When it comes to startup financing options, venture debt is the lesser known, often misunderstood, cousin to venture capital. So if you thought venture capital was a black box, you can only imagine the questions and roadblocks founders come up against when considering venture debt as an option.
Our goal is to give you an understanding of how you should think through venture debt and its suitability for your startup. It’s important that you have the context and confidence to have conversations with your team, investors, legal counsel and venture debt providers (check out our Open Source list here) if you’re looking to take on this form of financing.
On the other hand, this is not a detailed guide on the terms and mechanics of a venture debt deal. Understanding venture debt terminology is key, as venture debt providers rely on these contractual terms to protect their investments. There are some fantastic resources for this, like this one from LegalVision.
What is venture debt?
Venture debt is a type of debt financing available to startups or growth companies that typically have raised money from VCs. Startups without VC investors typically face difficulties in obtaining venture debt–it’s not impossible, but bootstrapped startups will need to show their financials are in order.
Venture debt doesn’t replace equity–they tend to go hand-in-hand together. Venture debt lenders commonly use venture capital support to validate underwriting a loan for an early-stage startup.
The amount a startup can borrow is based on several factors, including the equity raised, predictability of revenue, balance sheet strength, burn rate, growth rate and margins.
The differences between venture debt and venture capital
Before we dive further into the details, there are some fundamental differences between venture debt and venture capital to understand:
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Venture debt in action
Here are 2 fictitious scenarios demonstrating the impact of dilution when a round is composed of a) venture capital only, and b) venture capital and venture debt:
StartupX is looking to raise a $10m Series A. The company’s pre-money valuation is $40m.
The different types of debt financing for startups
If your startup is looking for additional capital, you may be thinking, “Why not get a bank loan?”. Banks loan money to companies that have collateral–cash flow, assets and profits–which startups typically do not have material amounts of. They look at a business’ balance sheet to ascertain if there is a clear path to servicing the loan. In lieu of that, they require the borrower to put up personal guarantees.
There are a number of different types of venture debt. In this article, when we talk about venture debt we’re referring to term loans, lines of credit and revenue-based financing.
- Revenue-based financing: typically used by early-stage companies who want quick access to capital with no covenants. In return for this flexibility, lenders generally advance smaller amounts of capital and require faster repayment. This equates to higher effective interest rates.
- Term loans: typically only available to venture-based businesses generating >AUD$5m in annualised revenue. Financial covenants and warrants are typically required, but the company gets access to a larger loan amount for a longer term, at a lower effective interest rate.
- Line of credit or revolving facilities are less common. They are typically offered as a flexible extension to a term loan or to inventory backed e-commerce companies to help with their working capital demands.
R&D, invoice and grant financing are other examples of debt financing options for startups. Their use cases, pros and cons are different to what we’ve covered here–as always, do your research!
2- Including interest and fees
3- Depends on how quickly you repay the loan. The APR will be higher if you pay the loan back faster
4 – Including interest, fees and warrants
5- Typically via inventory
Is venture debt right for your startup?
Let’s start with when venture debt isn’t a good fit or the right time for a startup:
Venture debt isn’t a good fit or the right time for your startup if:
- Your cash flow is volatile and hard to predict
If you don’t have a stable revenue stream or your working capital moves around a lot and is difficult to forecast, this increases the risk of taking on venture debt – you need to be confident you can make repayments.
- It’s unlikely you can repay it
If your burn rate is high (e.g. your cash runway is less than 12 months), you may want to reconsider raising venture debt. If you default on any repayment terms or covenants, the venture debt provider can call the loan and force your startup to be sold or liquidated.
🚩When markets are volatile, your ability to raise your next round may be affected. Be mindful of the risk this poses to your ability to repay debts.
🚩Don’t take on venture debt if you have no reliable means of repaying the debt, other than your VC investors in your next equity round.
- Repayments are >20% of OPEX
Taking on this debt is too expensive for your startup–you have to pay off the loan, not get buried under it.
🚩It can be a red flag to future investors who don’t want to see their investment used to repay debt, rather than stimulate growth.
