Venture debt is a type of loan that banks or specialty lenders extend to startups and early-stage companies. These loans typically have higher-than-average interest rates that reflect young businesses’ higher risk of default. Venture lending is often combined with equity financing from venture capital (VC) firms.
Key Points
• Venture debt loans tend to have higher interest rates, looser repayment terms, and usually no collateral.
• These loans help startups raise money without selling equity shares, so that founders retain greater ownership.
• Drawbacks include higher interest rates, operational restrictions, and some equity dilution.
• Timing is crucial; securing debt after VC funding enhances a startup’s negotiating power and flexibility.
• Common uses for these loans include managing setbacks, financing specific projects, and sustaining the company between funding rounds.
Understanding Venture Debt
For startups, venture debt loans can be an alternative to traditional small business loans. The specifics are important to understand.
Definition and Key Characteristics
Venture debt is a particular type of startup business loan for which lenders generally don’t require collateral or a history of consistent revenue. (Typically the startup companies will already be backed by venture capital.) Venture loans have higher interest rates than traditional loans, reflecting the greater risk lenders are taking.
Venture lending allows startups to raise money without selling shares of the company. As a result, venture debt will not lower the value of existing shareholders’ ownership stakes.
Startups that lack collateral to back a business loan may also consider an unsecured line of credit. Here too the interest rates are likely to be higher, but no collateral is needed and interest accrues only on the current balance.
Traditional Loans vs Venture Debt vs Equity Financing
• Traditional loans: Traditional small business loans are available to a wide variety of businesses, with interest rates based on the business’s financial and credit history and a fixed repayment schedule. A small business may also qualify for a business line of credit it can tap into, pay off, and use again. For traditional loans, lenders typically require collateral but not equity. In some cases lenders may ask owners of a new company to guarantee the debt personally in case the business defaults.
• Venture debt: New companies with the ability to get equity financing and the potential for high growth may be able to access venture debt loans. Some specialized lenders take on these riskier loans, for which interest rates can be comparatively high. Lenders may be more flexible than usual on repayment terms and collateral requirements, knowing that at first, venture capital may be a company’s main source of income.
• Equity financing: This method of raising money is not a form of debt. Rather, it involves selling ownership shares of the company. Venture capital is one form of equity financing, in which professional VC firms invest in startups with high growth potential. Private equity, angel investing, and an initial public offering are other forms of equity financing.
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How Venture Debt Works
As detailed above, venture debt can be significantly different from banks’ traditional business loans. Here’s a closer look at how a deal might be structured.
Typical Terms and Structure
The terms, interest rates, and structure of venture debt can vary widely. The details of a specific deal often depend on factors such as business size, the specific purpose of the money, and the amount of equity the business has already built. In fact, lenders often calibrate their loan principal to be about 25% to 35% of the amount a company raised in its latest equity round.
The duration of the loan will also vary by business and how the loan is to be used. Generally, loan terms are about three to four years; often they start off with interest-only payments for the first six to 12 months.
Interest rates will vary, as well, but typically fall between 10% and 15% (or 6-10% higher than the prime rate).
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Warrants and Covenants
Venture debt deals often include instruments known as stock warrants and debt covenants.
A warrant gives the lender an option to buy some amount of equity at a fixed price within a given period of time. This may provide some added incentive for the lender beyond interest rates, possibly helping a startup secure a loan at a lower interest rate.
A covenant is an agreement set up by the lender with minimum requirements for company performance. This helps the lender protect its interests while the startup has access to capital. The provisions might include how much cash a company must keep on hand, how much revenue the firm must make by specified dates, or how borrowed money can be used.
Companies that run afoul of their covenant agreements will be in default. Depending on the terms of the agreement, default could lead to penalties or interest rate increases. If there’s an acceleration clause in the covenant agreement, the defaulting startup may be forced to repay the loan immediately.
Pros and Cons of Venture Debt
Venture debt can be an important tool in the early days of a startup. But as with any tool, there are potential pros and cons.
Advantages for Startups
Venture debt offers startups several advantages, such as:
• Lenders don’t insist on collateral or fixed assets, looking instead at the startup’s ability to keep raising capital.
• The deal requires no equity, so founders retain more ownership.
• It can supplement equity investment, giving the startup more capital to keep it going between VC rounds.
• Debt can be structured and priced to accord with the startup’s circumstances.
Potential Drawbacks
At the same time, venture debt has negative aspects to be aware of, such as:
• Higher interest rates make venture debt more expensive than traditional bank loans.
• Debt covenants may limit companies’ operational freedom through restrictions on spending, borrowing, and reporting.
• Warrants can dilute equity, though usually far less than equity financing does.
• As with any loan, if a company defaults, it damages its credit score and thus its ability to get funding in the future.
When to Consider Venture Debt
Venture debt is usually taken on by startup businesses that anticipate strong growth in the near future. These businesses are often already funding their venture, having received pre-seed funding, seed funding, and rounds of equity financing. Startups may take on venture debt as well, to help sustain the company between funding rounds.
Strategic Timing and Use Cases
Entrepreneurs often pursue venture debt early in their startup’s lifecycle after one or more rounds of equity financing. This timing demonstrates that they have VC backing, which typically makes it easier to secure a venture loan. Raising debt early on — well before a cash crunch — also allows the borrower to have more leeway in negotiations.
With strategic timing, startups can deploy debt capital to achieve key milestones or complete specific growth initiatives before the next equity round. For example, unexpected trade problems may push back schedules, slowing down progress toward specific revenue targets.
Venture debt loans can help companies avoid bridge financing rounds, which could send negative signals to investors. It also enables companies to finance specific projects without selling shares to raise additional equity. (Selling more equity dilutes the founders’ shares.)
The Takeaway
Startups and other early-stage businesses needing capital may decide to take on venture debt.
These loans are designed for young companies on a growth trajectory that have already raised equity from VC firms. Indeed, venture debt often supplements equity financing, as it can help a company stay afloat between funding rounds.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How is venture debt different from traditional bank loans?
Traditional bank loans usually require that businesses have a strong credit history and collateral to back a loan. Venture debt is designed for startup companies who typically don’t have a long financial history or significant collateral.
When in a startup’s lifecycle is venture debt most appropriate?
Venture debt is often used early in a startup’s lifecycle after one or more rounds of equity financing.
What happens if a startup defaults on venture debt?
If a startup defaults on its venture debt, the lender may demand immediate repayment of the loan. The company is likely to lose any collateral it had posted, and its credit score will probably fall.
How do venture debt lenders evaluate potential borrowers?
Because startups have no business history, lenders evaluate potential borrowers on other aspects. Generally these include the type of business, amount of venture capital already raised, and intended use for the borrowed funds.
Can venture debt replace equity financing?
Venture debt is typically not a substitute for equity financing. The loans can be very costly. Instead, startups rely mostly on equity, using debt as a complement.
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