Venture debt or venture debt financing is any type of financing provided to start-ups’ dependent on venture capitalists for funding and other operations. In this, a company can secure business startup loans instead of accenting funds from investors for shares in the company.
However, don’t mix venture capital loans with traditional loans. The two are entirely different. Venture debt financing is especially for businesses that do not have a positive cash flow or assets to put up as collateral. The businesses in this can seek a large amount without being backed by a guarantee.
Start-up business owners find it incredibly difficult to secure and manage finances, having so much on hand. Limited trading history and low productivity and success record make it challenging for them to secure funds through traditional loans. And owing to this, many start-up owners turn to investors for gaining funds for equity in the company.
But in a case where the company isn’t willing to offer equity for the funds or take up very bad credit loans with no guarantor from a direct lender, venture debt financing seems a promising opportunity in this case.
When should you consider venture debt financing?
There could be multiple reasons a start-up needs additional funds, but for venture debt financing, here are some of the most popular reasons:
- Innovative and rapidly expanding firm needing funds for growth
- For meeting working capital requirements
- For supporting capital expenditure – like equipment purchase and securing software license
- When a startup finds it hard to get funds from traditional sources
- Startups aiming at equity dilution
Apart from this, certain businesses have poor credit standing or constant bad credit and no guarantor direct lender loan rejections, making it difficult to fulfill business needs. Consider venture debt financing if you are facing any of the above situations.
What is the difference between Venture capital and Venture debt?
Venture capital is an investment firm that invests in an innovative and unique idea at the early age of business. They buy equity in the companies and operate as independent and private enterprises. These companies provide cash to the startups for a share in the startup. Investors here only gain profit when a company earns a profit or launches a successful IPO. Venture capitalists make money by selling the equity at the exit stage at a profit.
Venture debt is a debt that a startup seeks funds for through venture debt financing. In this, instead of seeking help from the company’s investors, the startup prefers taking a loan. Startups may consider venture debt financing when they are on the verge of expanding their business operations or growth opportunities.
In opposition to venture capital, startups have to repay the venture debt within the deadline. Here, venture debt lenders earn returns through interest payments, fees, and warrants. However, average venture debt returns are less than compared to venture capitalists’ returns. Venture debt collectors do not have a stake in the property like venture capitalists who have the equity.
How does Venture debt financing work?
Unlike business startup loans, venture debt financing DO NOT require a business to stake collateral. Instead, the loan is secured by the startup warrants on the equity. Venture debt financing is ideal for those companies who have been seeking funding from venture capitalists for good years but need capital to meet the urgent market requirement and notch up among the big floating startups in the industry.
The debt lenders provide funds for a short duration than other very bad credit loans with no guarantor from a direct lender.
Venture debt lenders lend funds for roughly about 3-4 years. An equity loan is provided based on the recent funding received by a start-up. These loans are also known as business lines of credit. Warrant distribution, in this case, represents 20% of the total value of the loan provided by the lender to the start-ups.
These warrants can be exchanged for shares. And therefore, lenders keep warrants as a security for the loan. These warrants yield promising returns in the future.
For repayments, most lenders ensure covenants, whereas some lenders are flexible and only take a small amount.
The start-ups may receive a higher loan amount compared to the equity or the state of cash in the company. However, the interest rates could be high in venture debt financing as compared to bad credit and no guarantor direct lender loans. Still, if you grow your start-up quickly without diluting your equity, it is indeed a great option to go for. However, if you are starting a company with minimal revenue and equity, you may find it hard to get financing.
What is the average default rate of a venture-debt portfolio?
According to statistics, the average default rate of a venture-debt portfolio in the UK is 2%”. The creditor releases the securities only after the complete loan repayment. VC-backed and exploring companies are therefore attractive to venture creditors.
As the loan is not secured by collateral, it is risky for both the creditor and the borrower.
And in some situations, startup companies end up receiving help from venture capitalists. Creditors find it difficult to continue to support a startup with continuous venture debt financing in such a situation. And here, the creditor shares rights to take over the startup with the securities he already has.
However, many venture debt creditors support startups with a negative cash flow, but they still look for the start-ups’ eligibility to fulfill the basic requirement of taking a loan. They analyze whether the startup bears the potential to pay repayments or will fall on the same after some time. It helps the creditor to decide whether to provide the startup with the next round of funding. However, venture funding is riskier than business start-up loans. It is indeed profitable as well. Start-ups can receive large funding to meet their current business needs and plan their business expansion without relying on investors.
What are some Pros and Cons of Venture Debt Financing?
While venture debt financing is risky, it is helpful for budding startups. Let’s analyze the Pros and cons of venture debt financing.
Venture loans can be extremely useful when a startup needs:
- Financing an extensive project quickly.
- Restrict dilution of the equity/ownership
- Invest in a promising opportunity to grow
- A fairly large amount for a short time
- To start an immediate purchase like equipment
- Need extended runway amid the rounds
- Help you postpone investments
- Debt is cheaper than equity, and one can secure at better terms than traditional loans
However, venture debt financing is beneficial and indeed a jackpot for startups. It has downsides:
- Like other loans, startups need to repay it
- Managing repayments along with using the loan amount becomes complicated
- Failure to pay repayments could lead to bankruptcy or business liquidation
- It is risky
- Costly repayments
- It is only for startups that have already raised venture capital for their business
- It could affect a business’s future fundraising requirements and abilities
Thus, it is a good option for only those startups who are confident in their approach to meeting repayments responsibly and have been funded by venture capitalists.
So, is Venture Debt Financing Right for You?
Start-ups with good backups looking to expand their business and meet the current business need, such as funding working capital gaps, investing in equipment, or funding a big-ticket project, should explore venture debt financing. It could be a great option for start-ups that want to meet business requirements independently of venture capitalists and have difficulty getting traditional business startup loans. If you can keep up with repayments, venture debt financing can boost your business to incredible heights by providing it with the funds needed to thrive.