How does venture debt compare to traditional loans for startups?

Back in 2017, Cozmo, a miniature toy robot made by Anki, was the best-selling toy on Amazon in the United States, France, and the United Kingdom. However, just two years later, Anki had to shut down because a funding deal fell through at the last minute. Despite its early success and raising over $258 million, the robotics startup had to shut down because of a lack of funds.

This instance highlights a critical lesson for startups, which is that relying solely on equity funding can be risky. To mitigate such risks, startups should consider using traditional loans and venture debt in conjunction with equity funding.

In this article, we will explore what venture debt is, its benefits, and how it differs from traditional loans.

What is venture debt?

Venture debt is a form of startup financing extended by banks and non-bank lenders backed by venture capital firms. It is a common misconception to think that it is meant to replace equity funding. It merely extends the timeline for reaching the goals set in previous funding rounds when funds raised prove insufficient.

Note: Typically, the amount of venture debt that a lender would extend ranges between 20% to 40% of the funds raised in the previous round.

If a startup raised $2 million from venture capitalists in its Series A funding round, it could receive $400,000 to $800,000 in venture debt funding. Typically, this has a tenure of 2 to 5 years which includes an interest-only period of 3 to 12 months. So, if you secure venture debt on 1st January 2025, you may pay only the interest until 1st July 2025.

Venture debt lenders limit their client base to startups that have already raised funding owing to the lower perceived risk. The reasoning is that such startups were subjected to a high degree of due diligence which yielded positive results and currently, shrewd and seasoned industry professionals and fund managers are overseeing their operations. Given the high-risk nature of startups, to secure venture debt funding, startups must abide by certain clauses in the agreement referred to as covenants and provisions.

Covenants and provisions in venture debt agreements

• Financial reporting covenants – This is a very common debt covenant that exists in the venture debt agreement, the borrower may be required to periodically share its financial statements in the prescribed format and report key metrics specified by the lenders.
• Insurance covenants – This covenant imposes a duty on startups to actively mitigate foreseeable risks by subscribing to the protection of insurance schemes.
• Covenants against additional debt – If a lender believes that the venture debt being extended will exhaust the borrower’s ability to repay, they may include a covenant against additional debt.
• Asset lien provisions – In venture debt, liens are legal claims over specific assets of the borrower. These claims are exercisable in the event of a default and allow the lender to seize or sell said assets.
• Cross-acceleration provisions – The cross-acceleration provision requires the borrower to accelerate the repayment of all debts if one debt is accelerated. This provision is meant as a protection against borrowers favoring the repayment of other debts than their venture debts.
• Cross-default provisions – These provisions require the borrower to default on all debts if one debt is defaulted on. This provision is meant to dissuade borrowers from defaulting only on their venture debt obligations.

Some venture debt agreements may also require startups to achieve certain performance metric milestones during the tenure as per a set timeline.

What kind of traditional loans are available to startups?

Securing traditional loans can be challenging for startups due to limited financial history, and unstable revenue streams. Most traditional banks and financial institutions will prioritize prospective borrowers with established creditworthiness and stability, making traditional loans like term loans and lines of credit inaccessible for startups.

However, startups may have a much better chance of securing certain other traditional loans such as:

• Secured loans – Given the high risk of failure and financial instability associated with startups, they have a better chance of receiving secured loans rather than unsecured loans. Typically, startups will put up assets like machinery and equipment, real estate, and intellectual property rights as collateral to receive such loans.
• SBA loans – The US Small Business Administration (SBA) acts as the guarantor in SBA loans which can be used for starting a business, purchasing commercial real estate, acquiring other businesses, expanding into new locations, and many other business purposes. In a 7(a) loan, which is the most common type of SBA loan, the US SBA extends a guarantee of up to 85% for loans of up to $150,000 and up to 75% for larger loans.
• Equipment financing – Equipment financing is a form of secured loan that can allow startups to purchase any tangible asset other than real estate. In some cases, equipment financing may be structured as a lease which is beneficial for expensive equipment that may become obsolete quickly or has a short useful life.

What are the key differences between venture debt and traditional debt?

The following table summarizes the key differences between venture debt and traditional debt.

Eqvista – Helping Startups Take Flights!

Venture debt provides valuable funding for startups, offering flexibility through interest-only periods. While it comes with certain disclosure requirements, performance milestones, and terms regarding debt acceleration, these are often objectives the startup should already be striving to achieve.

Instead of putting up collateral as they must in traditional loans, startups can secure venture debt by issuing warrants that are only exercised in case of defaults. These warrants also ensure that the lender’s interests align with the startup’s interests. In contrast, traditional loans are generally not accessible to early-stage startups but offer simpler terms when available.

Thus, venture debt allows startups to strategically extend their runway to achieve their growth objectives. In partnership with Cheqly, Eqvista is helping startups secure venture debt. Contact us to know more!