debt will be repaid or you don't think you will be able to repay it. If venture debt is not repaid, it's possible that venture lenders could take over the company's assets and sell it off for parts, so to speak. This could potentially lead to the company folding and the owner going into bankruptcy.
- If the payment amount to pay off the debt is greater than 20 percent of the total operating expense for the company.
- If the business is low on cash and getting funding is the last resort in trying to keep the doors open.
- If your venture investors don't think that it's a good idea to take on venture debt.
- If the covenants or terms of the venture debt that the lending company offers are not worth the risk, if you were to default.
Reasons to Consider Using Venture Debt
When considering whether to get venture debt, here are some reasons for why a company would be perfect for this type of funding:
- If you need additional funding to reach the company's next milestone, which would lead to a leap forward in its viability and profit.
- To get the company through a tough spot, especially when profitability is sure to happen, but you just need to get through a dry spell.
- When funding a large expense that will increase the company's profit share, such as an acquisition or large purchase.
- To create a bridge and get your company from where it is currently to a state of profitability.
- If you've finished lining up investors, and you calculate that you'll need additional funding in order to meet your current goal.
Getting Venture Debt: Advantages and Disadvantages
Here are some pluses and minuses of getting venture debt that you might want to consider:
- Having venture debt gives you some buffer with the equity of your company, so you have the funding you need to reach that next goal in case you run into unexpected complications.
- It prevents diluting the ownership of the company while still providing additional needed money.
- It should be fairly easy to pay back if used for its purpose and helps the company to grow, which in turn increases profits.
- It could lead to financial ruin for a company that is already at risk for folding, which may additionally lead to those who have invested in the company losing money and possibly going bankrupt.
- For companies that are not currently faring well financially, the contract for venture debt could include unfavorable covenants.
- Taking on additional debt could cause friction with investors unless those investors have been consulted and are on board with the idea of getting venture debt.
Not Getting Venture Debt: Advantages and Disadvantages
On the flip side, there's good and bad when it comes to deciding against venture debt.
- For startups, not getting venture debt could help companies avoid pitfalls, which include taking on too much debt early. Because it takes time for companies to become viable, taking on debt early may cause an inability to pay back that debt, especially if equity in the form of investors doesn't materialize.
- Founders experience less stress and anxiety about how the debt will be paid back.
- When courting venture capitalists, you won't have to worry about whether they'll see the venture debt as a negative.
- Not having the additional funding could make it take longer to reach goals set out by the company, which could have serious consequences such as being outpaced by competitors and losing market share.
- You could lose equity from potential investors that don't feel the company is progressing as quickly as they should.
Common Venture Debt Phrases You Need to Know
Dilution: Dilution has to do with the percentage of ownership within a business. When the founder of the business first opens shop, he or she generally owns 100 percent of the business. Then as investors are brought on to help fund the business, the founder gives up a percentage of the business to these investors. This gives them a say in how the company is run, the direction the company should take, and whether to sell or acquire.
Collateral: Assets that are collected by the lender if the loan goes into default. This may include assets purchased with the loan or assets owned by the company itself.
Covenants: Stipulations within the contract for debt funding. These can include two types: financial and non-financial.
- Financial covenants include provisions such as hitting a certain revenue target or having a specific level of cash on hand. This is typically not required for startups, which are more volatile. They're more likely used in contracts for established companies that are more stable with predictable income.
- Non-financial covenants prevent the business owner from making specific decisions, such as selling the company or making acquisitions. If an owner chooses to make these decisions without approval from the lender, he or she would be in breach of the covenant causing the leader to be in default of the loan.
Revolving credit: A line of credit that the borrower can borrow against when needed while paying down the debt over a set period of time, typically 12 months.
Term loans: A loan that includes a 6-to-12-month period where only interest is paid followed by a period of 24 or 30 months where the debt is split into equal monthly payments.
Frequently Asked Questions
- What is a warrant?
When it comes to venture debt, warrants are basically the same as stock options. In the contract created with the venture debt lender are terms for warrant coverage. Here, the lender may have a stipulation that it will be able to buy stock sometime in the future, typically within 7 to 10 years, at an agreed upon exercise price (or strike price). At the exit of the loan, the lender will typically exercise these warrants if there is a difference between the exercise price and the current price.
