Venture debt financing consists of a term loan from a financial institution to your company. It’s a way of funding your startup without issuing equity and diluting shares.
Unlike a regular small business loan, debt financing is only available to entrepreneurs whose companies have already been backed by venture capital, ie. a financing round. Debt financing can provide cash flow to a startup that needs working capital.
What is venture debt and how does it work?
Venture capitalists give startups money in exchange for equity. They don’t loan money to startups. Venture debt lenders, specializing in venture debt financing, do.
Venture debt providers include private equity firms, hedge funds, banks, and business development companies (BDCs). The typical term for a venture debt loan is three years, and it’s senior debt—meaning, it must be paid back before other debts the borrower may have.
Typically, venture debt includes “interest” in the form of stock warrants and basis points (BPS), and which includes an origination fee. The size of the loan may be based on a percentage of the value of the most recent round, eg. 30% of a company’s Series A financing. The venture lender may also charge interest on the loan as a percentage of the principal, typically in the 12% – 15% range.
This loan is covered by a blanket lien on your company’s assets; this lien may cover the CEO’s shares in the company, or intellectual property (IP).
If you take on venture debt in order to purchase equipment, the loan is covered by the equipment; in the event you can’t pay back the loan, the lender has a lien on the equipment you purchased.
Venture debt vs. venture capital (equity financing)
To reiterate, venture debt financing differs from typical fundraising in that it does not require you to issue stock to the lender. Meaning, shares in your company do not dilute—ownership stays the same. Venture debt can help business owners retain control of their company.
That being said, you will typically be required to issue stock warrants to the lender. But the dilutive potential of these is much less than what would result from issuing equity to a venture capitalist.
In contrast, venture capital firms provide your company with working capital in exchange for equity, which can considerably dilute your ownership. To learn the ins and outs of venture capital, check out our article, How Do Venture Capitalists Make Money?
Debt funding vs. business loans
The biggest difference between venture debt financing and a business loan from a bank is that, in the latter case, it doesn’t matter whether the company being loaned money has already raised any venture capital. In the case of venture debt financing, this is a requirement.
Other differences include how one qualifies for a loan (the underwriting process) and what type of collateral can be offered.
Qualifying for debt financing vs. a business loan
In the case of a typical business loan, the lending institution looks at a company’s financial history, including revenue and cash flow, to determine how risky it is to lend that company money. They also look at the company’s credit score.
But early-stage startups rarely have any revenue to speak of. In fact, since they’re new companies, they don’t have much financial history at all. Going purely on those factors, it’s unlikely any financial institution would be willing to lend a young startup money.
That’s where equity investors play a role—and that’s why your company needs to complete at least a Series A before you can take on venture debt.
Rather than looking at your company’s financial history, a venture debt company will look at your investors, and how much they’ve financed your company already in previous equity rounds. They’ll also look at how much your company has raised overall, and they’ll use their own criteria to assess the quality of your product, your team, and your business model.
Collateral for debt financing vs. a business loan
As mentioned above, venture debt companies may, in the case of growth capital loans, put a blanket lien on your company’s assets. They do this because your company—being new, without a proven track record—is a high-risk borrower.
In contrast, a typical small business loan may require you to post no collateral at all, or take only a part of your business—your accounts receivable, or tangible assets like equipment—as collateral.
Stock warrants and venture debt financing
One very important difference between venture debt financing and business loans: they include stock warrants as part of the deal.
A stock warrant is a guarantee to the holder that they’ll be able to purchase stock in a company at a specified price (the exercise price) before the expiration date of the warrant. If an individual or institution acquires a stock warrant for a company with a low exercise price, and uses it to purchase stock later, when the company has reached a higher valuation, the holder of the warrant can make a profit. Typically, this is after an IPO, or after the company is acquired.
Lending money to new startups is high-risk for a financial institution, even with a blanket lien. So high-risk, in fact, that typically such a loan would come with an interest rate higher than most startups could afford to pay back.
In order to mitigate risk and reduce the interest rate, venture debt lenders include stock warrants as part of their terms. So, when you borrow money from one of these institutions, you also give them stock warrants—regardless of your future ability to pay back the loan.
Keep in mind that warrants are a form of dilution; granted, they typically create a much smaller amount of dilution than the outright sale of equity.
If your company is successful, the lender has the potential to make significant profit from stock warrants; this offsets risk for them, and ensures you get an interest rate you can afford.
Typical venture debt financing interest rates
For a typical business loan, the interest rate is in the single digits. When venture debt financing companies charge interest as a percentage on a loan, it’s typically at a rate of 12 – 15%.
