Financing, Investor-Readiness, Startups

Funding your Startup through Venture Debt: What You Need to Know

Fundraising is an important part of any founder’s startup journey. When people speak about fundraising, they normally think of raising capital from investors, such as venture capitalists, by selling shares (equity) in the company. Although raising capital through equity financing remains a very attractive and popular way to fund a company, there are times when debt financing would be a better option for your business. For instance, if you are about to hit a key company milestone (major sales win, new product launch etc.) in the next 3 to 9 months which will significantly increase your valuation, you might be better off raising debt to fund your business on a short-term basis and then raise an equity round later at a much higher valuation.

What is Venture Debt?

Venture debt is a form of debt financing provided by specialized lenders and banks to high-growth companies in exchange for principal repayment with interest, and often warrants. As companies strive for rapid growth, venture debt financing is becoming increasingly popular amongst fast-growth startups because a significant amount of non-dilutive capital can be raised.

Venture Debt vs Traditional Bank Debt

The main difference between venture debt and traditional bank debt is that venture debt providers have expertise in the technology and venture-backed industry and are willing to provide financing through more creative mechanisms to startups that may not qualify for traditional bank loans.

Unlike traditional debt that is provided by banks or financial institutions, venture debt is specifically targeted at high-growth companies and will normally involve some sort of equity compensation. If you are an entrepreneur just starting out from your spare room or a small office, it likely won’t be for you. Most companies using venture debt are already supported through prior equity financings and will normally be generating revenue. However, their balance sheet or income statement are not strong enough to obtain a conventional commercial loan from a bank.  All lenders will evaluate a company’s ability to service a loan through its current operations and growth trajectory.  However, a venture debt provider will normally put a greater emphasis on a company’s growth potential and/or ability to raise a future round of financing when deciding whether to extend credit.

How Venture Debt Works

Venture debt tends to vary in terms and conditions, with different providers having their own specialty industries or stage preferences. Venture debt providers can normally provide either a line of credit (for SaaS companies, this is normally tied to a multiple of MRR) or term loan, or combination of the two. The loans will normally have an interest rate that ranges from prime +0.5% to 3% but interest rates can go as high as 15 to 19%, depending on the company’s specific risk factors. The amount that can be raised is typically smaller than equity financing raises and the total loan will normally be released in tranches.. The tranches are usually linked to the company’s progress, such as reaching specific milestones or achieving certain revenue targets. The debt may require that interest and principal payments are made monthly over the term of the loan. In many instances, there is an ability to delay interest and/or principal repayments until a later date during the term of the loan.  For example, interest only payments in year 1 of a loan and principal and interest payments starting in year 2 of the loan.

Another unique aspect of venture debt is that it can also come with equity kickers, such as warrants. This allows the lender to participate in any potential upside of the company’s success. It also means that the lenders have “skin in the game” and are aligning their own interests with those of the founders and investors.

Pros and Cons of Venture Debt

The key advantages of venture debt are that it is non-dilutive, allowing the company to maintain ownership and control. It also offers flexibility in terms of timing and can be used for a variety of needs such as covering working capital, funding R&D or critical hires, or bridging to the next equity round thereby enabling the company to further increase its valuation prior to the next equity raise. Additionally, raising venture debt is often quicker and less intensive than raising equity financing.

The downside of taking venture debt is that it must be paid back with interest and adds pressure on a startup’s cash flow. Ensuring that you accurately forecast your cash flows to ensure that you can service the debt will be important. Having a considerable amount of debt on your balance sheet may also limit the amount of equity financing that can be raised in a subsequent funding round as the debt will need to be factored into a company’s valuation since a portion of any new funds raised will go towards servicing the debt rather than directly growing the business.

Summary

Overall, venture debt can be an excellent financing option for startup’s looking to fund their growth without giving up ownership and control. However, it’s important to assess your own company’s financial situation and ensure that you have a solid plan for servicing the debt. It may not be the right choice for every company, but for those who qualify and are able to successfully utilize it, venture debt can be a valuable tool in the startup financing toolbox.