In the world of startups, a variety of funding options exist for companies looking to foster growth or scale their operations. One of these options is venture debt financing. While it might not have the same amount of public visibility or recognition as other funding methods such as equity financing, venture debt still plays a key role in the developmental journey of many startups. A sizable number of them will turn to it at some point in their life cycle.
In this article, we’ll explain what venture debt is, how it operates, and what its future prospects are, including whether it could be a smart funding choice for your enterprise in 2024.
What Is Venture Debt?
In the simplest terms, venture debt is a form of debt financing provided to startup and growth-stage companies that have already received funding from venture capital (VC) firms and now need a financial injection to either hit the next milestone, finance a specific project, or simply extend their runway to the next equity round.
How Does Venture Debt Work? Components and Structures
Venture debt is provided as a loan (or a series of loans) that needs to be paid back — typically within three to five years. The venture loan is offered by a debt provider and includes an interest rate that can be variable or fixed, depending on the terms of the deal.
Venture Debt vs Standard Business Loans
One of the biggest differences between venture debt financing and a standard loans is that the interest rate of venture debt is typically higher than that of a regular bank business loan (but lower than the cost of equity financing, which we’ll get into in more detail below). The rate of interest is not the only distinction between a venture debt and a traditional bank loan, however. Unlike the latter, which typically requires proof of stable cash flow or considerable collateral — both of which many startups might not have — venture debt is structured around the future capital-raising potential of a company as well as its growth trajectory.
Consequently, venture debt is often seen as a riskier form of financing. Therefore, it’s typically provided exclusively by specialist banks and other entities that are conversant with the nature of startups and are therefore unwilling to take on the greater risk that venture debt entails.
Equity Warrants
These entities are then compensated for this greater risk with equity warrants from the firm taking on the debt. An equity warrant (also known as an equity kicker) essentially gives the venture debt lender the right to buy stock in the company at a specific price within a specific time frame.
Warrants can be extremely profitable for venture debt providers. If the startup succeeds and its value improves significantly, the lender can purchase its shares at a cheaper price than they are worth and then sell them later for a huge profit.
To avoid having to sell a lot of their stock at a lower price than its worth, most startups restrict the equity offered to venture debt lenders in the form of warrants to between 5% and 20% of the loan amount.
Covenants
In addition to warrants, some venture debts also include covenants. These are contractual agreements embedded within the loan terms that impose certain obligations or constraints on the borrower’s operations. Covenants can range from financial performance metrics, like maintaining a minimum cash balance, to operational guidelines, such as not taking on any additional debt until the next equity round. It’s an important aspect of the term loan agreement.
How Does Venture Debt Differ From Equity Financing?
The main difference between equity financing and venture debt is that debt does not significantly dilute the founders’ and other shareholders’ present equity stake. As the name suggests, equity financing involves exchanging a portion of the company’s equity capital for funding. Venture debt, on the other hand, is issued in the form of a loan, which means that founders and other early investors don’t have to give away some of their ownership in the company immediately to acquire funding.
What’s more, equity financing might also involve other concessions, like giving away a certain number of board seats to equity investors. With venture debt, companies don’t have to worry about this aspect
That said, both equity financing and venture debt serve distinct purposes in an organization’s life cycle. None is inherently better than the other. Venture debt should be used to supplement equity, not replace it.
Are There Risks To Venture Debt?
Venture debt, while offering numerous advantages for startups, also carries several inherent risks. One is the obligation to repay the debt regardless of the company’s performance. This can strain cash flow, especially for businesses yet to achieve profitability or those facing slower-than-expected growth. Furthermore, the dependence on future funding rounds for repayment of the debt adds an element of risk. A downturn in the fundraising environment could hamper the ability to secure additional capital.
Also, if a venture’s debts include covenants, it can limit your company’s operational flexibility. If covenants are broken, there’s a possibility of expedited payment demands from the venture debt lender, which can put your firm under even more financial strain. Additionally, venture debt can raise objectives with new investors in the next equity round. Some of them may not take kindly to some of their money being used to pay off previous debt.
Therefore, while venture debt funding can be a useful form of financing, it requires careful consideration of these potential downsides and a solid plan to manage them.
Is Venture Debt a Viable Fundraising Strategy for the Future?
The total capital raised in the venture debt market was estimated to hit US $59.2 billion in 2023. While this is lower than the previous year’s total of $62.1 billion, analysts believe that the venture market is actually growing and that this form of financing will continue to be a smart and viable option for startup and growth companies in 2024.
This optimism is fueled by two main key trends:
Increasing Availability of Capital from Current Lenders
With the startup environment thriving, venture debt lenders are starting to expand their offerings and increase their current loan volumes to meet the growing demand. Some lenders are also becoming more specialized, catering to specific types of industries, companies, or stages of growth. This puts them in a position to better meet the unique financing needs of their customers.
Rise of Alternative Lenders
The venture debt landscape is witnessing a significant shift, with traditional banking institutions, which have historically dominated this scene, now facing stiff competition from non-banking entities such as private equity firms, specialized debt funds, and venture capital funds.
These new players are more in tune with and have a deeper understanding of the startup environment. As a result, they can offer more flexible and innovative financing solutions that are better suited to the needs of evolving startups.
In a nutshell, these two trends suggest that venture debt will continue to be a valuable and accessible fundraising option for startups and growth companies in the foreseeable future.
Final Thoughts: Using CapLinked To Handle Your Deal
Venture debt offers a unique blend of flexibility and equity preservation, making it an attractive choice in the diverse landscape of fundraising strategies. As we’ve seen, it’s expected to remain a viable option for many startups and growth companies in 2024, thanks to the increasing availability of capital in the market and the rise of alternative lenders.
If your business is currently engaged in or planning a venture debt deal, CapLinked can be a valuable partner. Caplinked’s Virtual Data Rooms (VDRs) provide state-of-the-art tools for seamless document management and collaboration. These tools are complemented by advanced security features that ensure your confidential data remains protected throughout the transaction.
Discover the efficiency and security that CapLinked brings to your financial deals by enrolling for a free trial today.
Sean LaPointe is an expert freelance writer with experience in finance and tech. He has written for several well-known brands and publications, including The Motley Fool and Angi/HomeAdvisor.
Sources
Statista: Venture Debt Worldwide
Element Saas Finance: What is an Equity Warranty?
