Venture Debt is a financing mechanism used primarily for early-stage ventures that have already attracted investment from venture capitalists. Venture debt is a means of raising additional capital through advances from lenders. In this manner, it provides an efficient way to obtain additional funding and reduce immediate dilution of ownership.

The structure of venture debt differs significantly from that of traditional bank funding. Specifically, venture debt is generally based on many different metrics (potential for future growth, backing by venture capitalists, and the company’s long-term strategy) rather than current profitability or the amount of tangible assets owned by the business. Therefore, the maximum amount of venture debt that a start-up can bear will typically be lower than would be the case with traditional bank financing. In addition, venture debt can be used in combination with equity financing to ensure that the start-up has an adequate runway to grow without the need for additional equity investments in the immediate term.

Venture Debt Loan Amounts

Venture debt is typically determined as a percentage of the equity raised in a funding round and generally ranges from 20% to 35% of the amount invested in equity. Using the above example, if a startup had raised 10 million dollars during its Series A round, the startup would be eligible to raise 2 to $3.5 million in venture debt. This allows startups to maximize their equity capital use and encourages startup growth while still having the flexibility to use their capital.

Flexibility for Borrowers

Venture debt also has a large amount of flexibility. In fact, many venture debt agreements will allow the borrower to defer both principal and interest for some period. This provides the borrower with a buffer while the startup is investing heavily or experiencing fluctuating cash flow, so the management team can focus on growing the business instead of worrying about short-term repayments.

Equity Incentives for Lenders

In addition to providing financing, lenders will also require some sort of equity incentive, either through warrants or conversion rights, to help offset the risk of making the loan. The lender will have the right to purchase stock at a specified price or convert the debt into equity if the company does well. Although many people refer to venture debt as being “non-dilutive”, startup founders should be careful to understand this could potentially result in dilution over time.

Covenants and Borrower Obligations

Almost all ventures include covenants in the venture debt agreements, which include requirements for the startup to achieve certain operational and/or financial metrics such as revenue targets or minimum cash balance requirements. These covenants protect the lender and enforce financial discipline; however, if the startup does not perform at the specified level, they may limit the startup’s flexibility. In general, venture debt offers entrepreneurs rapid access to capital, but it also comes along with the responsibility of making regular payments on all debts and meeting defined covenants with lenders.

Who Can Access Venture Debt?

• Growth-Stage Companies
  Typically, startups will qualify for venture debt only if they are growing and funded by an external investor (usually institutional), have capital requirements of $2 million or more than two years’ back taxes, or have shown potential for significant revenue in future years. Many technology-oriented and scalable companies (software-as-a-service, biopharmaceutical, healthcare, FinTech) raise venture capital funding rounds with either series A or series B investors.

• Funding Timing
  Most startups raise venture debt either at the same time or shortly after they have raised an equity funding round. Series A or B investors typically invest in a startup before the company raises venture debt. Many startups use this financing to provide increased working capital, finance operational costs, and expand into new markets to finance operational expenses without raising additional equity funding and delaying their growth plans until their valuation increases.

Why Use Venture Debt?

Companies that need to increase their cash flow to support hiring new employees, conduct R&D, or expand into new markets often use venture debt. This funding option allows founders to delay their next equity raise for several months until they meet additional milestones and increase their company valuation.

When Venture Debt Is Not Suitable

Founders of new companies without venture capital backing, founders are still searching to determine a viable business model, or companies with limited previous revenues generally cannot obtain venture debt because most lenders require visible signs of market traction (evidence) of adequate financial management and a reasonable plan for company growth. The best candidates for venture debt are firms with a realistic growth strategy and a precise plan for using capital to achieve measurable success.

Benefits of Venture Debt

Longer Timeline for Achieving Goals

Venture debt gives start-up firms additional time to hit key financial and operational milestones which could add to the company’s value prior to the next round of equity financing.

Less Dilution

Because customers do not receive new shares when they obtain venture debt, the company’s founders and other existing shareholders have greater amounts of ownership than they would if they raised equity financing for the same amount as the venture debt.

Faster Access to Funding

Venture debt is typically a quicker transaction than an equity financing transaction because it has fewer steps and shorter durations for due diligence. This enables the start-up company to acquire funding for growth in a timelier manner without having to wait for a protracted negotiation period.

Flexible Loan Terms

Many lenders provide interest-only payment periods or can create repayment plans that adjust based on actual revenue levels. This flexibility is extremely beneficial to start-up companies because their cash flow frequently fluctuates.

Signalling Financial Responsibility to Future Investors

Successful closure of a venture debt financing transaction shows financial responsibility and stability to future investors since the company has undergone a thorough review by lenders before being awarded the capital.

Tax/Debt Benefits

Interest payments on venture debt are usually deductible by the start-up as a business expense, and making the regular payments establishes a credit record for the start-up to use in financing future growth.

Risks and Limitations of Venture Debt

When a startup is sold or liquidated, debt is paid before equity. Therefore, when founders take on venture debt, they accept more risk than if they were using equity.

• Higher Interest Rates: The risk to banks when they lend to a startup is greater than when they lend to an established business, therefore, they will charge the startup a higher interest rate for the use of their money.

• Potential for Dilution from Warrants: While initially perceived as non-dilutive, most venture debt consists of warrants or conversion rights that can lead to significant equity dilution.

• Restrictive Covenants: A common feature of venture debt is performance covenants; if the company doesn’t meet certain performance levels, they may trigger an event of default and/or subject themselves to penalties.

• Cash Flow Pressure: With regular principal/interest payments, a startup needs a predictable source of revenue to make those payments.

• Limited Strategic Support: Most venture debt sources will focus on repayment and not provide the strategic and networking support that is typically provided by venture capitalists.

To maximize the benefits of venture debt, founders need to plan carefully so that they understand how the benefits outweigh the disadvantages.

How to Approach Venture Debt Effectively

To maximize the benefits of venture debt, founders should approach venture debt with the same diligence as any other capital raise. Understanding key components such as interest rates, warrant structure, covenants, and events of default is critical to this process. When approaching multiple lenders, it may give the founders more negotiating leverage and therefore deliver more favorable terms.

Founders should also retain legal counsel who are well-versed in the structures of venture debt, as they tend to be complex. After securing venture debt, founders should communicate openly with their lenders to avoid escalating problems. Startups should also develop realistic financial forecasts and establish validated product market fit. Last, startups should have a clear plan for deploying capital on growth strategies.

While used properly, venture debt can support the growth, not limit, of a startup.

Partner with ERB

As startups evaluate the potential for venture debt, it is important for them to partner with trusted advisors. ERB has developed a comprehensive support system servicing U.S. startup and includes services related to entity formation, accounting, compliance, payroll, and tax compliance.

ERB has years of experience working with startups and venture-backed companies. In terms of venture debt, ERB provides both consulting and structuring options. Our fractional CFOs work alongside founders to develop the financial models and forecasts lenders expect, while ensuring that the terms negotiated for venture debt are sustainable.

With ERB as your trusted partner, venture debt is transformed from a financing burden into a strategic growth tool, allowing your startup to grow confidently and sustainably.