What is venture debt? How does it work?
In order to better understand venture debt terms and how it works, let’s take a deeper look.
Venture capital may be the most common method of raising money for startups. It has become a popular financing option for startups over the years, prompting some to wonder if this is the new form of venture capital.
Venture Debt financing
Specialized banks or non-bank lenders provide debt financing to venture-backed companies to fund working capital or capital expenditures, such as equipment purchases. In contrast to traditional bank lending, venture debt is available to start-ups and growing businesses without positive cash flow or significant assets to use as collateral. Venture debt providers bundle their loans with warrants or rights to purchase equity to mitigate the higher risk of default.
Entrepreneurial companies can use venture debt as a source of financing. Debt financing is an excellent complement to equity financing because it provides growth capital to extend the startup company’s cash runway while minimizing equity dilution for investors and employees.
What is venture debt?
When a startup or early-stage company needs money, it may turn to venture debt. In most cases, this type of debt financing is used to supplement equity venture funding. Banks and non-bank lenders can both provide venture capital financing.
Venture debt and its considerations
Due to the lack of substantial assets that can be used as collateral, venture debt does not require any form of collateral like traditional forms of debt financing. For the high-risk nature of the debt instruments, lenders are compensated with the company’s warrants on common equity rather than collateralized by them.
If a startup has successfully completed several venture capital equity funding rounds, it is more likely to receive venture capital debt financing. Conventional loans are not available to these businesses because they lack sufficient positive cash flow to qualify. In order to meet anticipated milestones and acquire the necessary capital assets, these companies rely on financing.
Types of venture debt
Many types of loans fall under venture debt, including capital revolvers and synthetic royalty loans. In general, loans fall into the following four categories:
- Growth capital – Loans that can be used for any business purpose are referred to as growth capital. There is a blanket lien on the company’s assets, which may or may not include a lien on the intellectual property when a company takes outgrowth capital loans.
- Accounts receivable financing – Accounts receivable financing is the sale of receivables to a third party at a discount in order to accelerate cash receipt. The discount is the fee that the third-party buyer charges for its services. In determining the amount, the customer is notified of the sale, and the factor is in charge of the collection. Receivables can be sold either recourse or non-recourse. Invoice financing is another name for accounts receivable financing.
- Equipment financing – In the majority of cases, equipment financing is used to acquire expensive capital goods. In most cases, the repayment period matches the expected lifespan of the equipment provided. For asset-free SaaS (Software as a Service) companies, equipment financing is not very useful.
- Royalty monetization – Depending on how much money the borrower expects to make in the future, the royalty monetization they receive is calculated. The loan payments fluctuate in relation to a predetermined multiple of the original loan as the borrower’s revenue performance changes. Non-dilutive and non-minimum principal payments are just two of the advantages of this type of financing. In order to attract royalty-based financing lenders, the borrower must have generated revenue and have a high gross profit margin.
Structure of venture debt
A “non-convertible debenture” is the underlying instrument of venture debt (NCDs). In NCDs, the borrower gives the lender a coupon-bearing instrument in exchange for a loan.
An equity warrant is another instrument the lender holds in addition to this coupon-based instrument. It is a form of financial security that gives the holder the right but not the obligation to invest in the company’s stock at a predetermined price and a predetermined time frame.
Benefits of venture debt financing
In what situations is venture debt a better option than a round of equity financing? It can provide a buffer against future financial risks and extend the current funding cycle’s cash flow horizon as a safety net. Equipment purchases, hiring new employees, and day-to-day financing operations all necessitate adequate (and quickly available) capital.
- Companies can reach growth milestones – Venture debt is used to accelerate growth to a point where more affordable capital is available.
- Debt invariably costs less than equity – Venture debt terms are structured in a way that is more favorable to the borrower.
- Startups can focus on profitability rather than immediate growth – When it comes to debt financing, the focus is solely on the company’s financial viability over a predetermined period rather than the company’s long-term growth potential.
