What are the risks and benefits of venture debt for startups?
By Katerina Mansour - 02 March 2023
To grow a successful business, odds are you’ll need to seek external funding at one point or another. Luckily, startups benefit from access to a rather large variety of potentiel investors today. Among these, Venture Capital (VC) investors have played a significant role in the startup ecosystem. However, after a few years of intense VC funding, with huge valuations and exorbitant ticket sizes, the market has shifted. VCs are tightening the purse strings and being more conservative with their investments. According to Pitchbook, from Q3 2021 to Q3 2022, VC funding for startups fell by 54%. As a result, startups are turning towards the other funding methods at their disposal, such as venture debt.
What is venture debt?
Venture debt is a type of loan aimed at venture-backed startups seeking to secure funding without sacrificing a significant amount of equity. It gives early-stage and high-growth startups access to capital that supplements a previous equity round. The providers of venture debt loans will typically be specialised banks or non-bank lenders. However, many entities have come to offer these types of loans. There are several different ways to structure venture debt that will depend on the type of investor you are working with and the reasons you are seeking funds.
Growth capital term loans are a common form of debt. Usually structured over three years, they require monthly payments at a fixed interest rate. Startups can also seek debt as a line of credit, borrowing up to a certain amount of money and only paying interest on the money they borrow within that limit. Secured, unsecured, MRR-based – lines of credit can come in different forms. Equipment financing (borrowing to finance costly assets with a repayment period often based on its expected life) and royalty-based financing (a loan based on the startup’s future revenue with repayments that fluctuate based on performance) are also common forms of venture debt. Other more hybrid forms of funding incorporate aspects of both debt and equity, such as convertible debt, which comes with the option of converting the debt into equity at a specific point in time.
What is the difference between venture debt and venture capital?
There are several critical differences between venture debt and venture capital that entrepreneurs should have in mind when deciding which option to go with.
Venture capital is open to all companies regardless of their prior funding. Venture debt, on the other hand, is for fast-growth startups that have already received VC funding. The goal for most companies seeking venture debt is to secure cash that will extend their runway while they wait for their next round.
Equity and investor control
VC investors become shareholders in a company and often ask for a seat on the board to have more control over the direction it takes. After all, if the company experiences success, the VC will reap the benefits at its exit. This isn’t the case with venture debt. Those lending venture debt don’t become shareholders involved in the management of the borrower’s business. They may provide advice on your company’s finances, but they won’t have any control over your company beyond what you signed off on in your debt agreement.
Venture debt is a loan that needs to be repaid over time whereas VC money is provided in exchange for equity. Venture debt lenders make their money through interest payments, fees and warrants. On the other hand, venture capitalists make their money by selling equity during an exit opportunity (e.g. upon acquisition or IPO). Entrepreneurs seeking debt must therefore ensure they can withstand the pressure of recurring payments.
Time and ease of access
Raising VC funding comes with a more extensive due diligence process and requires a valuation of your company. Furthermore, it takes time, a lot of pitching and extensive meetings to even find the VC investors that are interested in and right for your business. In general, securing VC funding is therefore more time consuming than it would be to secure venture debt.
Key advantages of venture debt funding
There are certainly many advantages to debt funding. Many entrepreneurs will seek this type of financing as it enables:
Preserving equity and control
Debt costs less than equity. While some forms of venture debt can lead to a small amount of equity being given to investors, it’s minute compared to the large portion of equity venture capitalists will seek in exchange for an investment. By raising debt, startups can avoid further diluting their shares in their business. Furthermore, debt investors won’t require a seat on the company’s board.
Accessing investments structured to your needs
As previously mentioned, venture debt loans come in many forms. As a result, entrepreneurs can pick the type of loan that fits best with their situation and their needs. Moreover, with venture debt entrepreneurs will often benefit from more flexible terms than with loans provided by traditional banks in terms of covenants, guarantees and amortization.
Extending your runway between rounds
Not only does preparing a round of VC funding take time in itself, so does getting your company to a favourable position for another equity round. Venture debt comes in as a great solution in these situations to extend your runway until you’re ready for your next round. Receiving a venture debt loan will also typically come with less paperwork and stringent qualifications than traditional bank loans and thus be easier to obtain.
Key disadvantages of venture debt funding
Of course, every entrepreneur should weigh the pros and the cons before making a decision when it comes to funding their business. As is the case with any form of financing, venture debt comes with drawbacks depending on your company’s current situation and needs.
High interest rates
Venture debt typically comes with higher interest rates than traditional loans. This is because the lender is taking a risk by investing in a company is not established yet. Indeed, startups will face interest rates ranging from 10 to 20% for their loan.
Repaying debt can be a deterrent to the growth of your company. You’ll need to ensure your company will have the cash flow necessary to make these repayments while still growing and reaching your anticipated milestones. If your company is unable to repay the loan you took, there will be consequences that could be quite costly for you and your business.
Risk of default and penalties
Debt covenants help investors mitigate risks but can be hard for a startup to live up to. By definition they dictate what a startup must and must not do, and any violation of a debt covenant could ultimately result in the investor declaring default on the loan, applying penalties, or requiring the borrower to pay the loan in full immediately. It is therefore vital for you to carefully examine and consider the covenants in your loan agreement before signing.
Ultimately, while many are turning to venture debt in response to the slow-down in VC funding, there are important risks to consider. Taking on debt can help you reach milestones on your roadmap faster or could put a wrench in your startup’s growth. While debt may seem like an easier pill to swallow than giving away a significant chunk of your company’s equity, it’s important to carefully weigh the pros and cons. You should only take on debt if you’re fully confident in your ability to repay it. If you have a high cash-burn, an unreliable and variable revenue stream, or the debt payments would represent a significant portion of your operational expenses (>20%), debt may not be a good option for you.