Understanding the complexities of venture debt
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When you’re trying to grow a small business, getting the funding you need may seem impossible. You’re faced with dozens of daily decisions, whether it’s about new hires, choosing the right software, or finding customers interested in your product.
With so many decisions to make, many small business owners stick to what they know and choose a traditional bank loan to acquire funding. While this is one of the most common ways to secure capital, it’s not the only way.
In this article, we’ll discuss venture debt, how it works, and provide you with pros and cons to see if venture debt is the right choice for your business.
What is venture debt?
Venture debt is a form of debt financing given to early-stage venture capital-backed startups and companies. It’s a way for these companies to enjoy liquidity between equity funding rounds. Venture debt shouldn’t be confused with a long-term funding solution.
The loans acquired from venture debt are usually repaid within a period of 18 months but can stretch up to three years. This is because venture debt lenders expect to be repaid with the proceeds companies receive from their next funding round.
How does venture debt work?
Venture debt is normally provided by non-bank lenders or specific venture financing banks. Hedge funds, business development companies, and other private equity firms are other popular options for venture debt providers.
Venture debt differs from conventional loans. Instead of a debt repayment term of several years, the debt is usually short-term, only lasting three to four years. Many venture debt loan agreements will include interest payments. However, they often begin with a period of 6 - 12 months where the business only pays accumulated interest but not the principal.
The principal amount of debt is calculated using the amount raised in the previous round of equity financing.
Since there is a high default risk associated with venture debt, lenders get the option to purchase company stock at a certain price within a specific time frame. This financial security is known as warrants. The time frame of the warrants can last anywhere from one to fifteen years, and the total value of the warrants ranges between 5% - 20% of the loan’s principal sum. Although the lender has the option to purchase stock, they are not required to do so.
Covenants are also applied in venture debt loans. These are additional terms and restrictions made to ensure repayment from the borrower. Lenders can impose both non-financial and financial covenants.
Each business is unique, so terms will differ between startups. However, these are the typical venture debt terms most companies can expect to see on their term sheet:
- Interest rate: Variable interest rate based on the prime rate
- Loan size: Total amount your business secures from the venture term loan
- Repayment duration: Agreed upon period of time to repay back your loan interest and principal
- Collateral: Business assets or other property that serves as repayment to the lender if your fail to repay your loan.
- Covenants: Terms and requirements enforced by your lender that can cause you to default on your loan if not met
- Amortization: Your loan repayment schedule
- Warrants: Legal right to purchase your company’s stock at a fixed price for a period of time.
Types of Venture Debt
These are the three main types of venture debt:
This type of venture debt is based on the financial statements of the borrowers. Businesses can borrow money based on the accounts receivable on their balance sheet.
Term loans, also known as term debt, are loans structured over three years. These loans are given to high-growth companies that pay back a portion of the money each month. Term loans are usually senior debt. This means they are repaid first in an exit or by bankruptcy if a company fails to make payments.
Based on the borrower’s estimated revenue stream, royalty monetization is a more flexible form of venture debt. As your company’s revenue performance changes, so do your loan repayments (although this amount is relative to the original loan).
How is venture debt different from venture capital and equity?
Since the capital issued is in the form of debt and not equity, business owners don’t have to give away portions of ownership in their company. Unlike venture capital, venture debt lenders don’t become company shareholders or interfere in business management.
Venture debt providers profit from interest payments, fees, or stock options through warrants. On the other hand, venture capitalist firms make money when a startup goes public or is purchased, and they exit the venture.
In addition, venture debt funding is only available to high growth businesses that have already received venture capital funding. In contrast, venture capital funding is available to any business, regardless of whether they’ve secured funding in the past.
When compared with equity financing, the investment period of venture debt is much shorter. Instead of a fixed repayment schedule, equity investors take profit from their stock in your business.
This table explores the major differences between venture debt, venture capital, and equity financing.
The pros and cons of venture debt funding
Financing a small business is never a simple task. Venture debt funding comes with many advantages, but there are also some downsides to this type of funding. Here are a few pros and cons to getting involved with venture debt:
Advantages of venture debt funding
- Reduces equity dilution: One of the biggest advantages of venture debt is that it reduces the equity dilution of your business. As a business owner, you’ll gain access to additional cash without significantly diluting your ownership. While you may give up some common or preferred stock in your business, it will be much smaller than what you would give up during a full equity round of funding.
