What is Venture Debt and how does it compare to Venture Capital?

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Many people may have heard of Venture Capital, but Venture Debt may not be so familiar. Like Venture Capital, Venture Debt can be a viable source of capital for startups and also a way for astute investors to add to their investment portfolio.

What Is Venture Debt?

Put simply, Venture Debt is a loan from a lender to a company. In some ways, it is similar to a conventional loan from a bank, since there is a principal amount ,an agreed interest rate and regular repayments. However, the terms and conditions of a Venture Debt agreement can vary greatly compared to a conventional bank loan. Venture Debt is a way for startups and early-stage companies to access capital without having to give up significant equity, or in some cases, any equity at all.

Uses of Venture Debt

Venture Debt is generally utilized to fund growth rather than to maintain operations. The money might be used to purchase equipment, carry out research and development, employ a sales team, build a marketing strategy, or other similar activity to expand the business and grow revenue. Another common use of Venture Debt is for a startup to extend their “cash runway” between rounds of raising equity. This refers to the amount of time a startup can operate on their existing cash reserves before they require another capital injection.

For example, if a startup is holding $1.2m in cash and their cash “burn rate” is $100k per month, then their cash runway would be twelve months. This represents the amount of time the business can continue to operate without raising additional financing. Venture Debt can be used to extend that length of operating time to drive growth and potentially enable the startup to hit some benchmark performance indicators, which may in turn lead to a higher valuation at the next equity round.

Ideally, Venture Debt would not be used to fund operational activity or for ongoing working capital, because the repayments may not be sustainable, and it could negatively impact future equity raising. And there may be other, potentially cheaper ways to fund working capital.

Debt Follows Equity

It is important to note that Venture Debt is not a replacement for Venture Capital. In fact, Venture Debt is typically not accessible for startups who have not successfully secured Venture Capital, hence the expression “Debt follows Equity”. This is related to both the due diligence process and the level of confidence in the business, because venture lenders often use the evidence of a Venture Capital investment as an indicator of startup potential and capability.

Simply put, if a VC firm does not have sufficient confidence in a business to invest equity, then it is unlikely that a venture lender would get involved. Venture Debt and Venture Capital can be a good combination for startups that leverage the best of both worlds. It is generally considered to be good timing to access venture debt shortly after, or even in conjunction with, an equity round.

How Is Venture Debt Structured?

There are no hard and fast rules mandating how Venture Debt is structured. Many possibilities are available in these non-standard lending arrangements because it is a direct agreement between a lender and a borrower, meaning the terms and conditions can vary greatly between different lending deals. Some key considerations of a Venture Debt agreement are discussed below:

  • Seniority: The single most important condition associated with Venture Debt is Seniority because this determines where the debt sits in priority of repayments in a liquidation event. The lender will want to ensure they are first in line for any repayments in the event the borrower falls into financial difficulty.
  • Term: Loan terms are typically short to medium term, say up to four years.
  • Repayments: Regular repayments are generally required, sometimes with an initial period of interest-only, followed by principal and interest repayments.
  • Interest rate: Venture debt can be expensive, with high interest rates because of the high risk associated with providing funding to startups and early-stage companies and the subsequent risk of failure. Depending on the operational status and success potential of the startup, interest rates could be in the range of 10% to 20% p.a.
  • Loan amount: The maximum loan amount is generally linked to the amount of the most recent equity round, with loan amounts typically in the range of 25-30% or even up to 50% of the latest amount of equity raised.
  • Collateral: Collateral (also called Security) is often required, which could include a company’s Intellectual Property (IP), source code, patents, customer relationships, etc. Often these are intangible assets rather than tangible assets like real property, which a startup may not have. Note it is possible that a Venture Debt deal may require no collateral.
  • Warrants: Stock warrants are often provided to the lender, allowing them to purchase shares at an agreed price at some point in the future so they can benefit from potential upside if the company’s share price is higher than the warrant price in a liquidity event.
  • Multiples: Principal multiples are sometimes included, where the borrower may need to repay a multiple of the principal, e.g. 2x or 3x the principal.
  • Default conditions: Conditions detailing what happens in the event of a default are included, detailing legal recourse options such as collection of collateral, taking over the business, etc.