For example, let's say that the contract for the venture debt amount is $1 million and has a 5 percent warrant coverage. This means that the lender has the option to buy $50,000 in stock at a price of current market value when the contract was issued. When it comes time to exit, let's say that the company's stock value has increased by 50 percent. The lender purchases stock paying $50,000 that is now worth $75,000, allowing them to then sell and pocket the difference.
- What happens if I can't repay the loan?
There are a couple of options if you find the loan coming due and you can't repay it.
One way to repay is to find another lender who is willing to give you a new loan, which you can then use to pay back the first loan.
A second way is to talk to your current lender and see if you can negotiate new terms for the loan repayment plan. Lenders have the option of selling off the company's assets in order to repay the loan if you are in default. However, lenders try to avoid this because they are more likely to get all of the loan back if the business continues to operate. Don't be afraid to contact them if you're worried about paying off the loan when it comes due. More than likely, they'll work with you and your investors to change the terms of the loan, which is called restructuring.
Another option, and possibly a better one, is to get equity from investors, which you can then use to pay back the loan. Venture capitalists might be slightly put off to find venture debt on your balance sheet. However, if they want to invest in your company, they will invest regardless of whether you have venture debt on the books or not. It's not common for a venture capitalist to decline to invest solely because of venture debt.
- How do I choose a venture debt lender?
Venture debt lenders vary widely in how they deal with clients, including how they handle clients that default on their loans. Because of this, you'll want to find out ahead of time how they've handled difficult situations in the past. The best way to do this is by calling past clients that the venture debt lender has worked with, especially clients that have gone through a restructuring with the venture debt lender.
Banks are your best bet and are the first lender you should contact because they have lower interest rates than venture debt funds. The problem with banks, however, is the size of the loan they are able to provide. You may, in the end, need both a loan from a bank and a fund in order to reach the sum you need. This will result in part of the amount at a lower interest rate and at the same time will help you get the amount you need.
- What factors affect the terms of the loan?
Just like any lending institution, you'll get better terms if you're seen as a low-risk investment. Venture debt lenders will look at your business much the same way that a venture capitalist will. A fast-growing company with highly respected venture capitalists investing in the company will more likely receive good terms. A lot of it has to do with what you can convince the lender about your business.
- What does the venture debt process look like?
One of the reasons that many companies will look into venture debt fundraising immediately or soon after getting investors is much of the same material is used for both.
- Ask your investors to help make introductions to lenders, which will help you make a good impression right off the bat.
- Provide potential lenders with an outline of what your business does and its goals and possibly demonstrate your product. You'll then provide them with diligence materials.
- Encourage lenders to chat with investors about your business. Hopefully, you'll receive some offers that you can consider.
- Negotiate the terms of the offers that you like the most and providing a counter proposal. Remember, they have to fight for your business! Be confident about what you're looking for.
- Narrow down your choices, and do your due diligence to make sure that the lenders you're considering are worth doing business with.
- Sign the papers, and the deal is complete.
- How do I secure venture debt?
Not all venture debt is equal. It can be a great way to secure additional funding, but the following should be considered:
- If you don't negotiate properly, it can end up costing the company a lot of money and has the potential to restrict the business owner's ability to make decisions. For this reason, having a venture lawyer is essential to ensuring that the contract drawn up is in the best interest of the business and makes sense to helping the business grow.
- If possible, delay the draw down. For companies that already have equity raised and will not need the money from the venture debt immediately, negotiate the terms of the draw down. If possible, extend it out between 6 and 12 months, so you will not have paid back a significant amount before you even need to touch that money. Extending the draw down will extend out the for when you have to start paying back the money and interest on the loan. If the lender is not able to do this, see if you can at least change the terms, so you're making payments only on interest rather than on interest and the principal for the first year.
If you need any help with venture debt, including help with understanding a proposal or contract from a lender and creating counter proposals, feel free to post your question on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to this site. Lawyers on UpCounsel come from top law schools, including Harvard Law and Yale Law, and have an average of 14 years of legal experience, including work for or on behalf of Google, Menlo Ventures, and Airbnb.