Are you wondering what is venture debt?
Most successful businesses use forms of debt financing to help fund their operations and reach important milestones. Venture debt, also known as “venture lending” is one way of doing this. It’s important as an entrepreneur that you understand what venture debt is and how to use it.
In this article, I’m going to explain the types of venture debt you may encounter and what’s usually included in such a deal.
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Venture Debt Explained
In simple terms, venture debt is like any other debt. It’s an agreement between you, the entrepreneur, and a lender, where your business is given an amount of capital that it must pay back over time, including interest.
What separates venture debt from other forms of credit, is that it’s usually available only to start-ups and other fast-growing companies with limited access to standard forms of credit.
Most businesses looking for venture debt, do not have:
- Valuable assets or collateral that can be used to secure credit.
- No significant positive cash flow for the entire business.
How then does a business apply for venture debt from banks or lenders without either of these.
The answer, is that venture debt incorporates warrants into each agreement.
What is a Warrant?
A warrant, in this instance, is a legally binding agreement that allows the creditor lending the venture debt to purchase stock in the debtor’s company. Much like a share option, a warrant provides the creditor with the contractual and financial means to buy or receive a portion of equity at a later date and under certain circumstances.
The price of the equity is set within the warrant at the time the venture debt is granted. This price is known as the “exercise price”. Entrepreneurs need to make sure that they can afford to sell the equity at that price if the debt cannot be paid back otherwise.
A warrant has an attached expiration date, usually the same day as the business pays back the venture debt. The type of stock, common or preferred, is also an important part of the debt agreement.
To protect your business, all warrants should be overseen by legal representation.
In essence then, should a business default on payments, the creditor can choose to activate the exercise price clause and buy the previously agreed amount of equity.
Types of Venture Debt
There are typically three types of venture debt that you will encounter as an entrepreneur. They are:
1) Equipment Financing
This type of venture debt agreement is for the specific purpose to buy equipment and other infrastructure. That bought equipment and infrastructure can then be turned into security for the debt alongside, or as an alternative to buying shares in the company.
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2) Growth Capital
Used to fuel growth. Traditionally, this type of loan operates like a fundraising stage. The finances offered are used to reach the next funding milestone. It can also be used during a merger and acquisition, as well as to simply keep a business running as a going concern.
3) Accounts Receivable Financing
This is by far the most complex type of venture debt. It involves using future receivable income as a security. Essentially, this means that any business that owes your business money, pays this now directly to the venture debt creditor.
All three types are structured differently from each other. If you are entering into an agreement with a creditor, make sure that you are fully aware of the structure and what you are risking should the worst happen.
Who Are Venture Debt Lenders?
Strictly speaking, there are two types of business which offer this structure to start-ups and growth businesses. These are:
1) Venture Debt Firms
These are lenders who specialize in this. One of the advantages of using a venture debt firm, is that it may be able to provide more finances than a bank, as banks often have guidelines to only offer so much. Venture debt firms also offer a wide range of debt structures, being traditionally more flexible than many other lenders.
Entrepreneurs are often unaware that they can apply for venture debt from many commercial banks. It’s very common for startups to be offered venture debt options by the banks they use for their other financial matters. Though such banks often have a lower cap than venture debt firms, they are a great option for smaller loans and still have the financial might to scale up to offering millions of dollars in credit.
Some entrepreneurs will prefer to work with banks they already have business dealings with, while others will opt for the flexibility of a venture debt firm.
For this you need to target specific institutions that are used to these types of structures such as Silicon Valley Bank or Square 1 Bank.
Common Venture Debt Terms
Like any loan, venture debt agreements will vary widely. However, I’ve listed below the more common aspects of these deals you’re likely to encounter:
Most deals run from between 12 to 48 months.
2) Repayment Plan
Repayment can be structured as interest only for the first few payments to keep financial pressures off of the debtor. Alternatively, it will be a monthly payment consisting of interest accrued plus a percentage of the principal loan. Lastly, you may be able to negotiate a balloon payment, where a large amount of the interest is paid only at the end of the loan duration.
The interest rate for a venture debt loan depends on the common rate (see: Yield Curve) within a chosen industry or sector. For accounts receivable loans it’s calculated based on the current prime rate decided by the banking system. A further percentage will usually be added to either of these values.
The amount and value of equity will be declared in the agreed warrant. A rule of thumb is that the amount of equity owed to a lender, if there is a default on the loan, is between 5% and 20% of the full loan value.
5) Other Terms
Other stipulations can be included such as giving the lender the right to invest in future investment rounds. Always be aware of any additional clauses.
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