Venture Debt vs. Venture Capital (Equity Funding)

There are some key differences between Venture Debt and Venture Capital (equity funding), as highlighted in the following comparison table.

Equity dilution

Minor dilution may occur in a liquidation event if stock warrants form part of the dealSignificant dilution occurs
Investment timeframe1-4 years5-10 years or more
ValuationsCompany valuation is not required – often the valuation from the prior equity round is usedCompany valuation is required
Cost of capitalPre-agreed fixed rates Fluctuates over time, depending on valuation
RepaymentsRegular, structured repayments are requiredRegular repayments are not required
TimingOccurs after initial equity rounds, and some companies may already be generating cash flowCan occur at any stage of the startup’s lifecycle
Capital recoveryRepaid regularly over the life of the loanRepaid at a liquidation event when the investor sells equity
Due diligenceThe due diligence process is often not overly detailed, with some reliance often given to the due diligence from previous equity rounds Rigorous due diligence is generally carried out
Board seatsBoard seats are typically not requiredMajor investors often require board seats

What Parameters do Venture Debt Funds Consider Before Lending?

There are a number of venture debt lenders active in the marketplace, including some banks and specialist venture debt funds. Prominent venture lenders include Silicon Valley Bank, Franklin Templeton, Signature Bank New York, Trinity Capital, Western Technology Investment, and TriplePoint Capital. Venture lenders will consider a number of parameters associated with the borrower before investing, including factors such as:

  • Industry strengths and opportunity
  • Market strength and opportunity
  • Existing investors
  • Revenue model and margins
  • Founders and key management
  • Ability to scale up
  • Liquidity / cash position
  • Corporate governance
  • Operational stage
  • Ability to generate ongoing cash flow

How Can Investors Invest in Venture Debt?

Investors can access Venture Debt investments by investing with a specialist Venture Debt fund or an alternative Investment platform such as Propel(x).

How do Venture Lenders Make Money and how do they Manage Risk?

Venture lending is a risky undertaking, with potential for complete loss of capital. However, Venture Debt may be seen by some as lower risk than Venture Capital, because of the ability to include favorable terms for the lender, such as seniority, collateral, and regular repayments. Venture lenders have the potential for upside via instruments such as stock warrants that allows them to participate in a valuation uplift in a liquidity event.

Who Should Invest in Venture Debt?

High net worth individuals and investors interested in alternative Investments could consider investing in Venture Debt. For more information about alternative Investments and things to consider, you can find out more in the Propel(x) article What are alternative investments and should I have some in my portfolio?

Why Would a Startup Raise Venture Debt?

As noted earlier, a startup can benefit from Venture Debt by gaining access to capital without giving away too much equity, and to extend their cash runway before the next equity round in the hope of achieving a higher valuation. This may be a particular priority if the startup is facing a “down round” on the next capital raise, which could occur if their financial performance is below expectation. This could trigger a drop in valuation that may have serious implications for investor sentiment and stock dilution.

Venture Debt Caveats

It is critical for investors and startups to remember that Venture Debt is a liability that must be repaid. It has the potential to be a drag on future equity investment because adding debt to a company’s balance sheet can be seen in a negative light by some investors. It is also important for borrowers to check the background of a lender and assess the risk of loan default and the corresponding risk of losing all the company’s assets. Experienced investors with large balance sheets may be a better option than an opportunistic lender who may be more inclined to take over a business in the event of a loan default.

The Future of Venture Debt

The venture debt market has continued to develop since its emergence in 2008. With increases in Venture Debt lenders and deals, loan terms have become more favorable, which continues to make it more attractive to startups and investors alike. While Venture Debt is not a replacement for Venture Capital, it looks set to continue growing in popularity as a viable source of capital for startups and early-stage companies.

As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return.

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