The number of startup companies turning to venture debt to get additional capital has been rising in recent years. The reason behind this change is because, with venture debt, a startup doesn’t have to cede a large part of its founders ownership, it’s easy to access the new funds and hit performance milestones required by VC backers.
As a result of economic uncertainty created by Covid-19, startups are opting for venture debt to avoid raising funds with a reduced valuation and get funds to help them adapt to unexpected market conditions or face short-term challenges.
While there are many benefits of raising many through venture debt, this is not a direct replacement of equity rounds from venture capitalists.
The article will help you understand venture debt as an alternative source of funding.
How Different is Venture Debt from Other forms of Funding?
Venture debt is a way of borrowing money that is different from conventional business loans because it doesn’t depend on accounts receivable, cash levels or inventory held. Instead, venture debt depends on the relationship between the VCs and the entrepreneurs.
The debt is capped between 20-35% of the company’s recent equity round, but a conventional loan depends on the business’ projected ability to repay the borrowed amount based on metrics related to its current performance.
Further, venture debt is used as growth capital or for equipment financing like machines for a factory secured by those assets only. However, the growth capital is secured by the company assets and can be used for any other purpose.
A business can also use venture debt when facing temporary market challenges or when there is an opportunity to adapt rather than raise VC funding at a time when it might give up a bigger equity stake due to reduced valuation. So a venture debt is a better deal than venture capital during the short-term market downturns or when it faces unexpected events such as operational glitches.
The venture debt is only applicable to high performing, VC-backed startups. A startup negotiates this debt at the same period it’s receiving an equity round. So companies use venture debts and VC financing for growth purposes such as investments in R&D, marketing and developing a sales team.
Some companies that provide venture debt financing are entrepreneur-focused banks and specialized venture debt funds like Western Technology Investment, Trinity Capital, and TriplePoint Capital. So entrepreneurs shouldn’t visit a commercial bank seeking venture debt. However, they can approach private equity firms, hedge funds and business development companies.
Comparison between Venture Debt and Venture Capital
It’s important to note that venture debt and venture capital can’t be used interchangeably nor substitute venture capital financing with venture debt. Venture debt is used to complement VC firms or investors equity funding. So a startup has first to receive venture capital and then apply for venture debt because it doesn’t fully fund a startup in its early stage or help it move towards an exit. But a startup can obtain venture debt to avoid or delay its next round of venture capital.
With venture capital, the investor takes a significant stake in the startup company, but with venture debt, the company has to pay the loan back at the agreed interest rate and over a period. So a founder with venture debt gets a bigger reward when they exit than when there is venture capital funding.
Venture capital is not returned, but venture debt is paid back, and the company has to focus on its growth as it does so. So a startup with a huge venture debt repayment may have a hard time discharging itself from the VCs because the investors’ focus may be to repay the funding debts instead of seeking growth opportunities.
Also, a startup that opts for venture capital instead of venture debt benefits from partnership opportunities, access to networks, talents, business advice, and media coverage.
Additionally, a venture debt doesn’t require a new company valuation, but this is mandatory when it comes to venture capital. Another factor is that there is no need for a board seat with venture debt, but with venture capital, the investor will require a board seat.
Venture debts don’t require a comprehensive due diligence process, but this is a mandatory requirement for venture capital.
The Future of Venture Debt
While venture capital funding has been in existence for some decades now, venture debt emerged during the 2008 financial crisis to help foster competition. However, the demand for venture debt has risen because the market had become a lot more borrower-friendly. That means there are more venture debt lenders, favorable loan terms, structures and interest rates.
Further, the pandemic has bolstered the need to raise money through venture debt in order to prolong the need for the next round of VC funding or even to avoid it altogether. However, Venture debt cannot replace venture capital despite the traction.
The reason why a company can prefer venture debt despite the interest rate is because of down rounds that have a high potential of diluting the founders’ ownership. Also, the economic uncertainty stemming from the Covid-19 pandemic has motivated governments to maintain low interest rates, thus making debt more appealing for young businesses.
Still, companies shouldn’t add a lot of debt to their balance sheet because this will become a burden when the market takes an unfavorable turn or when its performance lags.
Startup businesses can apply for venture debt after venture capital financing when they meet unforeseen changes in the market in order to help it adapt. The debt is paid with an agreed interest rate and at an extended period.
The advantages of venture debt over venture capital is that there is less equity dilution, no valuation, strict due diligence, nor board seat is required.
However, adding more debt is not recommended, especially due to an economic downturn or unfavorable business environment.