What is Venture Debt?
Venture Debt is a form of flexible, non-dilutive financing offered to startups to extend their implied cash runway and fund near-term working capital needs until their next round of equity financing.
Venture Debt Financing for Early-Stage Startups
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.
What is the Funding Criteria for Venture Debt Financing?
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?
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)
What is the Difference Between Venture Debt vs. Equity Financing?
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.
Venture Debt Financing Terminology
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