What Venture Loan debt costs

It's no secret that entrepreneurship and venture capital have become synonymous with innovation and growth these days. Early stage companies are constantly looking for ways to finance their R&D and operations. For startups looking to avoid selling equity, after having already raised funds for example, a venture loan may be the solution. Originating in the 1980s in the United States, a venture loan is a specific type of finance for startups and growing businesses that is similar to a traditional loan, but with features tailored to the specific needs of this type of business and specific risks for the lender.

While risk loans can be an attractive source of finance without committing to more traditional funding arrangements, soaring interest rates make this solution not insignificantly expensive. So let's take a closer look at how venture loans work.

Understanding venture loans

Who can benefit from venture loans

Before we dive into the specifics of the cost of debt for venture loans, it is essential to understand what venture loans are. A venture loan is a type of financing specifically designed for early-stage companies that have not yet reached profitability but are close to it.  Venture loans are mainly aimed at businesses generally considered too risky for traditional loans, but with a certain level of maturity and traction. It offers more flexibility and less stringent requirements. Venture loans are typically provided by venture capital firms or other private investors seeking to diversify their sources of revenue and broaden their investment portfolio.

How it works

In general, venture loans for startups can range from €200,000 to several million euros. It is common for these loans to be structured according to company milestones or specific financial achievements. As businesses demonstrate greater growth and revenue potential, venture loan amounts may increase accordingly to help support larger projects or expansion efforts.

The term of venture loans also varies depending on several factors, including the financial health of the borrower, the size of the loan and the lender's policy. However, the average term is between 3 and 5 years. This allows early-stage companies to have sufficient runway to use the capital for growth before starting to repay. Some venture loans may also include features such as interest-only periods or balloon payments at the end of the term, offering additional flexibility to the borrowing company. It can also include share warrants (BSA) that allow investors to buy shares in the startup and earn an additional return. In the specific case of a convertible loan, however, the debt can be converted into shares.

Focus on the convertible loan

In the case of a convertible venture loan, the investor has the option of converting the loan into a share in the company instead of being repaid, which is similar to an equity mechanism. This can be done at any time during the term of the loan and by various methods, such as a share exchange, share purchase or cash conversion. This gives the investor the opportunity to participate in the growth of the business and potentially earn a higher return if the business succeeds.

The cost of debt for venture loans

The cost of debt for venture loans refers to the interest rate and fees associated with borrowing money through this financing option.

Interest rate

The interest rate for venture loans can be determined by the company's creditworthiness, market conditions, and the lender's risk tolerance. Venture loan interest rates are often higher than traditional loans due to the increased risk involved with lending to startups. However, they may also be lower than other forms of financing like equity investments, as they do not require dilution of ownership.

On average, the interest rates for venture loans can range from approximately 9% to 14%. The variation largely depends on the economic climate. It's important for startups to assess these rates carefully, as the cost of capital can significantly impact their financial runway and operational strategy.

In 2011,Square (since renamed Block), the payment solutions company co-founded by Jack Dorsey, secured a venture loan that highlighted the potential benefit of this financial instrument. Square raised $100 million in venture debt from Victory Park Capital amidst their rapid growth stage. Although the specific terms and interest rate were not publicly disclosed, the deal exemplified a strategic move to bolster their balance sheet without diluting existing equity holders' shares. The venture loan provided Square with the operational flexibility to expand their product offerings and market presence, ultimately contributing to their success and IPO in 2015. This example shows how venture loans can be successfully used by companies with high growth potential to raise additional capital without sacrificing equity.

Fees

In addition to interest, venture loans may also include various fees, such as origination fees, commitment fees, and prepayment penalties. These fees are meant to compensate the lender for the time and resources spent evaluating and managing the loan. Borrowers should carefully review and negotiate these fees before signing a loan agreement to ensure they are not paying more than necessary.

Impact on financials

The cost of debt for venture loans can have a significant impact on a company's financials. The interest and fees associated with this type of financing can increase the company's expenses, potentially impacting its profitability. However, if used strategically, venture loans can also provide a boost to the company's financials by providing the necessary capital to fuel growth and generate higher returns. For instance, it can be used as a safety valve when a company is not performing as expected and does not have enough cash to last between fundraising rounds. If a company is not performing as expected, it is likely to raise funds at a lower level. Venture debt could have helped bridge the gap until the company was back on track.

Finding the best possible deal

Considerations for borrowers

Before deciding to take on a venture loan, borrowers should carefully consider their ability to make timely payments and manage the added financial burden. It is essential to have a solid repayment plan in place and to closely monitor cash flow to ensure the loan can be repaid on time. A venture loan should not be taken out too early, because in the early stages a company needs cash to build up a team, create a product and find clients. As the return on investment is not immediate, the company burns its cash every month and generally does not have the means to repay a loan other than by refinancing it, either with another loan or a new equity injection.

Risks for lenders

Lending to startups is inherently risky, as many new companies fail within their first few years of operation. As a result, lenders can mitigate this risk by requiring personal guarantees or security from the borrower or by opting fora convertible loan. Additionally, lenders may also conduct thorough due diligence on the borrower's financials and business plan before approving a loan. This means that borrowers with a lower credit rating or weaker financials may end up paying a higher cost of debt for their venture loan. On the other hand, borrowers with a strong credit profile may be able to negotiate lower interest rates and better loan terms.

To help financial institutions mitigate their risk-taking, ScaleX Invest offers a scoring solution for businesses as well as a portfolio monitoring module to track the performance of a wide range of investment lines.

Thanks to its backtesting work, ScaleX Invest's data teams are able to assert that only 2% of all companies scored in the top 10% of our database go bankrupt within 36 months, while 38% of companies scored in the bottom 10% have gone bankrupt within three years following their analysis.

Prevailing market conditions

The cost of debt for venture loans is also influenced by market conditions such as the current interest rates set by central banks, inflation rates, and overall economic stability. In times of low-interest rates, borrowers may secure more favorable terms for their venture loans. On the other hand, in times of economic uncertainty or higher interest rates, lenders may be more cautious and charge higher interest rates to mitigate their risk.

When considering a venture loan as a financing option for young company, it's important to carefully evaluate the cost of debt along with other factors such as repayment terms and requirements. While venture loans can provide much-needed funding for startups, they may come with a higher cost of debt compared to other financing options.

For the banks and financial institutions on the other side of the negotiating table, the challenge is to turn a simple request for finance into a potential partnership, creating long-term value. ScaleX Invest with its scoring solution is the partner of choice for limiting their risk exposure. Our SaaS solution helps them to become anchors of innovation rather than obstacles to progress.