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Venture Debt: What is it and How is it Good for a Startup

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Venture Debt

The world is full of young or first-time entrepreneurs with promising startup ideas, but they lack the funds to get started or take their business to the next level.

Aside from capital startups requires strategic assistance, human resource, and financial management which are vitally important when growing.

Venture capitalist provides a valuable source of consultation and guidance in addition to financial backing. Further, they introduce startup founders to potential partners, customers and employees, and more.

Fast-growing, VC-backed startups can borrow money for growth capital or equipment financing through venture debt. This article will tell you more about this kind of credit and why it is suitable for a startup.

What is Venture Debt?

Startups and early-stage companies seek debt financing to help grow their business. Venture debt offers companies an influx of cash without diluting their ownership. This allows startups to stretch their runway between equity rounds which can help them hit performance milestones from VC backers.

Venture debt is different from traditional business loans because it doesn’t depend on held inventory, accounts receivable, or cash levels. Instead, the loan is pegged on the relationship between the startup founders and VC backers.

Companies can borrow 20-35% of their recent equity round in the form of venture debt. They can use the funds as growth capital or equipment financing. When taking a venture debt to buy machinery for a company, those equipment becomes the security of that loan.

Companies negotiate venture loans when receiving an equity round, and they use it for growth purposes the same way they use VC financing. This includes marketing, building or strengthening sales teams, investments in R&D, etc.

Startups can get this type of venture debt financing from entrepreneurial-focused banks, private equity firms, hedge funds, and business development companies because commercial banks don’t offer venture debt.

How Venture Debt Lenders Evaluate a Startup

Startups engage in an intense underwriting process as venture debt lenders select the perfect investment option. The factors they consider during the underwriting are the product, the management team, market traction, investors, and other value drivers.

Companies use future equity rounds to repay their venture debt, and so lenders keenly assess whether the startup is well-positioned for future rounds. Additionally, they take into consideration its life stage and capital strategy.

Based on these underwriting criteria, venture debt lenders evaluate early-stage startups based on the recent equity rounds, investor quality, and projected cash burn rate. Thus a company with a high burn rate is marked riskier due to its increased dependence on external capital.

Venture debt lenders make money through fees, warrants, and interest payments. On the other hand, traditional business loan lenders consider startups too risky to lend to, and they don’t want an equity stake in these young companies. However, venture debt financing can be converted into shares during an exit during IPO or acquisition, thus giving the lender an outsized return.

Still, lenders tend to consider late-stage companies’ ability to attract non-dilutive capital. This is a clear indication that they have hit significant milestones in connection to financial performance and product development, thus making them attractive to new investors and lend to.

The Difference between Venture Debt and Venture Capital

Venture debt and venture are different sources of funding. Therefore a startup can’t use venture debt as a substitute for venture capital.

Venture debt is used to complement equity funding received from venture capitalist firms. That means a startup has to get venture capital first and then negotiate venture debt.

Therefore, an early-stage company can’t rely on venture debt to finance its growth or reach an exit. But, it can use this debt to delay the next VC round or avoid raising it at all.

VC firms take a significant equity stake when they provide a startup with venture capital, but they don’t do so when they give venture debt. Instead, the debt is paid back based on the agreed-upon interest rate.

Actually, this kind of debt involves warrants converted to equity at a pre-agreed price and Is less than what VCs would ask if it involved venture capital.

Advantages of Venture Debts

  • There is less equity dilution, so founders retain more of their company share and still raise capital.
  • Venture debt allows startups to extend cash runaway. In other words, they can hit certain milestones set by VCs between raising equity rounds
  • Startups experiencing unexpected market conditions and short-term challenges can opt for venture debt to remain afloat. Therefore it’s a more adaptable source of funds.
  • Venture debt can help companies put off raising additional equity rounds until they have a bigger valuation or gain more favorable terms in the market.

Disadvantages of Venture Debts

  • Venture debt has to be paid back, and so, a startup with hefty venture debt repayments can have difficulty raising funds from VC. So such a startup will spend a significant amount of time repaying debt instead of focusing on growth opportunities.
  • It doesn’t offer value-adds found in venture capital, such as access to networks, partnership opportunities, business advice, filling key roles, or media exposure.

I'm a passionate full-time blogger. I love writing about startups, how they can access key resources, avoid legal mistakes, respond to questions from angel investors as well as the reality check for startups. Continue reading my articles for more insight.

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