- The terms or covenants are burdensome
It’s important to model the cost of debt and understand the impact of any covenants on your business so that you’re not signing up for something you can’t handle.
In the following scenarios, venture debt may be a good fit for your startup:
- After a recent equity round
If you have at least 12 months of cash runway, you can use venture debt alongside equity to help you hit your next milestones. Raising venture debt after you’ve closed an equity round is advantageous as your creditworthiness and bargaining power are high, your startup’s valuation is up to date, and your due diligence information is available.
- You have a predictable business model
You have a high degree of confidence in your startup hitting its growth milestones and your ability to raise future capital through equity rounds, get to breakeven, or become cash flow positive.
What should a startup use venture debt for?
- Extend runway to next valuation
Raising venture debt can extend your cash runway (existing minimum requirement is ~>12 months) to your next equity financing round, which is typically tied to achieving a predetermined milestone (e.g. ARR target). You can use venture debt to help grow your company and attract a higher valuation at your next equity financing round without incurring additional dilution.
- Extend runway to cash flow positive
If your startup is on the cusp of breakeven, you can leverage venture debt to fund your company until it becomes cash flow positive. This can reduce or eliminate the need to raise additional equity financing.
- Fund acquisitions or growth initiatives
Venture debt can fund acquisitions to expand your offering to customers, or to double down on sales and marketing initiatives to help cement your startup’s position in the market without relinquishing ownership.
🚩Compared to equity financing, venture debt’s repayment profile and covenants provide less capacity to pursue the same level of growth. Hence, equity should be the primary source of growth capital as you get to use 100% of it.
Pros of venture debt
- Lower dilution and cost compared to equity
The price of equity varies based on your valuation. If structured correctly, venture debt generally costs less than equity financing.
Venture debt injects capital into a healthy and growing startup, with less dilution than venture capital financing.
- Speed and ease
The combination of not requiring a valuation and a simpler due diligence process means the entire process is faster compared to obtaining venture capital.
- Control
Venture debt providers don’t take a board or observer seat, and don’t have veto rights over certain business decisions.
- Can be structured to fit business objectives
While equity is typically funded in one upfront lump sum, some lenders provide venture debt funding in tranches or lines of credit. This gives companies the option to draw down capital as required to fund growth plans over time.
- Complementary to equity
If a business has assets (e.g. accounts receivable, inventory), debt can be used to fund those assets while equity is reserved for true OPEX.
Cons of venture debt
- You don’t get to use the full loan amount
After factoring in interest payments and fees, the net capital available for use is significantly lower than the headline loan amount. Under revenue-based financing and term loans, you start making principal repayments almost immediately. Let’s take a look at how that works in the example below:
StartupX is looking to raise $3m in venture debt on the following terms:
• Interest rate: 16%
• Term: 36 months
• Interest-only period: 6 months
This results in a total interest bill of $860,000 and “net loan” amount of $2,140,000 (or ~71% of the original loan amount). Further, the term loan’s repayment profile sees a decreasing amount of capital available over the life of the loan.
- Senior debt
Venture debt is typically structured as a senior debt, meaning it is a company’s first tier of liabilities and must be repaid ahead of any other debt obligations. Because venture debt is senior to preferred equity, it may dissuade future investors as they’ll be mindful that if things don’t work out, the debt is repaid first.
- Covenants
The unpredictable and variable nature of startups can create a lot of angst when you’re getting close to breaching covenants. Most venture debt providers are practical and want to see the business survive, so they’ll work with the company if they find themselves in a tricky situation. It is key to model out covenants during the term sheet discussion stage, to see how much buffer you have.
- Taking on too much debt
There are 2 ways of thinking about this:
• Every dollar of a loan repayment inflates your burn, which you feel acutely if things aren’t going to plan and you’re down to a couple months of runway.
• Future potential equity investors will quickly do the math on how much of their investment will go towards repaying the loan vs growing the business.
Venture debt providers
Here’s our Open Source VC list of venture debt providers. You can add or update a venture debt provider listing here.
Looking for other sources of funding? Check out our Open Source VC investor list.
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