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VENTURE DEBT EXPLAINED

What is Venture Debt? How does Venture Debt Work?

Which businesses should look at venture debt as a financing option?



What is venture debt?

Venture debt, also known as venture lending, refers to a variety of debt financing products offered to early and growth-stage venture capital (VC)-backed companies. Provided by technology banks and dedicated venture debt funds, venture debt generally consists of a three to four-year term loan or equipment lease. Unlike traditional bank lending, venture debt is available to startup companies without positive cash flow or significant assets to use as collateral. The idea of venture debt is simple. From a practical standpoint, imagine a new startup which 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 X% to the investors. The entrepreneurs may still have a need for more capital to purchase equipment, fund marketing, or product development for additional growth, but instead of adding to the dilution, the entrepreneurs choose to add some venture debt to their raise and save dilution for a future Series B round.


There are three primary types of venture debt:

  1. Growth capital - it is typically structured as a term loan and can be used to replace or supplement an equity round, finance M&A activity, or provide additional working capital;

  2. Accounts receivable financing - it allows revenue-generating startup companies to borrow against their accounts receivable (typically 80-85%); and

  3. Equipment financing - it is typically structured as a lease and is used for the purchase of equipment such as network infrastructure, manufacturing, etc.


Pros and Cons of Venture Debt

Pros

If you structure it appropriately, venture debt can be an attractive financing option for the following reasons:

  • It results in no or less equity dilution for entrepreneurs and investorsVenture debt does not involve exchanging equity for capital. Instead, the loan requires monthly payments and entrepreneurs are able to minimize the dilution of equity at any stage. Revenue-based financing also offers this as another alternative to debt and equity financing.

  • Extend Cash Runway - Businesses may opt for venture debt when wanting to extend their cash runway or to act as a bridge from one funding round to another. This capital provides the necessary means to achieve the next milestone.

  • Increase Valuation - Acting much like a bridge round, venture debt offers entrepreneurs the opportunity to receive capital in order to reach growth milestones and get to the next round of financing at a higher valuation.

  • The due diligence process is typically less exhaustive compared to equity - As opposed to the due diligence process of venture capital which would take months, venture debt requires a less exhaustive due diligence process. Entrepreneurs get funded more quickly, allowing them to achieve the next milestone sooner.


Cons

  • Possible Dangerous Financial Covenants - The main disadvantage of venture debt is the possibility of dangerous financial covenants. If a company does not meet certain metrics set forth in the loan terms such as net income losses, this can lead to a default. When a company is in default, the loan is accelerated and 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.


Who Can Get Venture Debt?

Companies that are ideal candidates for venture debt include those with subscription-based or recurring revenue models or those with an enterprise customer base that will be a long-term customer of the startup. While venture debt can play a supporting role in early-stage companies who have recently raised an equity round, this form of financing is easier to secure for more established startups that are creditworthy with significant assets on their balance sheet or cash flow. Typically, venture debt financing is available to companies that have secured at least one round of venture capital financing.


When to raise venture debt?

Four common use cases when to raise venture debt:

  1. Extending the cash runway of a business to hit the company’s next milestone;

  2. Preventing the need for a bridge round or a down round to get through a tough period without creating a negative signal to the market and venture capital community;

  3. Funding large capital expenses, acquisitions, or acting as a bridge to profitability; and/or

  4. Acting as insurance in case it takes longer than expected to hit the next milestone.


Important terms when you raising venture debt

There are five most important areas to consider include:

  • The size of the loan;

  • The duration of the loan (when does it need to be repaid?);

  • The price of the loan (what are the fees and interest rate?);

  • The covenants (what are the financial and non-financial covenants?);

  • Timing of the amortization (when do we start repaying the loan?)


Before making a final decision, it is recommended that you work with a lawyer that has venture debt experience to review the lender’s documents and explain the financial covenants that your startup is obligated to.


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