How Does Venture Debt Financing Work? How Does Venture Debt Financing Work?
While venture capital is a staple for early-stage startups looking to accelerate growth, venture debt is an equally important tool for startup companies to consider. If a company has not yet generated revenue but still needs to raise capital, venture debt financing is a great complement to equity financing to achieve growth.
Venture debt is offered by specialized venture debt lenders in the form of a loan that allows startups to achieve a variety of growth-related milestones. Many venture debt lenders also offer startups a host of other services along with the loan. Below we'll cover what venture debt is, how it works, the difference between venture debt and venture capital, and more. Let's get to it!
Key Takeaways:
- Venture debt is offered by specialized venture debt lenders in the form of a loan that allows startups to achieve a variety of growth-related milestones.
- Many early-stage startup companies find venture borrowing an advantageous option because of the flexibility it affords them to achieve a range of growth-related goals.
- Venture debt is not used in place of venture capital, it compliments it.
- Most venture debt terms include a higher interest rate and shorter maturity periods.
What is Venture Debt Financing and How Does it Work?
Venture debt is a great option for early-stage companies that need additional capital that offers flexibility while not giving up any equity. Generally, venture debt has higher interest rates and shorter repayment terms. However, this can be less expensive than the cost of giving up capital equity in the company.
As mentioned above, many early-stage startup companies find venture lending an advantageous option because of the flexibility it affords them to achieve a range of growth-related goals. Venture debt loans warrant consideration from startups because they provide short- and long-term capital for everything from equipment costs, research and development, expansion of operations, funding for acquisitions, capital expenses, and more.
Perhaps most the important thing to note about venture debt is that it is not used in place of venture capital, it complements it. Venture capital plays a critical role in companies securing a venture debt loan. We'll dive into that below.
Venture Debt vs. Venture Capital
There are several notable differences between venture debt and venture capital, and it's critically important for startups to know how to use these two tools in tandem to achieve their growth goals. Startups raise venture capital in exchange for shares of their company -- a venture capital firm will provide an early-stage business funding in exchange for an ownership stake in the company along with voting rights and potentially even a seat on the board of directors. Repayment of venture capital isn't necessarily required, but most agreements involve a promise of liquidity for investors within a certain timeframe. Cash flow received in exchange for equity can be used to help startups achieve a wide range of business goals -- from expanding operational capacity to purchasing equipment.
Rather than serving as an alternative to equity financing, venture debt is a complement to this type of financing. Unlike equity financing, venture debt doesn't require startups to relinquish any equity in their company in exchange for growth capital -- venture debt is a loan with an interest rate and requirement to repay within an established timeframe, similar to other loans. Venture debt also relies on venture capital in the sense that companies looking to borrow will be evaluated by venture debt lenders based on the amount of venture capital they have raised. For instance, a venture debt provider may look at a startup's most recent equity round along with the growth goals tied to that capital when deciding on whether to lend. A venture lender will use that information, in conjunction with your company's strategy for future rounds of equity financing, to determine the terms of the venture debt loan they are willing to issue. Venture debt is available based on these conditions and others, with loan types and amounts varying based on factors including how big your company is, how much equity you've raised so far, what growth goals you are targeting with that equity, and what progress you've made toward achieving those goals. It is extremely difficult for companies without venture capital investors to secure venture debt.
How are Venture Debt Loans Structured?
Since venture debt is almost always supplemental to equity capital, loan amounts usually vary between 20% and 30% of the amount raised during a company's most recent equity round. While venture debt can be used as short- or long-term capital, your lender may base the structure, pricing, and duration of your loan on the intended purpose of the working capital. Term sheets usually include clearly-defined repayment terms and some may also include other conditions that limit how the debt financing can be used to mitigate risk to the lender (these can include requirements to achieve certain milestones within a set timeframe or providing performance updates on an established schedule).
Most venture debt terms include a higher interest rate and shorter maturity periods of about one to two years, which makes this form of financing best-suited for achieving goals that require an injection of working capital to accomplish.
Do You Have to Repay Venture Debt?
In short, yes. Unlike venture capital equity where venture capitalists receive an ownership stake in a company in exchange for capital, venture debt is a financing option that requires borrowers to repay the loan within an established timeframe with interest payments and fees. The fees include origination fees and prepayment penalties, but every lender will structure their loans differently so it's important to ask about potential fees or penalties during the application process.
If you have any questions about how venture debt can help your company achieve its growth goals, or if we can be of assistance in helping your business meet its banking needs please don't hesitate to reach out to our Startup and VC Banking team!
