What Is Venture Debt and How Does It Work?

Startups and early growth-stage businesses can be a challenging prospect for investors and lenders.

Why? Well, that’s because they often carry significant risk. However, that is offset with potentially huge success.

Therefore, startups require their own special set of investment types, such as venture debt.

Unlike a traditional loan, venture debt is a type of financing specifically reserved for startups or early growth-stage businesses that have already secured venture capital.

In this article, we’ll explore venture debt in-depth, including how it works, what you can use it for and its pros and cons.

What is Venture Debt?

To understand venture debt financing, it’s important to first grasp what venture capital is: funding provided by investors in exchange for equity.

For instance, a company that develops software might secure venture capital of $5 million in exchange for 20% ownership of the business.

Once the venture capital has been spent, a company may seek additional financing, often through a venture debt loan. This is somewhat similar to a traditional loan and is generally repayable on a short- to medium-term basis.

You might be wondering, why not go for more venture capital instead of taking on venture debt? Here are a few key reasons: 

• While venture capital dilutes ownership, venture debt allows the company to retain its current equity.
• Venture capital is typically used for large-scale investments, whereas venture debt is ideal for smaller needs, such as extending runway or making business-related purchases.

Another important difference to point out is that if the business fails, venture lending is still repayable regardless of the circumstances. In contrast, if a business fails with venture capital, the investors lose their entire investment.

Non-Dilutive Financing

As you may have guessed, venture debt is appealing for startups because they aren’t required to sacrifice their current ownership stake in the company for the sake of funding.

Venture debt is a form of “non-dilutive financing” because the business gets the investment it needs while retaining its equity.

Young businesses typically go through several rounds of venture capital funding. For smaller investment needs, it’s wise to preserve equity until larger-scale growth requires additional venture capital.

What Types of Companies Use Venture Debt?

Any early-stage business backed by venture capital can take on venture debt. However, it is most commonly found in the following industries:

• Biotech and life sciences
• Technology
• Software as a service (SaaS) providers
• E-commerce and marketplace platforms

How Does Securing Venture Debt Work?

The process of securing venture debt is similar to obtaining a standard loan.

1. Approach one of the following lenders:
   • A traditional bank with specialized venture debt lending divisions
   • A dedicated venture debt lender
   • Alternative lenders that cater to specific industries
2. Go through an initial assessment to determine eligibility. The lender will evaluate the health of the business and the ability to repay.
3. Negotiate the terms such as interest rates and repayment schedules.
4. Venture debt lenders will perform due diligence and risk assessment. This involves digging deeper into the business financials to assess suitability.
5. Once the assessments are finalized and the venture debt is approved, the funds are either released as one lump sum or in incremental amounts.

Eligibility Requirements

To qualify for venture debt, you must be able to display strong investor confidence and excellent financial management skills.

Here are some of the requirements:

• Backing from a reputable investor: If you’ve secured venture capital from an experienced, reliable tier-1 investor, you will have a greater chance of securing venture debt.
• A high cash balance: Venture debt providers will typically lend up to 40% of a business’s existing cash balance. For newer startups, they will look at non-cash collateral.
• Collateral: Lenders want you to provide collateral that is valued at around 1.25 – 1.5 times the outstanding loan balance.
• Current Ratio: You will also need a current ratio (Current Ratio = Current Assets / Current Liabilities) of 1.5 or higher.

What can disqualify you from obtaining venture debt? 

Ultimately, lenders seek companies with a proven business model, a solid customer base, and a strong leadership team. They want to ensure you will be able to pay back your debt.

For instance, you are unlikely to qualify if you:

• Have senior debt on your balance sheet.
• Have less than 18 months’ worth of remaining runway.
• Cannot demonstrate strong financial skills and a solid business model.

Venture Debt Structure: How Much Funding Can Be Secured?

The amount of venture debt funds that can be secured is usually tied to the most recent equity round. In most cases, this ranges between 20% and 40%.

For instance, if a startup raised $10 million in the last equity round, it could be eligible for $2 to $4 million worth of venture debt.

Alternatively, the amount of venture debt may be based on a percentage of the company’s latest post-money valuation. This ranges between 6% and 8%.

So, if a business was valued at $50 million, it could potentially receive between $1 to $2 million in venture loans.

Venture Debt Repayments

Venture debt repayment terms are usually a bit more flexible than other loan types and can be negotiated to suit a startup’s needs.

The repayment period is short- to medium-term. Most debts are paid off in around 3 to 5 years. 

Often, the initial repayment period consists of interest only, followed by principal payments. Balloon payments (a large one-time payment at the end of the repayment period) are also common.

Given the risky nature of young businesses, the interest rates are higher than traditional loans and range between 9% to 15%.

Venture Debt Warrants

Warrants, also referred to as equity kickers, serve as a way to incentivize lenders by offsetting some of the risks associated with this type of financing.

