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Venture Debt

Guide to Understanding Venture Debt

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Venture Debt

Venture Debt Financing for Early-Stage Startups (Funding Criteria)

Venture debt is one of the financing options available to early-stage startups seeking to raise more capital from institutional investors.

Over the course of a company’s lifecycle, most reach a critical point in time when additional capital is necessary to grow and reach the next stage of growth.

While traditional bank loans are not available to unprofitable startups, venture debt can be raised to increase the liquidity of a startup and extend its implied runway, i.e. the number of months during which the startup can rely on its existing cash reserves to continue funding its day-to-day operations.

The “catch” here, however, is that venture debt tends to only be provided to startups with backing from venture capital firms (VC), meaning that outside capital was already raised.

The startup must also have a clear pathway to becoming profitable, otherwise, the risk would be far too substantial from the perspective of the lender.

As a result, venture debt is not an option for all early-stage startups. Instead, the short-term financing (i.e. approximately 1 to 3 years on average) is typically only offered to startups with promising outlooks and backing from reputable institutional investors.

How Does Venture Debt Work (Step-by-Step)

In practice, venture debt typically serves as a unique type of bridge financing, wherein the underlying startup is in between financing rounds but might want to intentionally delay the next round or a liquidity event such as an initial public offering (IPO).

The management team of the startup could decide to raise venture debt, rather than equity financing, in anticipation that doing so can enable them to raise capital at a higher pre-money valuation (and the negative effects of dilution are reduced).

Therefore, venture debt functions as a flexible method of non-dilutive, near-term financing to extend the implied cash runway and fund urgent working capital needs until the next round of equity financing.

For instance, a startup might be burning cash too rapidly and urgently need capital to fund its working capital needs, yet the timing of the next equity financing round could be premature, i.e. prone to the risk of undergoing a forced “down round” despite only requiring a minor cash injection to remain on track.

Generally speaking, the primary use cases of venture debt are as follows.

  • Secure Near-Term Financing with Flexible Lending Terms
  • Extend the Implied Runway (i.e. More Time in Between Equity Financing Rounds)
  • Reduce Dilution and Retain Existing Equity Ownership Percentages of Existing Investors
  • Improve the Odds of Raising Capital at a Higher Valuation in the Next Equity Financing Round
  • Obtain Near-Term Liquidity for Short-Term Working Capital Needs (e.g. A/R Financing, Equipment Financing)

Venture Debt Funding vs. Equity Financing (Startup Benefits)

Venture debt is a specialized form of early-stage financing that is fundamentally different from traditional debt instruments raised by corporations.

Nonetheless, the characteristics of venture debt are still closer to traditional debt than equity financing, as implied by the name.

Most notably, venture debt represents a contractual obligation because the lender is guaranteed to be repaid on the loan.

Considering that a startup is likely unprofitable or their cash reserves are insufficient to agree to a strict amortization schedule, the lender is often repaid on the basis of meeting specific milestones, which can be tied to events like revenue targets.

Thus, a core component of venture debt is that the financing is meant to be complementary to startups and existing equity at a critical inflection point in their growth (i.e. increased “upside” potential).

While venture lenders are more understanding of the circumstances that the startup is in, their priority remains focused on capital preservation and the protection of their downside risk, akin to traditional banks.

In contrast, providers of equity financing such as angel investors and venture capital firms are far more lenient from a capital loss and risk perspective.

One of the aspects to venture investing is referred to as the “power law of returns”, in which one successful investment (i.e. termed a “home-run”) can be enough to make up all the losses from the other failed investments in the rest of their portfolio.

In effect, early-stage equity investments are completed with the anticipation that most of them will fail, contrary to debt lenders that want to earn a specific yield and minimize their capital losses.

Learn More → Ten Questions Every Founder Should Ask Before Raising Venture Debt (Source: Bessemer Venture Partners)

Venture Debt Financing Terminology

Term Definition
Commitment (Principal)
  • The dollar amount of capital initially offered to the startup as part of the financing arrangement.
Draw-Down
  • The capital available from the financing that could be delivered at once or be drawn from on an ad hoc basis (i.e. as-needed).
Amortization Schedule
  • The amortization schedule states the specific dates on which interest expense and principal repayment are required.
  • The terms are unique to each lending scenario and there is much flexibility in terms of how it can be structured, namely because it is not the objective of the lender to force a startup into default.
  • Most venture debt initially starts with a period where only interest is owed with no mandatory principal amortization to benefit the short-term liquidity of the startup from the onset (and interest + principal amortization can be required once the startup’s performance has normalized).
Interest Rate (%)
  • The interest rate (%) is stated in the formal lending agreement and represents the cost of financing throughout the borrowing period, and can be structured as either a fixed or floating interest rate.
Commitment Fee
  • If the loan is a line of credit (i.e. “revolver”) with a set borrowing limit, the unused portion of the credit facility is charged a marginal fee to compensate the lender for holding the funds.
Prepayment Penalty
  • If a startup’s financial performance exceeds expectations, it may want to de-risk by paying back any outstanding debt earlier than originally scheduled, making the company more attractive to other equity investors.
  • But early repayment reduces the returns to the lender since interest is not received, so a prepayment fee can be charged to compensate them for the reduced yield and the risk of having to find another startup to lend to.
Warrants
  • As part of the debt financing agreement, one method to reduce the interest rate and obtain more favorable terms is to attach warrants to the debt.
  • Warrants enable the lender to purchase equity at a set price (i.e. a price lower than the price offered to other investors), which can increase their upside from participating in the financing.
  • While the warrants can increase dilution, the net impact is typically negligible and far less relative to a round of equity financing.
Debt Covenants
  • Covenants on debt are restrictions placed by the lender to reduce their credit risk.
  • In venture financing, restrictive debt covenants are rare, mostly because the business model of the startup is currently a work-in-progress and limiting its ability to adjust as needed would be counterproductive to all parties.
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