Venture Debt, Explained
When we think about fundraising for start-ups, scale-ups and growing SMEs we tend to think about Funding Rounds and Equity-based investment, most often within the Venture Capital model.
However, in recent years, with ambitious companies growing in numbers almost everywhere in the world, the market started offering a more diversified set of products for Businesses looking to raise finance.
One of these products is Venture Debt.
Venture Debt can be considered, in many ways, a hybrid between traditional debt – like a business loan – and Venture Capital. Although it is not designed to fully replace VC funding, it can be a convenient complement to it if the circumstances require it.
While it may better suit the needs of a fast-growing company, taking Venture Debt must be considered very carefully, as like any other form of debt it can become a burden on the company’s balance sheet.
Below we examine all the main characteristics, pros and cons of Venture Debt, especially in comparison with VC funding.
What is Venture Debt?
Venture Debt is a form of a credit offered by specialised, entrepreneurial-focused banks or funds (Triple Point Capital is an example of the latter).
It differs from more conventional forms of credit because it does not rely on factors such as accounts receivable, inventory held, or cash levels – which would likely disqualify early-stage companies – but on a closer relationship with a company’s existing VC backers.
By relying on the due diligence process carried out previously by Venture Capital backers, Venture Debt lenders are able to offer between 20% and 35% of what the company already raised in VC funding (according to Silicon Valley Bank).
The capital is then repaid with an interest over a usually short period of time, 3 years on average. The most common source of the repayment, according to most lenders, are successive VC rounds. Because of this, Venture Debt is often considered as “bridge funding”.
Therefore, lenders tend to evaluate borrowers based on their growth potential and capacity to attract further investment, rather than their immediate ability to generate revenues.
Pros & Cons of Venture Debt
Founders typically have four main reasons to benefit from Venture Debt:
- Avoiding Dilution: if the company has to make substantial investments to fuel growth, but the existing shareholders are reluctant to give away any equity, Venture Debt can offer a financing solution that allows them to retain ownership.
- Extending the Runway: cash can be tight between early-stage funding rounds, and extending the Runway by only a couple of months could mean successfully hitting a milestone which will unlock further equity funding.
- Facing Unexpected Challenges: companies that are hit by unexpected market conditions that undermine their ability to sell equity to investors may turn to Venture Debt as a way of sustaining ongoing expenses and successfully getting through a crisis.
- Avoiding Down Rounds: similarly to the two points above, sometimes a company is facing adverse conditions that create a disadvantage in raising capital. If the Founders are confident that a smaller investment may help put the company in a more favourable position to negotiate investment terms, then Venture Debt can be a great bridge funding solution.
A lot of the risks of Venture Debt are common to all forms of debt. However, its relationship to Venture Capital funding must also be considered carefully in a growing company’s funding journey.
- Drag on Growth: firstly, the choice of using debt to invest in growth (commonly equipment, a factory, sales and marketing) must be made with a clear view of the future cash needs of the business. Otherwise, the repayments will hinder a company’s future ability to spend on growth in the longer term and eventually defeat their own purpose.
- Burden on the Balance Sheet: a hefty debt can be seen as a liability for future investors, who may be averse to their capital being used to repay pre-existing debt as opposed to growth. Venture Debt should always be planned within a clear fundraising roadmap.
- Reliant on VC Funding: lenders often look at previous (and upcoming) VC investment, both as a guarantee of the company’s potential and as a likely source of repayment. This means it might not be a viable option for companies that are struggling to raise VC capital.
Venture Debt vs. Venture Capital
Venture Debt and Venture Capital are not to be considered alternatives or substitutes to each other.
On the contrary, they complement each other, and often happen at the same time.
Especially at later stages, company Funding Rounds are part VC and part debt. This allows the company to invest more heavily in growth without the investors committing additional capital.
Most lenders in this sector work closely with VCs, to which they essentially outsource part of the due diligence process.
The key difference between Venture Debt and Venture Capital is the reliance on equity.
While Venture Debt almost never involves equity, Venture Capital always does. This means that VCs main interest is the eventual success of the company, most likely an exit. Venture Debt lenders, instead, are mainly interested in the company’s ability to repay the debt, which almost always translates to its ability to raise further Venture Capital.
Venture Debt in context
Venture Debt emerged as a product after the 2008 financial crisis, when the start-up ecosystem as we know it started booming.
With new lenders entering the market, the terms became more friendly to borrowers, especially high-growth companies as they became more and more prevalent.
Now, with record-low interest rates as a result of the COVID-19 pandemic, many Founders are looking at debt as a convenient addition to equity funding.
However, as all debt implies some risk and weighs on a company’s balance sheet, Founders should be aware of alternatives for bridge funding, including solutions such as grants, R&D Tax Credits and revenue-based financing.
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