How Does Venture Debt Financing Work?

All Your Business Needs to Know About Venture Lending

creditanalyst.jpg
••• Eric Audras / Getty Images

Venture debt, also known as ‘venture lending’, is financing provided by specialized banks and lenders to supply working capital for specific capital equipment expenditures they could otherwise not afford. Unlike traditional financing, venture debt is offered to companies that do not have a positive cash flow or significant assets that could be used as collateral.

Purposes of Venture Debt 

Companies generally seek venture debt financing for: 

  1. Growth capital between investment rounds to be used for merger and acquisition activity, milestone financing or working capital
  2. Equipment financing for large purchases and infrastructure investments
  3. Accounts receivable financing for companies that have a lot of unpaid receivables and need to free up cash faster than they anticipate receiving payment

Venture Debt Financing Terms

100% financing is often available for growth capital and equipment financing, whereas receivables financing is typically capped at 80-85% of the accounts receivable balance to offset the risk of future non-payment. In addition to different interest rates, the terms can vary on several factors:

  • Loan length (usually 12-48 months)
  • Interest-only followed by interest plus principal vs. a balloon payment (with rolled-up interest) at the end of the loan period
  • Collateral requirements
  • Right to invest in the future, aka warrants
  • Covenants (additional restrictive terms and conditions)

Benefits for Investors

Venture debt is a way for lenders to invest in emerging startups and fast-growth businesses that already have some traction but need more capital to grow. The lender is betting that the company’s future success will provide most of the returns. Venture debt providers typically charge 12-25% interest rate, but also include warrants—the right to buy equity in the company at a future date—as part of the deal. Because venture-funded companies have gone through due diligence and often have strong boards of directors, venture debt financiers are able to save time and money during the review phase and can piggy-back off the work previous investors have already done.

Pros for Companies

Venture financing can help extend a startup’s “runway” (how much time the company has before they run out of money), as well as provide the capital needed to reach key milestones. Reaching these milestones makes the company more valuable before they raise the next equity round. Early financing minimizes the equity dilution for current investors and employees, and takes the pressure off the founder(s). By using venture debt money, they can postpone another investment financing round until they feel the company is ready. While the interest rates are higher and the payment terms shorter than for traditional bank loans, venture loans can be easier to get for companies with lots of potential but little history.

Cons for Companies

One downside of venture debt is that, unlike venture investment, venture debt needs to be repaid. If your projections fall short or you are trying to raise money from investors while simultaneously paying off the loan, things can get tricky. Investors don’t like the idea that their investment is going to repay a loan instead of providing new growth opportunities for their equity position. Another serious downside is that if your company cannot pay off the loan, the lender may force the company into liquidation or bankruptcy. This is not the case when you take on venture investment, which is equity-based.

Applying for Venture Debt Financing

Unlike bank loans, venture loans are a form of direct investing for a lending institution or group. As such, understanding your business and believing in your team are important aspects of the decision-making process for the lender–just like for VCs.

Setting up meetings and getting to know potential venture debt lenders is something CEOs and board members should do as early as possible.

To be successful, you will need to have a solid business model, details about your product or service, a go-to-market plan, and clear milestones you are hoping to achieve. It should be clear to the potential lender that their additional financing will help you get to your next round of venture funding.

Bottom Line

If you do not already have venture investment backing behind your company, you cannot access venture debt financing. However, if you are a venture-backed company and are looking for access to more capital without diluting ownership–and you have a solid plan in place for how that money can be used to increase the value of your company before your next investment round–venture debt financing could be a solid choice for your business.