Venture Debt: The Why, What, and How of Debt Financing for Startups
What Is Venture Debt?
Since its start about 50 years ago, venture debt has taken on many forms.
In the 1970s, venture debt helped early-stage companies that lacked the cash flow and collateral required by more traditional forms of debt acquire assets such as computer or laboratory equipment. The venture debt industry continued to grow during the 1980s and 1990s, mirroring venture equity trends. Like other forms of financing, venture debt hit an all-time high during the dot com era.
Venture debt now broadly refers to a type of financing for venture equity-backed companies that lack the assets for more common forms of debt financing or that want greater flexibility.
Venture debt, also known as venture lending, is often a complement to equity financing and is frequently structured as a three- or four-year term loan or a series of loans with minimal warrants for company stock. Venture debt can take many forms, and funds often have different investment criteria.
How Does Venture Debt Work?
Venture lending is a non-convertible, senior term loan. While its use and terms vary, venture debt is typically repaid in monthly payments over the life of a loan. Venture debt generally results in minimal to no dilution, with dilution typically taking the form of warrants. Agreements usually require financial covenants, although they are less restrictive than bank loans.
Pros of Venture Debt Financing
Venture debt financing is an appealing tool for a variety of reasons.
Typically, venture debt results in less equity dilution for an early-stage entrepreneur and their company’s investors. It also doesn’t require a valuation of a business, which can expedite the fundraising process. And in addition to a less time-intensive due diligence process, venture debt lenders do not require a seat on a company’s board and thus enable entrepreneurs to maintain control over their business.
While venture debt financing takes many forms — including revenue-based financing, various term loans, and lines of credit — it is typically a complement to other capital or can serve as a bridge to extend a company’s runway.
Venture debt is also easier to obtain than a bank loan, which requires either meaningful positive cash flow or assets to collateralize. It can also be more accessible than venture capital, which requires early-stage companies to have extremely high growth rates.
Cons of Venture Debt Financing
While venture debt financing is typically less expensive than equity financing, it can still be a costly tool. Venture debt is “senior debt,” meaning that it takes priority over other unsecured or otherwise more “junior” debt owed. If a company were to default, lenders can take control of the company, its assets, and even force it to liquidate.
Venture debt is also not accessible to pre-revenue companies, as it is typically based on accounts receivable, company inventory, or consistent and predictable revenue. In addition, it is typically only accessible to companies that have previously raised venture capital.
Venture debt agreements can also feature covenants requiring companies to adhere to certain criteria. Loans tied to a company’s cash balance or accounts receivable are common types of debt covenants.
What is a Venture Bank?
A venture bank is a specialized type of bank or lender that offers financing and services to venture-backed businesses. They typically serve businesses that do not yet have sufficient cash flow that other lenders require.
Venture banks also require warrants for the purchase of company stock, in addition to a traditional interest rate for their financing. The warrants enable venture banks to be compensated for their risk by reaping the rewards of their portfolio companies if they were to sell or reach an initial public offering.
Some prominent examples of venture banks are Silicon Valley Bank and Pacific West Bank.
What is a Venture Debt Fund?
Venture debt funds are similar to venture capital funds in that they both look for growing companies in which to invest.
Where these two differ most significantly are in their business models and the types of companies they invest in. Typically, a venture capital firm expects most of its investments to fail and generates 80 percent of its returns via about 20 percent of its portfolio companies. In addition to more oversight and equity in its portfolio companies, venture capital firms require companies to have extremely high growth rates and a high probability for a large exit or IPO.
In contrast, venture debt funds often have a lower failure rate among their portfolio firms. Venture debt funds generate returns with steady payments from its portfolio firms via monthly payments and occasionally warrants.
Other Venture Debt Providers
There are a variety of venture debt providers for early-stage companies. In addition to venture banks, other venture debt lenders include private equity firms, hedge funds, and other specialized providers.
Unlike venture capital firms, venture debt lenders do not take equity in their portfolio companies. Rather, venture debt providers issue capital in the form of debt that is paid back over three to five years.
Examples of Venture Debt Financing
Many Software-as-a-Service companies have used venture debt financing to fuel their growth and to extend their cash runways. Here’s one example of how a real company used venture debt financing provided by Leader Ventures.
After a funding round, SoftwareCo was nearing break even on its balance sheet but wanted additional funds to grow its sales team and business. Hoping to avoid an equity round of capital, SoftwareCo found an alternative and secured $1.5 million in venture debt from Leader Ventures.
If SoftwareCo had sought out a venture capital firm, raising a $1.5 million round of equity financing would have spurred roughly 7% in dilution, according to Leader Ventures’ case study. For $1.5 million in venture debt financing, Leader Venture offered a three-year term loan with 9.5 percent interest and a 1 percent commitment fee. SoftwareCo also granted Leader Ventures warrants that led to roughly 1 percent of dilution.
By using venture debt, SoftwareCo not only saved time but also preserved control over its future for the same amount of capital.
Example of Venture Debt Limiting Dilution
One of the benefits of venture debt financing is that companies can limit dilution. Here’s an example of how venture debt can preserve ownership by using a fake company and investor.
A few years ago, SmartTractor raised a Series A round from BigTime Ventures and hopes to raise a Series B round with different lead investors to further its growth. With both SmartTractor and Big Time hoping to avoid further dilution, SmartTractor weighs using venture debt financing for a position of the $10 million Series B.
Rather than raising a 100 percent equity round, SmartTractor raises $6 million in equity and $4 million in venture debt. This strategy allows SmartTractor to give up only 9.6 percent of the company, instead of diluting the company by around 13.3 percent.
What is a debt covenant?
A debt covenant is included in an agreement between a company and a creditor that the company will operate within a certain set of rules established by the lender. These agreements, also known as banking or financial covenants, are intended to align the interests of the lender and borrower. Loans tied to a company’s cash balance or accounts receivable are common types of debt covenants.
A default clause is a legal provision in a contract that outlines what will happen if a lender or borrower defaults or fails to fulfill the agreement. So-called “material adverse change” and other “subjective default clauses” can allow a lender to recall their loan due to events beyond the company’s control, such as an existing equity investor not participating in a future round, according to the Kauffman Fellows Program. Novel does not include subjective default clauses in its investments.
A unique aspect of venture debt financing is that its cost to borrowers can include stock warrants.
Warrants allow for lenders to buy stock in a borrower’s company at a fixed price for a set period of time. Warrants are a financial incentive to the lender as they take on risk in financing an early-stage company. Unlike a stock option, a borrowing company issues warrants to lenders rather than employees.
Explore Your Company’s Capital Options
Every company’s financial situation is unique and there are a variety of funding options available. Thus, it’s important that entrepreneurs give careful consideration to why they are fundraising and to what ends that capital will serve.
When evaluating your company’s capital options, first consider what amount of funding you would need to accomplish the next milestone that adds genuine value to your company. If your company hopes to extend its cash runway, consider how much venture debt is necessary.
Regardless, it’s important to deeply consider your company’s needs and understand your fundraising goal as it relates to milestones that add value.
Reach Out to Learn More
Fundraising is a complicated and an often-frustrating process. Novel Growth Partners is here to help your company navigate — reach out here to learn more.