Not all venture debt financing companies charge interest as a percentage of a loan. Some will charge basis points (BPS) instead, in combination with obtaining stock warrants.
Is venture debt financing right for your startup?
Some scenarios where startups frequently make use of venture debt:
- To keep the business running until the next financing round. A venture loan can provide the cash injection necessary to keep your startup developing between milestones like funding rounds.
- To cover the last stretch until the startup is cash flow positive. If your startup is on the verge of becoming profitable, a cash flow loan can fund you until you’re in the black, while allowing you to avoid a final financing round.
- To limit dilution during a financing round. By supplementing an equity financing round with a loan, you can reduce the amount of equity you authorize and issue, diluting your shares—making it easier to maintain control of your company.
When not to use venture debt financing
Venture debt financing is a bad choice if your company is not locked into a pattern of stable, continuous growth. Defaulting on a loan with a blanket lien could mean the lender acquires everything you have—including intellectual property—or forces you to liquidate your company.
How to get venture debt financing (step-by-step)
Once you’ve decided venture debt financing is the right choice for your startup, the process of getting a loan is fairly straightforward. It can be broken down into six steps:
- Origination. Venture debt lenders may seek out eligible borrowers by talking to their network of VC firms and other investors. If a lender doesn’t reach out to you first, you can reach out to them directly—some have application forms on their websites you can fill out and submit.
- Screening. The screening process kicks off with a call between the lender and your company’s CEO or CFO. This call is your chance to pitch your company, disclose your financial history, and walk through your financial projections. The lender uses this call to get an idea of whether lending money to your startup is likely to yield a profitable return, based on the amount of risk they are undertaking.Be ready to provide a pitch deck, historical financial statements, and pro forma financials.
- Term Sheet Negotiation. If the lender determines that you qualify for a loan, they’ll send you a term sheet. It lays out the terms of the loan, including information about the amount and structure of the debt, and the interest rate you’ll be paying. Unlike a term sheet for a financing round, the term sheet for venture debt doesn’t include any stipulations about voting rights. It does, however, include covenants that lay out financial reporting requirements. At this stage, it is recommended you negotiate with the lender, with the help of your lawyer and/or financial advisor.
- Due Diligence. Typically taking upwards of six weeks, the due diligence process involves the lender digging deeper into your company’s financial history and cap table, as well as investigating your management team. The lender’s goal is to confirm all the information you’ve provided them about your company before giving you any money.
- Legal Document Signing. Once due diligence is complete, you’ll sign a lending agreement with your lender. Unlike the term sheet, this document is legally binding.
- Fund Transfer. Finally, the lender will wire you the loan. Assume that, until the money is in your bank account, the money isn’t actually yours. In other words, don’t start spending until you have the cash in hand.
What to look for in a lender
You may not want to take the first loan offered to you—predatory behavior on the part of a lender isn’t always obvious.
Keep an eye out for:
- Good references. Reach out to past borrowers and try to learn about their relationship with the lender. What went well for them, and what didn’t? Overall, was their experience a positive one?
- Reliable funding. Past borrowers should be able to attest to how quickly or slowly a lender provided funds, once negotiations were complete. Watch out lenders who come up with excuses for delaying transfers, or try to renegotiate the terms of your loan at the eleventh hour.
- Good working relationships. Your relationship with a lender doesn’t end once the wire transfer comes through. You’ll be working with them through the duration of the loan term. When you question past borrowers, try to get a sense of what it was like working with the lender. Was it difficult getting in touch with them? Were misunderstandings common? These are signs the lender could be difficult to work with.
- Competitive terms. This is one of the reasons why it’s smart to consider term sheets from multiple lenders. Even if one lender’s interest rate is the same as another, they may offer a better deal in terms of the amount of stock warrants they expect or the repayment period.
- Venture debt financing takes the form of a loan; unlike with venture capital financing, you do not need to issue equity to the institution providing capital.
- Since venture capital lenders take into account how much your investors have given you in order to determine whether you will lend you money, you must have already raised at least one equity financing round (also referred to as a priced round like a Series A) before you can qualify for venture debt financing.
- A venture capital loan includes in its terms the issuance of stock warrants. It may also include a blanket lien on your assets, including intellectual property
- It is unwise to take on venture debt unless your financial projections show you will be able to pay back the loan—defaulting on loan with a blanket lien can have serious consequences for your business. Venture debt financing is not appropriate unless you are experiencing steady, continuous growth.
Not sure whether you qualify for venture debt financing? Learn about the difference between priced and unpriced financing rounds.
Written by Capbase Staff
Capbase is a team of designers, engineers, and business professionals spread across 6 time zones on 3 continents united by our passion for dogs, coffee, and great software.