If you are a startup founder, you must be wrestling with the idea of venture debt. I am sure you have some ideas about it too. Venture debt can be really good or bad for your business, depending on what stage your business is at. It most certainly is a confusing term.
The best way to make a difficult decision is to get down to its basics. Before we understand when venture debt is right for your business, let us look at what it is and how it works.
What is venture debt?
Venture debt, otherwise known as venture lending, is a kind of debt financing that favors the needs of pre-profit companies and growing startups. Particularly for companies and startups that are already backed by venture investments.
Venture Debt is NOT an alternative to venture capital. It can be considered an additional source of funds for venture-backed startups and companies. Venture debt does NOT demand your company's equity as collateral (although that is the case with venture capital investment).
How does venture debt work?
Venture debts work differently from other loans. As mentioned earlier, it doesn't require any collateral to sanction the loan. Although the principal amount is determined based on your previous equity round. The principal amount is roughly 30% of the funds raised in the last equity round. It is a short or medium-term debt, up to 3-4 years.
The interest rate for venture debt is higher than banks' interest rates. This is because these loans are given to startups and companies that are not (yet) profitable or do not have significant assets, which increases lenders' default risk.
Additionally, the lenders would receive warrants on the company's equity as a part of the compensation for the higher default risk.
What are warrants in venture debt?
Warrants are unique to venture debt. They make venture debt an expensive option for businesses. Warrants are security that gives the lender the freedom to buy company stocks at a per agreed price within a specific period of time. Warrants also devalue a company or startup when it comes to raising funds in future rounds.
When is venture debt right for your business?
The right question to ask is "whether or not you should look at venture debt as a source of funding for your business ?"
By now, we know a startup or business can go for venture debt only if it has raised equity. Keeping that detail in mind, let us look at some reasons why debt financing might suit your business.
1. To stretch your cash runway
If your burn rate is high and you are looking to stretch the time period for which your business can remain solvent, provided it doesn't raise any additional funds. Venture debt works out well for fast-growing tech companies that are always on the lookout for cash. If you burn a lot of cash and are looking for funding. Venture debt is a quick and flexible way of getting cash. It allows you (the company) to focus on growth.
2. As a supplement to equity
Venture debt can be seen as a supplement to equity. If you are not yet generating enough revenue, it will be better not to pick a 100% debt-based round of funding. A combination of debt and equity will work out much better. It will ensure you get the funds you need without the dilution your business will incur if you were to opt for a 100% equity round.
3. To get a higher valuation
If you utilize your venture debt optimally, you can delay your last round of funding. This will help you when you dilute your shares for a given price X with the venture debt; this will last you another year or two. Within that period, your company's shares stand a chance of reaching 2X. Hence delaying your last equity round by a year or two, you'll have a bigger valuation and a higher share of the profits.
4. Expanding into new markets
Venture debt greatly benefits fast-growing companies wishing to sell in other markets. In recent years, venture debt has built a new market of cross-border facilities, offering equity-sponsored financing.
An international debt fund works well for companies as it can lend you money in the same currency. This offers a strategic advantage without them taking over your company.
Three things to consider while choosing venture debt
To be a little safe when going for venture debt, make sure to keep these things in mind while deciding when venture debt is right for you
1. Talk to multiple lenders
Talking to multiple lenders regarding your pricing and agreement terms is a good idea. While lenders may not have a say in your business, they can still be valuable assets to your business.
Carefully research the lender and their experience and reputation with similar lenders. This will give you an idea about who to place your trust.
2. Sum total of the loan Vs. Lender's fee
Carefully considers the sum total of the loan amount and the lender's fees before you make a final decision. According to experts, you should accept an amount extending the runway by approximately 6 months.
3. Legal fee for undertaking a venture debt
An important thing to remember is that you will have to incur legal fees for undertaking a venture debt above the loan amount provided. When deciding whether or not to take a venture debt, make sure to keep this detail in mind.
Advantages of venture debt for a company
Venture debt is critical to most entrepreneurial companies. Startups use venture debt as a multipurpose tool in their growth strategy. Let's discuss the 3 excellent advantages of venture debt for your company.
1. Helps extend the runway of the company
The venture debt can extend the cash runway of the startup until the next round of funding. Existing investors benefit from less equity dilution, too, along with the company.
2. Helps extend the runway to cash flow positive
The venture debt can extend a company's runway to be cash-flow positive. This is a great way to reduce debt as it reduces equity dilution for both employees and current investors. It helps the company move forward during a critical period of growth.
3. Provides a cushion for what can go wrong
The venture debt can serve as a security for when something goes wrong. It helps the company till it gets on track.
Disadvantages of venture debt for a company
The grim possibility of not achieving your target within the time frame you set out for.
The risk of defaulting on repayment of debt. Usually, the loan agreements include a set of criteria for the business to follow. Not meeting these could be detrimental for startups.
Venture debt is not applicable for companies that have picked up angel investments.
I hope this blog was of help to you in your research. Make sure to keep the things mentioned above in mind before making a decision. Do your research well and don't rush into anything; decide carefully when venture debt is right for your business. All the best!
We at OpenGrowth, are committed to keeping you updated with the best content on the latest trendy topics from any major field. Also, both your feedback and suggestions are valuable to us. So, do share them in the comment section below.