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What Is Venture Debt? (And Is It a Good Option for Startups?)

Thursday, December 30th 2021 (19 days ago)

Venture debt provides financing to venture-backed startups that typically do not have significant cash flow or assets. As such, venture debt usually applies to early-stage startups that need supplemental financing to grow or sustain operations.

For example, if a startup needs additional capital to reach a significant milestone or harness an unexpected opportunity in between financing rounds, the startup may seek a venture debt deal.

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Illustration: Venture debt trade-off between equity and interest

How Venture Debt Works

Often, early-stage startups do not have the collateral needed to achieve a conventional loan. While startups usually raise cash in exchange for equity during a traditional fundraising round, they may opt for venture debt in between rounds.

Venture debt allows the startup to issue warrants on equity to account for the lender’s risk on the loan.

Unlike equity financing, startups do not give away equity when they make a deal for venture debt. As such, venture debt provides a less expensive option for startups to inject their business with capital in between rounds without further diluting their shares of the business.

Who Provides Venture Debt?

Traditional banks and venture capital firms do not usually supply venture debt. Instead, startups can partner with specialized venture debt lenders, such as business development companies, hedge funds, and private equity firms.

A venture debt deal usually spans over a 3-year term or series of loans with three to five-year repayment periods.

Typically, lenders will determine the loan amount based on a certain percentage of the previous equity financing round. For example, a startup could reasonably expect to structure the principal amount of debt based on 25-30% of total funds raised in the last round.

Illustration: Confident founder understanding venture debt

Does Venture Debt Carry Interest?

Similar to a conventional loan, startups should expect to pay interest on a venture debt loan.

Additionally, startups should expect lenders to require warrants on common equity, between 5-20% of the principal amount.

For example, if I raised $1M in my last equity financing round, I could reasonably achieve venture debt for $300,000. I should expect to pay interest based on the prime rate (currently 3.25%) and warrants for shares up to $60,000 in value.

Particularly if the lender is a specialized bank, they may also require covenants on the venture debt to mitigate additional risk on the loan, particularly because these startups do not have significant cash flow or assets to supply in the event they are not able to pay off the loan.

For example, lenders may insert an “investor support” clause, which means the lender can call a default if an event occurs that implies the startup will not be able to repay debt.

Should You Use Venture Debt?

As we mentioned, startups may realize the need for additional capital in between rounds. Venture debt provides an alternative to equity financing, which creates further dilution.

Illustration: Startup founder with insufficient capital for a major purchase

Because early-stage startups may not have adequate collateral to achieve a conventional loan, venture debt provides a reasonable alternative to receive potentially critical capital injection.

Startups may need to finance a specific project to catalyze growth, like a marketing campaign or major inventory purchase. Startups may realize a time-sensitive investment opportunity that may not be available when the next financing round rolls along.

They may discover the company is falling short of a significant milestone promised to investors and may need capital to ramp up production. Perhaps most critically, startups may opt for venture debt to extend the runway between rounds.

Forecastr allows startups to avoid some of these scenarios by providing accurate financial forecasts and cash runway projections. However, when an unforeseen event occurs, venture debt may allow the solution to scale your startup or generate growth.

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