What is venture debt?
Venture debt, also know as venture lending, is a type of debt financing designed for early-stage startups. Venture debt is often issued at the same time as an equity financing round, to provide non-dilutive financing (additional capital without further dilution).
Venture debt financing can be in the form of a fixed loan or line of credit. It’s typically private credit, meaning it is not issued by a bank. Instead, the loans are issued by other types of venture debt providers, including venture capital firms, private equity firms, business development companies, or alternative asset managers. However, some banks that cater to the startup ecosystem have started to offer venture debt, most famously, Silicon Valley Bank (SVB).
If venture debt is raised, then borrowers almost always raise venture debt in connection with an equity financing round, most commonly during early-stage raises, like Seed or Series A. In most cases, the amount of venture debt a startup raises will be between 20 to 35 percent of the total raised during the equity financing. For example, if a company raised $10 million, they would typically be able to take out $2 million to $3.5 million in additional debt.
Venture debt covenants
When you take out venture debt, you will negotiate terms with the lender, including your interest rate, repayment schedule, and conditions of the financing. Some conditions, also called covenants, of the financing may include a promise to hit certain milestones or metrics—whether that be number of users, a certain growth rate, or a specific revenue goal.
Missing these metrics could carry serious consequences, from increased interest rates to restricted access to additional credit from the lender. Depending on the terms of the agreement, missed targets could even mean you are in default on the loan.
Venture debt vs. traditional loans
Traditional business loans evaluate candidates based on metrics like revenue, profit, and assets owned by the company. Since early-stage startups often do not have these things, obtaining debt financing can be difficult. For early-stage companies that may not have access to more traditional debt financing, venture debt fills this gap.
Venture debt financing is determined by different metrics than traditional debt. Instead of profit, revenue, or assets, venture debt issuers choose to lend money based on the growth potential of the company and the legitimacy that venture capital investment signals—which is why it is usually only offered to companies when they are also closing a venture equity financing.
Venture debt lenders are taking on a higher risk than other business lenders, in hopes of a higher reward. For this reason, the interest and fees on venture debt are often higher than other types of business loans or lines of credit.
Venture debt vs. equity financing
Venture debt financing is distinct from equity financing. During an equity financing, startups sell ownership interests in the company ( equity) in exchange for capital. In a debt financing, no ownership changes hands, rather, you are receiving capital while promising to pay back the money with interest.
The pros and cons of venture debt
Pros:
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Ownership is not diluted. When you take out venture debt, you are able to obtain further capital without further diluting your company. You also will not grant board seats to venture debt financiers in the way you will for equity investors, meaning that you can raise more money without ceding more board control.
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Tax deductions. The interest paid on debt is deductible as a business expense.
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Build credit. When you take on debt and then pay it off on time, you build credit-worthiness for your business, which makes it easier to obtain other debt financing in the future.
Cons:
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You must pay the money back. Even if your company fails, the principal and interest is owed to the lenders. If your company goes bankrupt, you will need to liquidate its assets to pay back lenders. In the event of company failure, lenders are paid back first, before any preferred or common shareholders.
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High interest rates. Interest rates fluctuate based on macroeconomic conditions, and in high interest rate environments, venture debt may be too expensive to maintain from a cash flow perspective. Generally, venture debt will have higher interest rates than other types of debt, because of the additional risk involved.
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Requires regular income. In order to make regular payments on debt, your business needs to have a cash runway. This is more difficult for businesses that have irregular cash flow or are pre-revenue. Although venture debt is designed to accommodate companies with less regular revenue than is required for an additional loan, at some point you will have to make these payments.
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Terms that require certain milestones. The terms of venture debt financings may require certain goals to be met to remain in good standing with your lender. While with equity financing, it may be more difficult to raise money if you do not hit your goals, equity investors may be more willing to work with you if your goals change or company pivots. Some venture debt financing will have clear, distinct goals you are required to meet, or risk consequences including defaulting on the loan.
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