Venture Debt Explained

What is Venture Debt?

Venture debt refers to loans that are made to startup or growth-stage companies that do not have positive cash flows or significant assets to use as collateral. Venture debt provides an alternative source of financing in addition to equity financing from venture capital firms and angel investors.

Why Do Startups Use Venture Debt?

There are several reasons why a startup might consider venture debt as part of its overall financing strategy:

1. Extend Runway: Venture debt can extend a startup’s runway, giving it more time to hit milestones before needing to raise additional equity rounds. This helps avoid potentially dilutive downs rounds if milestones are not yet met.
2. Finance Growth: Venture debt can also finance working capital needs related to growth, such as hiring key employees, investing in R&D, purchasing equipment or hardware, etc. It provides flexibility in using the funds across these types of expenses.
3. Complement Equity Rounds: Venture debt can complement equity financing from VCs. The debt provides funding in between equity rounds, allowing startups to hit key milestones before raising their next round. This minimizes dilution for founders and early investors.
4. Increase Valuation: Using debt rather than equity may enable startups to achieve higher valuations in subsequent equity rounds, as they will have given away less ownership via funding rounds.

Costs and Fees of Venture Debt

Typical costs and fees associated with venture debt facilities include:

• Interest rates: Venture debt interest rates tend to range from 10-15%, on the higher end compared to other private company loan options. The rate may have downside protection should the company achieve a higher valuation in a future equity round.
• Origination fees: Lenders usually charge an upfront fee upon closing the loan, ranging from 1-3% of the total loan commitment. This compensates the lender for costs associated with underwriting and closing the deal.
• Warrant coverage: Most venture debt involves the lender receiving warrants, similar to equity options, as part of the deal. This gives the lender the ability to share in future equity upside if the company does well. Typical warrant coverage ranges from 5-15% of the loan amount.
• Prepayment penalties: Should the borrower repay the loan early, there is usually a prepayment penalty involved, often starting at 5% and declining over time. This compensates the lender for the lost interest income.
• Legal and banking fees: Like any financing round, the borrower usually pays expenses related to lawyers, banking advisors, diligence, and documentation involved in securing financing.

Venture Debt Provider Landscape

There are a range of potential venture debt providers startups can consider, including:

• Specialized Venture Capital Lenders: Several VC firms provide venture lending as a complement to their equity investing activity. These lenders are familiar with startups’ operating models and can move quickly. Examples include TriplePoint Capital, Horizon Ventures, and Silicon Valley Bank Venture Lending group.
• Commercial Banks: Some traditional commercial banks have groups focused specifically on lending to innovation companies and startups. They have large pools of capital but may not move as quickly as specialized lenders. Examples include Comerica Bank, Bridge Bank, and City National Bank.
• Corporate Strategic Investors: Large corporations have formed venture lending units to provide debt financing to startups, often synergistic with their strategic interests. Intel Capital, Samsung Ventures, and Cisco Investments provide venture lending offerings.
• Government Lenders: Some governmental and quasi-governmental organizations offer venture lending programs to support startups and innovation in their jurisdictions. Examples include the US Department of Energy Loan Program Office and Export Development Canada.

The above lenders have provided billions in cumulative venture loan financings across thousands of companies in recent years.

When Do Startups Obtain Venture Debt?

The most common time for startups to secure venture debt is in conjunction with or immediately following an equity financing round led by a reputable VC firm. The recently closed equity round serves as a signal that reduces uncertainty about the startup’s prospects. Venture lenders can also lean on the newly invested VCs to support the company if financial difficulty emerges. The typical timing includes:

Series A & Series B Rounds: Startups may take on venture debt alongside these early VC rounds to further extend runway. Amounts tend to range from $2 million to $10 million in these early stages.

Series C, D, & Beyond: In later rounds, larger venture debt facilities can complement mega-rounds. Strong revenue growth, low churn, and a clear path to profitability provide support for substantial debt capacity. Amounts can exceed $100 million for late-stage unicorns.

In between Equity Rounds: Besides pairing with equity rounds, venture debt also frequently supports startups in the gaps between scheduled VC rounds. This minimizes dilution as startups bridge funding needs before raising their next round.

Venture Debt vs. Equity Tradeoffs

When considering financing options, startups must weigh the tradeoffs between venture debt funding or pursuing equity-based VC rounds. Factors to consider include:

Control & Governance: Debt does not require giving up board seats or ownership through equity dilution. Founders maintain greater control compared to large VC equity rounds.

Dilution Impact: Equity rounds mean substantial dilution, sometimes even control-changing stakes, for existing shareholders. Debt avoids this dilution risk.

Cash Flow Pressure: Debt must be repaid on a structured timeline. Failure to achieve cash flow forecasts strains liquidity. Equity is more patient flexible capital.

Risk Profile: Debt compounds financial risk. Struggling to service debt on top of other expenses can quickly lead to insolvency. Equity cushions companies from cash strains.

Signaling Risk: Raising debt too early without proper metrics can signal financial weakness. Successfully raising from tier-one equity VCs provides positive signaling.

Exit Requirements: Debt investors expect timely repayment of principal and interest. Equity investors have longer exit horizons tied to large liquidity events.

As no financing path is without downsides, startups must weigh the above factors given their circumstances. Blending debt and equity across funding stages helps balance risk and optimize ownership.

Venture Debt Process and Timeline

The venture debt financing process mirrors that of venture capital equity rounds albeit in a more compressed timeframe. Key steps include:

1. Identifying Options. The company first identifies potential lending partners to approach, determining the right fit in terms of stage, sector experience, check size, and reporting requirements. Relationships with VC equity investors often influence debt options.
2. Due Diligence. The lender underwrites the opportunity through financial modeling and business plan review. This evaluates ability to service debt obligations and the underlying defensibility of the company’s model. Calls with management and reference checks on customers & partners provide qualitative diligence.
3. Term Sheet and Negotiation. Following initial diligence, the lender issues a non-binding term sheet outlining proposed terms like loan amount, warrants, interest rates, repayment schedule, etc. Key negotiated terms can include restrictions on cash or leadership changes.
4. Documentation. Attorneys draft and finalize loan agreements and associated legal contracts like security agreements, warrants, and ancillary documents. This can be an intensive legal process clarifying issues like default triggers.
5. Closing and Funding. Following completion of documentation, the lender transfers committed capital at closing to the company’s accounts. Funds can be made available as early as 2-3 weeks from initial outreach to lender.

Post funding, the company provides periodic financial information demonstrating adequate liquidity and metrics to service debt obligations. Failure to achieve agreed covenants would put the company in technical default.

In summary, venture lending can provide startups with an attractive financing alternative to complement equity VC rounds. By optimizing ownership and extending runway, debt helps founders achieve their vision while rewarding stakeholders.