Venture debt can be invaluable for startups looking to raise additional capital following an equity round, or those looking to minimize direct dilution. But what exactly is venture debt, how is it structured, and how does it compare to the other forms of financing? The answers to these questions and more are outlined in the guide below!
What is venture debt?
Venture debt is a form of debt financing used by startups and early-stage companies to cover short-term operating expenses, support market expansions, and bridge the gap between venture rounds. It is provided to companies that have high growth potential and are deemed to have a high reward. The principal borrowed must be repaid, along with the accrued interest over a specified period, and this form of financing is typically provided by venture capital firms, banks, or other specialized lending institutions.
Is venture debt securitized?
No venture debt is not typically securitized, meaning that it does not require any collateral to secure the loan. This makes it an attractive option for startups because it does not require them to pledge any of their assets as collateral. However, it typically is considered senior debt and as such, must be repaid first in the event of bankruptcy before the founders and equity investors.
How does venture debt work how is it structured?
Venture debt works similarly to traditional loans, except that it is typically only offered to startups who have recently raised a round of equity capital. The term sheets come with pre-defined maturity dates (when the loan must be repaid), set principal amounts (the amount borrowed), and set interest rates (cost of the loan), along with set repayment structures.
In most cases it’s structured as a bullet, meaning there are either no repayments or interest-only payments required throughout the life of the loan, followed by one balloon payment at maturity, for the remainder of the balance. Though, sometimes it can be structured with monthly repayments of both interest and principal throughout the life of the loan.
How much capital can startups access with venture debt?
The amount of capital that a startup can access with venture debt varies greatly based on the provider and the business's needs. It also varies heavily based on the amount of equity capital that the startup has raised and how the business has performed historically. Generally, debt providers will lend up to $10 million, but some providers may lend up to $50 million.
What does venture debt cost?
Like the amount of capital that can be accessed, the cost of venture debt varies from provider to provider and is based on the business's needs. Generally, they have lower interest rates compared to traditional loans—they are priced at Wall Street Journal (WSJ) Prime plus 1 or 2, compared to WSJ Prime plus 3 or 4. Debt providers also typically charge additional fees including origination fees, closing costs, and administrative fees for their services.
In addition to the interest and all the fees mentioned above, debt providers also typically require warrant coverage representing 2-3% of the overall equity pool as a stipulation of the deal.
These warrants may not seem like much, but if you take out a debt facility for $1M and your startup exits for $1B, the cost of capital for said facility is $20-30M, which is 20-30x more than you borrowed.
Is venture debt dilutive?
Technically speaking, venture debt is not dilutive. However, it can be dilutive if warrants are required as part of the deal. Warrants are convertible vehicles used by investors to gain equity in the business and sweeten the overall deal.
What are the typical qualifications or requirements for venture debt?
The main requirements for venture debt are strong business performance, positive unit economics, and a recent equity round (within the last 6 months). Generally, even if a startup has great financials, it will be unable to raise this form of capital unless they are backed by a top-tier venture capital firm.
What are the typical covenants associated with venture debt?
Venture debt providers often require businesses to abide by certain covenants in order to qualify for the loan. These covenants are typically related to the business's financials, such as limiting capital expenditures and meeting minimum revenue targets, and can also include maintaining specified debt-to-equity ratios, staying under loan-to-value ratios, and maintaining certain levels of working capital.
- Minimum revenue target: the stipulation that says the borrower must generate a certain amount of revenue each quarter to maintain the loan agreement.
- The debt-to-equity ratio: a stipulation that says the borrower must maintain a certain ratio of debt to equity to maintain the loan agreement.
- The maximum loan-to-value ratio: a stipulation that says the borrower must maintain a certain ratio of debt to the value of the assets to maintain the loan agreement.
- The minimum working capital: a stipulation that says the borrower must maintain a certain amount of working capital to maintain the loan agreement.
In addition to the financial covenants, debt providers may also structure the funding in tranches, which require the business to meet certain milestones to access additional funds. These covenants are designed to protect the debt provider and ensure that the business is performing positively over time.
Compared: venture debt vs venture capital for startups?
While both venture debt and venture capital provide financing to startups—they are quite different. Venture debt is a loan that is paid back over time, with interest, whereas venture capital technically isn’t repaid, or at least not directly.
Instead of monthly repayments, with venture capital, repayment is made upon a liquidation event, such as an acquisition or IPO when the equity is converted into cash. Also, whereas funding from venture debt is typically capped at $50M, startups can raise hundreds of millions if not billions from venture capital firms.
Compared: venture debt vs revenue-based financing?
Venture debt and revenue-based financing are two popular financing options for startups today. While they both provide capital to startups, there are some key differences.
- Venture debt is typically only accessed by top-decile, venture-backed companies whereas revenue-based financing can be accessed by any revenue-generating startup.
- Venture debt typically comes with a low-interest rate, longer repayment term, and bullet structure, whereas revenue-based financing comes with a higher interest rate, shorter repayment term, and monthly repayments.
- Venture debt is not technically dilutive, but when presented with warrants, is dilutive, whereas revenue-based financing is completely non-dilutive.
Compared: venture debt vs bridge loans?
Generally speaking, venture debt can be used for or substituted with bridge loans, whereas bridge loans cannot be substituted for venture debt. This is because bridge loans are typically only used to ‘bridge the gap’ between rounds of equity financing, whereas venture debt can be used for this purpose and many other more strategic purposes like product launches, equipment purchases, or market expansions. Also, bridge loans generally come with monthly repayments, whereas venture debt loans require interest-only payments each month.
Who are the top providers of venture debt?
The top providers of venture debt include banks, venture capital firms, and other specialized lending institutions.
- Banks are usually the most common provider of venture debt. Banks typically only provide this form of funding to startups that have recently raised a round of equity capital.
- Venture capital firms sometimes provide venture debt to startups to carry them over until their next equity round.
- Other lending institutions, such as peer-to-peer lenders, neobanks, and crowdfunding platforms are also becoming popular providers of venture debt.
How to select a venture debt provider?
When evaluating venture debt providers, there are several factors you should consider, including:
- The provider’s reputation and track record of executing deals in your space
- The provider’s ability to scale its capital facilities as you grow
- The non-monetary benefits of working with the provider: introductions to investors, partners, and potential customers, and their willingness to provide additional support and resources
What are the financing alternatives to venture debt?
For startups that are not eligible for venture debt, there are a few financing alternatives that can be explored.
- Revenue-based financing: while revenue-based financing comes with a higher upfront cost and shorter tenure compared to venture debt, it comes at a much lower cost of capital overall due to the convertible warrants associated with the venture debt.
- Crowdfunding: crowdfunding can be used to raise capital from a large group of individuals. It’s similar to an angel group, except that the investors in a crowdfunding campaign do not need to be accredited.
- Government grants and loans: government grants are typically provided to startups that have viable business plans and are deemed to have high growth potential, but have not yet started. Government loans on the other hand are typically for asset-heavy businesses such as coffee shops, restaurants, and construction companies.
Final thoughts on venture debt
Venture debt is an attractive financing option for top-tier, venture-backed startups. Its low initial cost of capital and bullet structure makes it the perfect fit for companies with longer-term capital needs. However, the 2-3% of required warrant coverage makes its long-term costs unfeasible for most companies and boards.
If you’re generating revenue and are looking for an alternative funding option that’ll enable you to pour metaphoric fuel on your fire, revenue-based financing may be a better fit. Learn more about RBF here.