Exploring Alternative Funding: When And How To Consider Venture Debt

Startup founders should have a clear view of when and how to consider venture debt. This form of alternative funding is an integral part of any entrepreneur’s journey and is a great complement to equity.

When setting up a new business, accelerators, incubators, and venture capitalists are typically the initial sources of capital. You can use venture debt as the next financing tool, which is non-convertible and designed for early-stage, hyper-growth startups.

Both banks and non-bank lenders offer venture debt as secured loans that are alternatives to convertible debt or preferred stock. Acquiring venture debt prevents the further dilution of the stake founders, investors, and employees have in the company’s ownership.

In the first two quarters of 2023, startups entered into 931 venture debt deals worth $6.34 billion across all industries. Although the total value has been dropping consistently over the last few years, venture debt continues to be an effective financial instrument.

Read ahead for more detailed information about how it works and when and how to consider venture debt.

Advantages of Venture Debt Financing for Startups

Using venture debt has several benefits for founders, such as:

• You’ll prevent equity dilution while achieving high business growth using the funds as capital.
• You can use this money as substantial working capital to fuel the needs of the rapidly growing company.
• Venture debt extends the startup’s runway and acts as a short-term bridge to keep it functional between funding rounds. As a result, entrepreneurs can enhance their credibility to raise funds down the line.
• Having a robust blend of equity and debt finance helps startups build a strong credit history in the early stages.
• Venture debt is an ideal solution when new businesses cannot acquire bank loans. You can use the funds for executing strategic business acquisitions and meeting capital expenditures.
• You’ll deploy the funding as performance insurance and for sourcing a steady supply of inventory.
• You can acquire short and medium-term loans with durations ranging from four to five years.
  

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How Venture Debt Capital Works

Venture debt capital is suitable for early-stage startups since they don’t have adequate assets to offer as collateral for loans. Instead, they offset the risks by offering warrants on the company’s equity.

Companies that have successfully raised several rounds of venture capital funding typically apply for venture debt. While they do have operational efficiency, their cash flows are not impressive enough for eligibility for conventional loans.

You can use the finance to reach the startup’s targeted milestones or to purchase the assets it needs to achieve its targets. As a rule, venture debt lenders may offer a maximum of 25% to 30% of the equity that the startup raised in its last funding round.

Accordingly, if the company raised $30M in the last round, lenders will likely consider a credit offer of $10M. Interest rates can be the ongoing prime rate or any other standard rate. Payments are typically interest only as against principal and interest.

Warrants

Venture debt lenders receive warrants that constitute 5% to 20% of the loan’s principal sum. Warrants are also effective compensation for the high risk of default. Lenders have the option to convert the warrants into common shares at a rate that is predetermined when the loan is issued.

Alternatively, founders can offer conversions at the prices per share applicable during the last equity fundraising. Or any future funding rate. These terms are effective incentives for the loans. However, warrants can be converted only within a specific period, and the option to convert into equity is optional. Lenders can choose not to accept equity.

Liquidity Preference Conditions

Loan providers are likely to include terms and conditions for offering venture debt. These terms or covenants are usually flexible when non-bank lenders issue the loans. However, banks underwriting the loans include more covenants to raise the likelihood of repayment and align objectives.

Venture debt also comes with a liquidation preference. This means that in the event the company folds, venture debt loan makers get their money back before other stockholders and shareholders.

Venture Debt Typically Follows Venture Capital

Venture capitalists offer debt backing as the next step after equity but not as an alternative. Having offered funding and validated the startup as an excellent investment, offering venture debt is easily done. Their investment is like a viable benchmark for underwriting the loan.

Having acquired VC, you’re likely ready with an effective pitch that outlines your intended objectives from the funding. Typically, founders are also ready with their estimates and strategy for raising the next round and how they’ll allocate them.

Using this successful pitch and the credibility you’ve earned makes it easy to acquire venture debt. However, the availability, amount, types, and loan terms are subjective. The loan depends on several factors, such as the quantity and quality of the equity you’ve successfully raised so far. It’s the opportune time for when and how to consider venture debt.

Loan makers also take into account the objective for which you’re applying for funding. The size of your company and its stage are also criteria. For instance, early-stage startups, companies that have yet to generate revenues or develop a product prototype, may get smaller venture debts.

But, more established companies that have already hit the growth trajectory will likely qualify for larger loans. Essentially, if you’ve already acquired venture capital for your startup, getting a venture loan is far less challenging.

