Role of Venture Debt in a Startup Growth
Typically, venture debt is offered to startups that have successfully completed several venture capital equity financing rounds.
Despite a recent increase in startup companies using venture capital, the concept of “venture debt” is still unfamiliar to most entrepreneurs. The use of this debt has skyrocketed in recent years. It’s possible that venture debt can be a good way for some startups to supplement their VC funding and boost their cash flow while also diluting their remaining equity to a minimum. However, there are trade-offs, and you need to learn the fundamentals before making a decision.
Venture Debt in Startup Growth
There’s no need for collateral for this debt because startups typically lack substantial assets that can be used to secure loans. Lenders are compensated for the high risk of the debt instruments by receiving warrants on common equity from the company as collateral.
What is Venture Debt?
Venture debt is a financing option for VC-backed startups that allows them to borrow money to raise capital. In contrast to conventional business loans, this debt is less dependent on factors such as accounts receivable, inventory held, or cash levels, making it more flexible. As a result of this, the venture debt and startup growth model focus more on the relationship between a company and its VC investors.
On the other hand, the size of a conventional loan will be determined by the projected ability of a company to repay the loan, which can range anywhere from 20% to 35% of its most recent equity round.
Types of Venture Debt
There are three types of venture debt that are most commonly used, namely growth capital, accounts receivable financing and equipment financing. The main differences between these three types are as follows:
- Growth Capital – Typically short-term loans are used for M&A activity, milestone financing, or working capital between equity rounds.
- Accounts Receivable Financing – Accounts receivable borrowings on the company’s balance sheet. Recourse and non-recourse receivables can be sold. Accounts receivable financing is also known as invoice financing.
- Equipment Financing – Obtaining financing for the purchase of equipment such as a network. The repayment period usually corresponds to the expected lifespan of the provided equipment.
Venture Debt vs Venture Capital
Venture debt and venture capital are two different types of financing. As a result, this debt cannot be used as a substitute for venture capital. Venture debt is used to supplement venture capitalists’ equity funding. Because of this, a new business must first secure venture capital before engaging in debt negotiations.
A startup cannot rely on this debt to fund its expansion or provide an exit. The company, however, has the option of using this debt to delay or omit the next round of financing. When venture capital is provided to a startup, venture capitalists take a significant equity stake in the company, whereas when this debt is provided, venture capitalists do not.
Instead, the debt is repaid in accordance with the agreed-upon interest rate. As the debt is convertible into equity at an agreed-upon price, it costs less than venture capitalists would charge if VCs financed it.
How Does Venture Debt Financing Work?
Unlike traditional loans, venture debt has its own set of rules. A short to medium-term loan is involved (up to three or four years). A company’s last round of equity financing is typically used to determine the principal amount of its debt. 30 percent of the total equity capital raised in the most recent funding round is a common principal amount.
Interest payments are common in venture capital financing. Either the prime rate or a different interest rate standard, such as LIBOR (London Interbank Offered Rate), is used to calculate the repayments. To make up for the high default risk, lenders who use this debt financing receive warrants on the company’s common equity. The total value of the warrants distributed typically represents 5% to 20% of the loan’s principal.
You can sell your options at the last equity financing round’s price per share to get common stock in the future. Compared to the value of the company’s common stock, warrants are often the best option for borrowers.
Why do Startups Raise Venture Debt?
Venture debt funding for startups has distinct advantages as it provides additional capital without requiring a significant equity commitment from the startup. However, startups can use this debt as a short-term solution to unexpected events, such as operational problems, difficulties in raising capital, or short-term market downturns.
- To Extend the Cash Runway – You can get more favorable terms on an equity raise by using debt to extend your cash runway for a few more months. In the absence of a strategy for deploying capital, taking on debt can damage your company’s long-term viability.
- For Insurance Policy – This debt has many uses, including performance insurance, a lower-cost runway extension, funding for acquisitions or capital expenditures and inventory, or a short-term bridge to the next equity investment round. VCs, in particular, will have a wide perspective on this debt and can introduce you to the players, so you should talk to your board before raising this debt.
- For Profitability – Given that venture debt is intended for companies that prioritize growth over profitability, the venture lender wishes to emulate the actions of known and trusted investors rather than risk lending to an unbacked venture.
Uses of Venture Debt in Startups
Appropriate use of venture debt is that it can help companies reduce their capital requirements and thus reduce their dilution risk, extend their runway, and/or speed up their growth at a minimal cost. A company’s ability to raise capital in the future may be hindered by debt if it is misused or with unfavorable terms.
It’s possible to use this debt in the following situations:
- Acceleration of growth without taking equity when a company needs additional capital.
- Additional funding can be provided in conjunction with or following an equity round.
- The purchase of new machinery or equipment.
- To make purchases; or
- When an equity round cannot raise the required amount of money.
What do Investors Evaluate in Startups Before Investing?
Debt lenders conduct a rigorous underwriting process to determine the best investment option for startups. There are a number of factors that underwriters take into account when reviewing a company’s application for financing.
Investors want to know if the startup is well-positioned for future equity rounds so they can repay their debt. The company’s life stage and capital strategy are also considered.
The fees, warrants, and interest payments of venture capitalists are how they make their money. Traditional business lenders are reluctant to lend to them because startup businesses are considered too risky, and the lenders don’t want an equity stake in the company. On the other hand, this debt financing can be converted into equity at the time of an IPO or acquisition, resulting in a significant return for the lender.
Lenders still consider Late-stage companies’ ability to raise non-dilutive capital. As a result, they are more attractive to new investors and lenders because they have achieved significant financial performance and product development milestones.
Pros and Cons of Venture Debt
Venture debt isn’t a direct replacement for venture capital-backed equity rounds, and it has a lot of important things to think about for startups who want to use it. This debt has significant benefits and some disadvantages for startups.
- With less equity dilution, entrepreneurs retain more of their company’s ownership while still gaining access to additional capital.
- The use of venture capital enables small businesses to extend their cash flow. To put it another way, between equity rounds, they can meet certain milestones set by VCs.
- Venture debt can help startups that are facing short-term or unexpected market conditions stay afloat. This means that the money can be used in a more flexible way than other sources.
- Companies can use this debt in order to postpone raising additional equity rounds until they have a higher valuation or better terms in the market.
- A startup with significant venture debt repayments may have difficulty obtaining VC funding. There will be an abundance of time spent on debt repayment rather than finding new ways to grow the business.
- No value-adds like access to networks, partnership opportunities, or business advice are provided by venture capitalists in this form of investment.
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