An Entry-level Guide to Venture Debt

On a global scale, market forecasters expect capital raised from venture debt lenders to reach over $40 billion this year. But what is venture debt? Is it the right option for your business? And what are the most common risks of this type of investment?

Our beginner's guide to venture debt provides an overview to help you decide whether venture debt is for you. 

We tackle:

• What is “venture debt?”
• How does it differ from “venture capital?”
• Is venture debt the right funding option for you?
• What are the common risks and benefits associated with venture debt?

Let's get into it.

‍What is “venture debt?”

‍Venture debt is a type of financing typically for early-stage, high-growth startups that have already received some venture capital investment. It can extend a company's cash runway, fund new growth initiatives, and strengthen its financial position - without diluting the ownership stakes of existing investors or founders.* 

Startups rely on venture debt to provide flexibility for unexpected needs or bridge gaps between equity rounds. Unlike traditional loans, venture debt can be more flexible because lenders assess and lend on a startup's growth potential rather than just their current financial status. A venture debt facility may comprise either a term loan, which may have a period of interest-only payments, or a revolving loan facility, on which the business can draw and repay as needed; or the lender may provide a combination of both types of loan. In return, the borrower will pay an interest rate and origination and availability fees. *Some venture debt facilities may also require a type of equity instrument called a warrant, which is an option issued to the lender that allows the lender to participate in the “upside risk” of the company. Warrants are dilutive to the existing equity holders, but issuing them may allow the company to pay lower interest rates than would otherwise be required.

Venture debt funding can allow startups to balance debt and equity better to finance their growth. It gives them the leverage to make significant investment decisions while minimizing dilution of ownership.

‍How does it differ from venture capital?

‍While venture debt and venture capital investment are both common financing options for startups, they serve different purposes with unique benefits and challenges. Venture capital investment involves investors’ contribution of cash in exchange for equity, with the percentage sold dependent upon the current value placed on the company and the amount of new money being invested. It’s not truly “dilution” because the company is getting value for the newly issued shares. Still, the shares on issue prior to a venture capital investment will represent a smaller percentage of ownership after the deal than before. In addition to the cash the company receives in a venture capital deal, it may also benefit from experienced investors’ insight and expertise. 

Venture debt is a form of financing where a business can obtain capital without giving up a significant ownership stake, allowing founders to retain more control over the company while accessing much-needed cash flow. Venture debt often complements existing VC funding by:

• Extending the runway between financing rounds;
• Supporting expansion plans; or
• Reaching key milestones needed before another round of equity financing. 

Venture debt may be less intrusive than venture capital financing, allowing a company to fuel growth without adding immediate pressure. However, although a venture debt lender may not take an active role in the business, many venture debt facilities will contain restrictive covenants and performance metrics for which the business will have to account in its operations going forward.

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‍Is venture debt the right funding option for your company?

‍To decide whether venture debt is right for your business, you'll want to weigh up your existing financial needs with the long-term strategy and goals of the company itself. Venture debt can be attractive if your startup is on a high-growth trajectory and you need additional capital without significantly diluting equity. However, it's essential to weigh the pros and cons carefully. It can be invaluable to consult with a lawyer who can explain the funding options available to you - and the potential consequences of each route.

• The Pros: Venture debt can allow you to access capital relatively quickly, often more swiftly than traditional equity financing options. A quicker influx of capital can be instrumental to reaching key milestones, such as product launches or market expansions while increasing your company's valuation before the next equity round. 
• The Cons: Venture debt is a loan with interest and comes with repayment obligations, usually requiring regular payments. As a result, you'll need a solid cash flow forecast to ensure your company can meet these obligations without jeopardizing operational finances. Additionally, lenders may impose covenants or liquidity requirements, which must be clearly understood and adhered to. 

Before taking the plunge, meticulously evaluate your startup's financial health, growth prospects, and the purpose of obtaining venture debt. Consulting with a venture debt expert can help you understand whether this financing method aligns with your long-term business goals.

‍Support with venture debt finding‍

While venture debt can be a powerful tool for growth, it's crucial to carefully assess your company's financial health and the potential impact of carrying this debt. Planning for various scenarios can help mitigate the inherent risks of this type of financing, but your best investment here will be legal advice. 

Considering venture debt financing? Discover how Biztech lawyers can help you get the best possible outcome.