Structuring Venture Debt

Here’s how these loans are structured:

• Venture debt loans are typically termed for a four to five-year amortization period.
• Founders also have the option to draw the loan down in smaller increments instead of receiving the entire loan amount in one go.
• The option to draw down is available for a limited time, usually nine to 12 months.
• For the initial three to 12 months, startups need not pay the principal but only the applicable interest.
• VCs tend to limit the venture debt they offer to avoid a large debt burden on the company. That’s because a large debt can affect its ability to raise funding in further rounds.
• Venture debt typically includes costs like an upfront fee to organize the loan facility and a final payment or backend fee.
• Loans typically carry interest rates of 7% to 12% but with the flexibility to repay earlier.
• Lenders include warrants, liquidation preference, and covenants in the contract.
• Venture debt can be categorized as equipment financing, growth capital, and accounts receivable financing.

Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

How Venture Debt is Different From Equity

Although the prospect of ownership dilution is a real factor, entrepreneurs cannot overlook equity capital as funding for their startups. Equity funding is expensive, and its allocation costs aren’t exactly economical.

This is why you’ll maintain an optimum cap table comprising both equity and debt financing. As long as the startup is establishing its product-market fit and yet to earn revenue, you’ll need equity. This should be your primary source of capital from external funders.

But, as the company starts rapid expansion and needs additional funds to scale, venture debt can serve as suitable complements. Especially when you intend to use the money for specific purposes, such as purchasing inventory or small tools. That’s the time when and how to consider venture debt.

Here are some additional differences you should know about:

• Venture debt loans come with an amortization period of four to five years. However, equity capital is an investment for five to 10 years or more.
• Founders accepting venture loans need not be concerned about ownership dilution. However, acquiring equity typically involves an exchange of substantial ownership stake.
• Venture debt needs interest payments at regular intervals, but equity does not carry interest.
• Investors offering venture loans can expect repayment within a fixed tenure. However, equity is not repaid. Investors can sell their shares in the market to liquidate their investments.
• Startups use venture debt to finance acquisitions, maintain cash flows, and cover operational expenses. However, equity is a great source of capital to expand the company and invest in acquiring talent. The cost of product research and development and advertising strategies are also covered by equity money.
• Venture loans come with clearly defined repayment terms. However, equity does not carry any repayment conditions.

Even as you’re reading up about venture debt, you should also know more about how venture capital works. Check out this video I have created explaining in detail how this investment option works.

Investor Criteria for Offering Venture Debt

Lenders have several criteria for offering venture loans to startups. Their screening conditions include factors like:

• Investors are more likely to back entrepreneurs and their business sense and industry-specific expertise. Their track records with successful ventures, vision, founding team, and other parameters dictate the decision to offer loans.
• Startups that demonstrate financial stability and efficient cash management with liquidity maintenance are more likely to qualify for loans.
• A robust product-market fit, Total Addressable Market (TAM), and a well-defined go-to-market strategy indicate potential for long-term scalability. And viability for loans.
• The company’s previous investors and its ability to raise funding is an attractive proposition for new investors. They are likely to view the startup as a great investment opportunity.
• Investors prefer to support startups that are stable with the potential for hyper-growth. If they can present compelling pitch decks with a proven revenue model and high profit margins–that indicates the ability to repay the loans with interest.
• Taking on debt should be an option only after balancing the interests of the company’s key stakeholders. And that includes existing investors, shareholders, employees, and founders. All these entities may hold equity and an ownership stake in the startup.
• Startups that have a low burn rate and maintain adequate liquidity for runway indicate that they also have momentum. In other words, they have the potential for accelerated growth and are thus ideal candidates for venture debt.

Your ability to raise venture loans for the startup is an indication that it meets the criteria for raising future funding rounds and repaying the loan.

When and How to Consider Venture Debt

If you’re trying to avoid ownership dilution, venture debt might seem like the ideal source of capital for your company. Entrepreneurs bootstrapping their startups may consider applying for cash-flow-based term loans or asset-based lines of credit.

However, these options work only if you can demonstrate a robust cash flow. And not when the startup is in its early stages. At this time, you absolutely need venture capital or other sources of seed funding. Especially if the company needs a substantial capital injection.

Once the startup is established with a working product prototype and you’re starting to generate revenue, that’s when and how to consider venture debt. You’ll have a better chance of getting these loans since lenders prefer to invest in companies that have already attracted funding.

A successful fundraising track record inspires trust and confidence in the minds of lenders. They are more confident that you can repay the debt by future fundraising.

From the entrepreneur’s perspective, take on venture debt only if you’re confident of paying it back with tenure. At least 38% of startups fail because they run out of cash to remain in operation. Being cautious with borrowing will keep you out of the 90% startup failure bracket.

Before reaching out to investors, you’ll work out the size and structure of the venture debt you can comfortably take. Also, align it with the needs of your company and further fundraising strategies.

Balance your needs with the terms and conditions you can agree to. Don’t hesitate to be aggressive at the negotiation table.

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