- Loans from venture debt lenders are flexible and work well with borrowers – There are no “rockstar” requirements for the borrower in terms of cash flow, debt-to-income ratio, or top-level leadership structure. Small and large banks do not have the resources or expertise to keep tabs on startups, so it is probably for the best.
Venture debt financing vs Equity funding
Equity financing and debt financing are the two primary sources of capital available to companies seeking to fund their operations. Most businesses use debt and equity financing, but each has its own advantages. To begin, equity financing does not have a repayment obligation and provides additional working capital that can be used to grow a business. Deferring repayment of debt does not necessitate a transfer of ownership interests.
Key differences between venture debt and equity funding
For instance, company ABC plans to expand its business by building new factories and acquiring new machinery. For its expansion, the company concludes that it will need $50 million in capital.
In order to raise the necessary funds, Company ABC has decided to use a combination of equity and debt financing. It sells a 15% stake in its business to a private investor in exchange for $20 million in capital for the equity financing component. It gets a $30 million business loan from a bank with a 3% interest rate for the component of debt funding. The loan must be repaid over the course of three years.
A wide range of outcomes can be achieved by combining the above example in various ways. The owners of Company ABC, for example, would have to give up a greater share of future profits and decision-making power in order to raise capital through equity financing.
How does venture debt financing work?
The value of start-ups rises over time as they achieve major milestones. In most cases, the best time to raise capital is immediately following one of these valuation drivers, resulting in less equity dilution for the same amount of capital raised. Venture debt can help a company grow and meet its capital needs more effectively.
Listed below are the three primary factors on how venture debt financing works.
- Extend the cash runway – It is possible to extend a startup’s cash flow through venture debt. It secures a higher valuation for the next equity round by raising a smaller equity round. There would be less dilution for management and employees due to smaller equity raises and existing investors would benefit from less equity dilution and less cash needed to maintain their ownership interest.
- Positive cashflow – A company’s “cash flow positive” status can be extended by taking out venture debt. It can be used to eliminate a final round of equity financing for the company. Using debt to fund the company’s growth allows it to retain more of the equity of its current investors while also reducing the risk to new investors.
- Avoid losses – Venture debt can provide a safety net when a company doesn’t perform as expected and doesn’t have enough cash to last between equity rounds. A company will likely have to raise equity at a lower round if its performance is below expectations. The company could have used venture capital to bridge the gap until it got back on its feet.
Venture debt consideration before investing
A fund analyzes a number of important business and industry factors. Investment decisions are made based on a wide range of factors, including business metrics and operational parameters.
- The power of the company’s founders and top executives: The qualities that venture debt providers are looking for in a company’s founders include domain knowledge, vision, and the ability to build strong teams.
- Lenders are comforted by the quality of Venture Capitalists and their willingness to support the company in the future, which lends credibility to the company.
- A high-growth company with a well-established revenue model and healthy margins can strategically allocate debt to support its current operations and scale. Most importantly, a company’s path to profitability must be crystal clear.
- Businesses need a large and growing customer base, strong product-market fit, and a sound strategy for using debt capital in order to grow.
- The company’s ability to pay its debts. Financial prudence is demonstrated by efficient liquidity management and a strong liquidity position.
- The relationship’s scalability. Scaling a company necessitates a close working relationship between the company’s financial backers and management.
- The company establishes protocols to ensure the integrity of the data they collect. In the absence of data integrity, information would at best serve as a secondary source. The foundation of the relationship must be built on trust.
- A framework for corporate governance. Stakeholders in a company, including employees, investors, and other interested parties, must be kept in the loop openly and objectively. Governance standards show how the company’s affairs are managed and run.
Get your business valuation with Eqvista!
Venture debt is a flexible, efficient, and non-dilutive funding option for small and medium-sized businesses alike. In order to prepare for future equity financing rounds, startups can use this funding to lay a solid foundation, realize their full potential, and speed up their growth. A good venture debt lender is essential. Don’t rush into making a decision. Get expert’s help for business valuation to raise venture debt with Eqvista. To learn more about our business valuation services, contact us today.