Venture debt is a form of loan financing offered by specialist banks or non-bank lenders to venture-backed enterprises to pay working capital or capital costs.
What exactly is venture debt?
Raising finance is critical to the survival and long-term success of startups, especially those with business models that attract venture capital (VC) investment. These businesses are often unprofitable (or pre-revenue). As a result, they need frequent capital injections to continue supporting their operations and development since little to no founder money have been invested in the organisation.
All firms seeking to raise money must choose which instrument to provide to their investors. The instrument of choice for startups differs according to the company’s stage of growth, investor base, and financial situation. This article will just provide an outline of venture debt as a means of raising financing for a developing startup firm.
Unless the founders are ready to furnish personal guarantees and have adequate personal assets to put as collateral, early-stage firms are seldom candidates for commercial bank loans. However, after a business has received institutional VC funding, several banks and venture lenders, such as Silicon Valley Bank, Square 1 (a branch of Pacific Western Bank), Western Technology Investment (WTI), and Comerica Bank, provide commercial lending services. Because VCs are generally prepared to contribute extra equity money to keep their portfolio firms financially viable, these venture banks and lenders see VCs as possible backstops if their venture-backed debtors fall on hard times. Venture debt is often comprised of three to four-year term loans. These are made accessible to beginning businesses even if they do not have any positive cash flow or assets to utilise as security. One of the most significant advantages for founders and early investors is that their shares will not be diluted by venture debt (assuming there is no other equity kicker in play). Consider a new firm that has received a seed round of $1M at a $3M valuation and subsequently a Series A round of $10M at a $25M value. The founders in this scenario have handed up the great bulk of their firm to outside investors. Not to mention that if the firm need further financing in a Series B round or later, the shareholders would be further diluted. In compared to obtaining capital via convertible instruments or as part of pricing rounds, venture debt is a potentially non-dilutive funding technique.
What are the three most common categories of venture debt?
Growth capital is a term loan that may be used to replace or augment an equity round, fund mergers and acquisitions (M&A), or provide extra operating capital.
Accounts receivable financing: It enables revenue-generating startups to borrow against their accounts receivable (usually 80-85 percent).
Equipment financing is usually in the form of a lease and is used to acquire equipment such as network infrastructure, manufacturing, and so on.
The Benefits and Drawbacks of Venture Debt
Pros
If properly structured, venture debt might be an appealing funding alternative for the following reasons:
No or little equity dilution: The benefit of venture debt is that it does not necessitate the exchange of shares for financing.
Extend Cash Runway: Businesses may use venture loan to increase their cash runway. Each firm has its own set of objectives and milestones, but for early-stage companies, the optimal runway is 15-18 months. It provides the chance to meet the company’s objectives while also preparing for the next fundraising round
Less formality: Unlike the due diligence process for venture capital, the due diligence procedure for venture loan is less formal. Due diligence is less extensive, and enterprises get financed more rapidly than with other approaches. This is a chance to reach the company’s next milestone in a shorter amount of time.
Cons
Financial Settlement Could Be Dangerous
The biggest downside of venture debt is the likelihood of a risky financial transaction. If a corporation fails to satisfy certain criteria outlined in the loan conditions (e.g., negative profits, inability to pay debt when due, etc.), the lender may declare an event of default. When a business goes into default, the debt is accelerated and becomes due and payable at that point.
Cash Advances Every Quarter
Although venture financing allows high-growth companies to maintain ownership while extending their financial runway, it also result in quarterly cash expenditures for the firm. This, unlike equity funding, must be returned at some time in the future. If handled effectively, venture debt may be a useful financing strategy that can increase the success of organisations who employ it in combination with equity funding. However, if not properly negotiated, it may become quite pricey.
When is the best moment to raise venture debt?
When it comes to raising venture loan, there are four main scenarios:
Extending a company’s financial runway in order to reach the next milestone;
avoiding the need for a bridge round or a down round in order to get through a difficult moment without sending a negative signal;
Large capital expenditures, acquisitions, or functioning as a bridge to profitability;
Acting as a safety net in case the following milestone takes longer than projected.
Important phrases to understand while raising venture loan
When raising venture finance, keep the following crucial phrases in mind to include in the agreement:
The amount of the loan;
The loan’s term – the amount of time it will take to fix the debt;
The amount of fees and interest rates charged;
Covenants, both financial and non-financial;
When the repayment begins is referred to as the amortisation period.
Before making a final choice, it is suggested that you study the paperwork with a lawyer who has expertise with venture debt.