November 26, 2020

Venture Debt — An attractive alternative for startups?

Raising capital for your business is an essential task for startups and is not only time-consuming but often nerve-wracking as well. A clear view of the available options is needed to make the right decision. One of the various options besides the frequently mentioned equity is debt — venture debt to be precise.

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What is Venture Debt?

Venture debt is a form of debt that is given to startups to fund their businesses. It works like a traditional debt which means to simply repay the borrowed money plus the interest payments. While this sounds like a normal business loan that a company could obtain, there is an important difference. Venture debt is less dependent on factors like accounts receivable, inventory held, and cash levels. The focus of venture debt is on the relationship between founders and the company’s VC backer. The ability to secure additional funding rounds is an important part to manage the high-risk profile of such debt structures, the chances of receiving venture debt are higher for startups that are backed by a VC investor.

There is a clear difference between convertible debt and venture debt. While both appear to be the same, the biggest difference stems from the convertibility to equity. If a founder agrees to a convertible loan, the lender will convert the debt to equity at a specific point in time (usually the next funding round). This results in a dilution of the cap table.

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Who should use Venture Debt?

Venture debt is an attractive option for startups that are backed by a VC. The best time to raise venture debt is during while or shortly after a successful equity round, since the creditworthiness is higher, and the startup will have better bargaining power. In addition, the startup should already create revenues as there will be the obligation to pay interest on the borrowed money. The use of the venture debt is very similar to equity funding (e.g. sales teams, R&D or marketing). If the debt is used to make investments in factories or machines, the venture debt will most likely be secured by these assets.

Why should startups consider Venture Debt?

One of the main reasons to consider venture debt is that the startup is not giving away equity. After the debt is paid back, the relationship with the venture debt lender ends. The other advantage is that it is an infusion of cash to overcome unforeseen short-term market downturns or challenges during the fundraising process. Raising additional equity to extend the runway or to bridge such market downturns leaves the startup in a weaker position to negotiate with a VC. Venture debt gives founders the chance to balance the sources of funds between debt and equity. A mix between equity and debt can be healthy and will actually increase the ROE for the shareholders as there is no dilution from venture debt. It highly depends on the industry and founders to determine what debt to equity ratio is appropriate. While venture debt has clear advantages, it is important for the startup to be able to repay the debt. The business model of the startup should be stable and proven, otherwise, venture debt can become a dangerous burden for the startup. Further, entering long-term relationships in the form of an equity investment can also have positive effects as investors can support your business growth and the incentives are more aligned compared to a venture debt deal.

Venture debt is becoming more popular since the COVID-19 pandemic has forced startups to cut costs and extend their runways. Founders want to avoid additional dilution and hard fundraising negotiations given the economic climate (depending on the industry). Current low-interest rates are additional factors that increase the attractiveness of venture debt.