- Access to an adaptable source of funds: If your startup is facing unexpected market conditions or short-term challenges, venture debt can help you stay afloat.
- Boosts growth: Venture debt boosts the growth of your company by extending the cash runway of your business. It can lengthen the time between funding rounds and buy you more time to hit necessary milestones.
Disadvantages of venture debt funding
- Negatively affect future funding rounds: Your business may have difficulty securing future funding after a venture debt loan agreement. Future investors may view debt on your company’s balance sheet as an issue. Since their investment will go towards repaying your debt, they might be hesitant to give you much-needed funding.
- Repayment terms may be difficult to meet: Your venture debt must be repaid according to its terms, along with interest. A young startup with unpredictable cash flow might struggle to make monthly payments.
- Financial covenants failure: Venture debt usually comes with financial covenants. These are requirements to hit certain financial milestones to maintain access to capital from the venture debt lender. Failing to meet these requirements can incur severe penalties. The lender may charge your business higher interest rates on remaining balances, require you to pay back the entire balance, or even force you into bankruptcy to reclaim their funds.
When is venture debt lending a viable option?
Venture debt lending may be a viable option if your business falls into the following categories:
- You’re close to reaching profitability: Companies approaching profitability may need an extra boost to go public without additional dilution from equity.
- Funding between equity rounds: Many companies opt for venture debt instead of choosing to raise a bridge round from their existing venture capital firms. For instance, let’s say you raised $11M in your series A round of funding but need $16M to reach your next business milestone. Venture debt can help you access this growth capital without going through a VC bridge round.
- As an insurance policy: You might want to have extra funds on hand as a financial cushion in case your business needs more time to reach its next milestone. Venture lending helps you access funds to tide your business over until this happens.
When you should avoid venture debt lending
While venture debt lending is a great option for some early-stage companies, there are certain situations where it’s best to choose another form of fundraising.
Your company is performing poorly: If your startup is struggling financially and your likelihood of raising more equity is low, avoid venture debt financing. Companies should only raise venture debt if they have investors who will invest more equity in the near future, allowing them to repay their loan.
- Your venture capitalist investors are against it: Although investors may not turn you away for having venture debt, they might pass on your company if they feel your VC investors will be difficult to work with.
- You need to pay the loan back immediately: A loan that requires immediate repayment may ruin your chances of using the money at all. A loan that amortizes immediately could force your company to repay a large portion of the loan before you use the money for business milestones.
- The covenants are too difficult: If the loan comes with financial covenants, failure to meet these financial requirements could cause a loan default. Typically, venture debt deals for early-stage companies or startups won’t have financial covenants due to their unpredictable nature. If they do, you might want to wait until your company is more stable to use this financing option.
Ramp offers sales-based underwriting for growing businesses
High growth startups without years of financials to speak for their company often struggle to secure the capital they need to grow. Traditional underwriting processes performed by commercial banks typically require a significant minimum bank balance to get approved.
Other alternative funding methods may not meet the needs of companies with limited funds or those in the eCommerce industry working with small margins.
Ramp’s sales-based underwriting process provides a financing option for companies without a long-standing track record to access funding. Aspiring entrepreneurs don’t need to worry about troublesome founder guarantees or years of audited financials. Instead, Ramp only needs businesses to have a year of sales history on popular ecommerce platforms like Shopify, Amazon, or WooCommerce.
Ramp uses your commerce sales history to underwrite credit limits for your business. Once approved, businesses get access to lines of credit through Ramp charge cards. Your startup can build business credit without the worry of incurring interest or high balances that roll over each month.
Searching for working capital to grow your startup? Ramp is your answer
Acquire the credit limit you need to grow your business with Ramp. Our new offering gives high-growth businesses the chance to secure credit limits of up to 30x more than those offered by traditional corporate cards.
Ramp’s funding comes with access to our finance automation platform to help you make the most of your new capital. You’ll gain cash flow visibility and control, save money, and streamline expense management.
Learn more about Ramp today.
The three main types of venture debt funding are term loans, accounts receivable, and royalty monetization.
Venture capital funding is a form of equity. It requires the giving away of equity, or business ownership, in return for funding.
Venture debt is a good idea when used wisely. Companies typically benefit from venture debt lending when it follows an equity raise, is used as funding between equity rounds, or is used as an insurance policy before your next round of funding.