Venture debt is a category of debt financing specifically targeted at startup companies that need funding to grow, and usually yet to be cash flow positive.
This type of loans or credit lines are specifically catered to the profile of young companies that are not able to obtain conventional loans from banks as the funding they require are considerably large and don’t have the revenue or cash flow to service them.
It is one of the two main ways that startup businesses raise capital to keep their operations running.
The first being the selling of shares to raise funding, and the second being venture debt.
They work very much like regular loans, except that the lender would usually obtain a certain amount of stock in the company or be issued warrants that can be exercised for stocks.
This allow founders to obtain the financing they need to keep the company afloat with more cash runway until the next round of fund-raising, or until certain milestones are met.
How venture debt works
Experienced venture capitalist (VC) often prefer that young startups don’t get involved with those offering venture lending until they have at least achieved a proof of concept.
This is because when new businesses have yet to generate any revenue or positive cash flow, funds raised from selling company shares would essentially be used to service the debt.
This deprives the startup from the cash they need to grow and scale the business.
It’s also a sign of how key promoters are running the company.
On top of that, when there is no proof of concept, the business idea would still be a high risk gamble and could potential fail any time.
Should the lender of venture debt be the VCs, then company failure would mean that they would not get the loan principal back. And there are little to no valuable assets to liquidate since the company has not created anything of value.
And should a VC be a shareholder, the lender holding the debt would have seniority that gives them priority over the assets belonging to the company.
In both instances, things would not turn out well for investors.
This is why the only time when venture debt financing (VDF) is appropriate is when they has already been a proof of concept, and that the business is already generating sales revenue which can be used to meet the debt obligations.
At too early a stage of the startup’s life, venture debt can often put too much strain on cash resources. Potentially dooming it to failure.
Why venture debt
The biggest advantage of taking on venture loans is that it allows the company to raise a significant amount of funds for working capital without giving up too much equity.
The founders might have already sold a lot of their stake in the company to raise funds previously, and have little left.
It could also be that they foresee that they would need to save the equity for a later round of fund-raising that is scheduled to come up.
When the projected upside in the company’s value is huge, especially when they are reaching critical mass, then founders might also find that it would be better to hold onto as much equity as they can as the shares would be worth a lot of money in the future.
Structuring a fund-raising deal with venture debt can also be strategically used by founders to protect the value of the company and prevent a down round.
For example, the company might have sold 5% of the company for $50,000 in series A which values the business at $1m. Now a new VC is approached for another $100,000 but he wants 12% which values the company lower than the last round. To retain the value of the company, a founder might choose to offer the new VC 5% of the company for $50,000 and a loan for $50,000.
This way, the value of the company is not affected and the main shareholder keeps more equity while avoiding excessive dilution.
The lender gets 5% of the company and would get back $50,000 when the loan runs it’s course plus the interest that is earned from the loan. Deducting the interest earned from the $50,000 for 5%, the new VC could very well obtain the price per share he was seeking at $100,000 for 12%.
Everyone goes home happy.
From the perspective of an investor, how he or she predicts the future of the company can determine whether a straight equity purchase or a loan would reap better financial rewards.
For example, if a unique technology company is growing exponentially and the prospect of it being acquired by one of the tech giants for crazy money is high, then holding an equity stake can probably reap more financial rewards when the exit arrives.
However, if there is little prospect of the company being acquired and it’s main profitability play is in the selling of it’s products or services, then not getting an equity stake and proposing a venture debt arrangement would not seem that bad of a deal as the opportunity costs is lower. A venture lender can also get his money back faster.
It would be even better for the lender if they can get the company to specially agree on a royalty deal since the business would be focused on marketing and selling for years to come.
It must be said at this point that how venture debt is structured can as flexible as one can imagine.
Some venture debt lenders might ask for a 10% interest, some might as for a flat profit, and some might even ask for a royalty for every product sold.
It really depends on the appetite of the lender and how desperate the company is for funds.
Venture debt eligibility
While we instinctively think of venture capitalists and private equity firms when we discuss venture debt, it should noted that financial institutions such as banks and government agencies are also involved in providing venture loans and venture debt programs.
Banks would want to profit from the growth of startups and government agencies want to play a role in helping local startups succeed.
They could very well offer better terms compare to typical VCs, but can be expected to be less flexible with approval.
For a startup company to be eligible, they might be required to meet certain criteria like:
- Having already raised a certain amount of funding from previous rounds
- Having already passed the seed stage and proof of concept stage
- Having institutional investors already on board as shareholders
- Locally incorporated with a percentage of local shareholding
- Having achieved a certain amount of revenue or having a certain amount of employees
- etc
The loan quantum could very well be based on percentage of the total amount raised from the latest equity round.
Startup businesses however, must be mindful that working with these entities can come with more oversight.