Essentially, they provide lenders with the right to purchase equity at a predetermined price before a preset expiration date. This lets them benefit from the startup’s success should the company increase in value. 

In some cases, a warrant is required as part of the venture debt lending conditions.

Warrant coverage typically ranges from 10% to 20% of the venture debt loan amount, with an expiration period of 1 to 15 years.

Benefits of Venture Debt

There are many upsides to pursuing venture debt as a startup:

• Non-dilutive financing: Secure funding without having to give away business equity or diluting the existing shareholder equity.
• Expand runway: Extend your existing runway, positioning your business for higher valuations in future rounds of funding.
• Obtain more venture capital in the future: Servicing venture debt signals financial stability, improving your chances of securing more venture capital.
• Helps your company grow: Venture debt provides a much-needed cash injection at critical growth stages. Without it, the business may stall, struggle, or even fail.

Risks and Drawbacks of Venture Debt

Any type of financing comes with some risk. Venture debt has several drawbacks that you should be aware of before committing to it: 

• Repayment responsibilities: The main concern is that you must repay venture debt regardless of your business’s performance, even if it fails or underperforms. 
• Warrant dilution: If you took out a warrant for your venture debt, you risk further dilution of the business if the lender chooses to execute it.
• Restrictions and limits: Venture debt terms may impose restrictions on fund usage or add extra covenants, depending on the lender’s conditions.

When Should Startups Consider Venture Debt?

Venture debt is worth considering when you need to secure extra capital without risking your equity. It is particularly useful for smaller financial needs that don’t justify pursuing venture capital, such as:

• Extending runway: Giving extra capital to continue operations and approaching key milestones that will increase the value of the business.
• Scaling operations: For small businesses that have been operating for a while and want to expand into new markets and grow infrastructure and resources.
• Large purchases: Funding specialized equipment, upgrades, or acquisitions. 
• Bridge financing: Serving as a bridge between the previous and next venture capital funding round.

Key Considerations Before Pursuing Venture Debt

Venture debt is not a decision to take lightly and requires a lot of work from your end to ensure its success.

Choose Your Lender Carefully

Needless to say, you must perform your due diligence when selecting a lender.

Take time to evaluate lenders. Choose one that is reputable, reliable, and offers terms aligned with your growth strategy. It’s also beneficial to select a lender with experience in your niche, as they’ll be familiar with your unique requirements.

Read the Terms and Conditions

Make sure you understand the repayment terms fully, including any warrant that may have been applied. Be aware of the implications if the lender exercises the warrant, especially how it may impact your ability to secure further funding.

Understand Your Current and Future Financial Situation

Keeping your finances in order and up-to-date shows a lender that your business is worthy of receiving financing. Don’t wait for the lender to assess your repayment ability—evaluate it yourself first.

Forecast your future cash flow to determine how feasible it will be for you to repay. You may consider consulting a financial expert, as an accountant, to help you determine this.

Assess Alternatives

It’s always a good idea to forecast how alternative forms of financing would impact your operations. Is venture debt the best choice for your business?

Also, assess your current debt and equity. Will the additional burden prevent you from seeking additional future funding? Or will it affect your growth plans?

Examples of Startups Successfully Using Venture Debt

Venture debt is not an uncommon thing and some of the world’s most successful organizations have used it to get started.

Airbnb

In 2016, before the company went public, Airbnb managed to secure a $1 billion venture debt fund from a variety of tier-1 lenders, including J.P. Morgan, Citigroup, Bank of America and Morgan Stanley.

At the time, the company was valued at $25.5 billion and had already secured $1.5 billion in its previous venture capital funding round.

Today, the organization is valued at $82.18 billion. 

Uber

In 2018, the ride-share company raised $1.5 billion in a leveraged loan despite the fact that it was losing money. 

The leveraged loan came from a collection of financial institutions in exchange for a 5% yield on the loan amount.

This venture debt was secured only a month after Uber obtained $3.5 billion worth of funding when the company was valued at $62.5 billion.

Fast-forward to today, and Uber is worth $130.81 billion.

Shopify

The e-commerce giant was founded in 2004 and is now known as one of the biggest platforms of its kind.

In 2013, it managed to secure $100 million in venture debt from OMERS Ventures and Insight Venture Partners—a specialist lender to technology companies.

Shopify used the venture debt to extend its runway before going public in 2015. 

The company is now worth a staggering $138.50 billion.

Final Thoughts

Hopefully, we have given you a good overview of what venture debt is and how startups and young businesses can successfully obtain it and use it.

If you are in a position to secure venture debt or other types of financial investment, having the right expertise is crucial.

At Finvisor, we specialize in providing financial solutions to high-growth industries like biotech, fintech, e-commerce and more. Our experts can help you identify and select the right venture debt companies, prepare the financial documents and ensure you stand the best chance of securing your investment.

To learn more about how we can help your business, get in touch with our team today.