Broadly, any business or startup can secure funds in two different forms, i.e. debt or equity. In debt based funding, the company takes a loan from an entity at a prespecified interest rate. In equity based funding, a startup secures funds from investors in return for equity dilution. With debt based funding, a startup is under high pressure to clear its dues at high interest rates. Moreover, startups usually don’t have enough tangible assets to meet the criteria of banking institutions. In equity based funding, a startup has to lose significant ownership of the company, which can also affect the team’s autonomy. Both scenarios, though they give access to funds for growth, have significant downsides to the startup. 

Witnessing the disadvantages of pure debt or equity forms of funding, new forms of funding emerged for startups. Venture debt is one of them, which moderates the downsides, and provides more advantage to startups. 

In this article, we look into what Venture Debt means, how it works, and how startups can best use this financial instrument. 

Venture Debt

In simple terms, Venture Debt is a debt based financing built to address the needs of startups. A debt issued by a bank involves a long underwriting process, and requires tangible assets to back the loan. However, Venture Debt provides funds with minimal underwriting process. Venture Debt firms work with VC investors to verify the ability of your business to repay the loan.  

Like any other debt based instrument, Venture Debt also secures its returns through principal and interest amounts. Moreover, the Venture Debt firm also secures warrants, i.e. an option to buy shares of the company at a fixed exercise price within a specified period of time. 

Venture Debt might have a comparable or a little higher interest rate than a bank loan, since the funds provided aren’t backed by any assets. Imposing high interest rates would increase too much pressure on the business, making the deal unfavourable to the startup. Instead of high interest rates, the firm gets its remaining benefit via warrants. Even then, considering a fairly successful startup, the amount of equity diluted is very low compared to equity based funding. 

Venture debts are usually structured for a short period of time, i.e. 2-3 years, instead of a long horizon of 10-12 years with small payments in bank loans. This is also one of the reasons why the financiers of Venture Debt will look for the startup’s ability to repay their funds in the specified timeframe, instead of reviewing the startup’s growth prospects.

Since Venture Debt is a debt based instrument, in the event of liquidation, Venture Debt will be higher in preference compared to preferred shareholders. 

Pros and Cons

There are many benefits when it comes to Venture Debt, but it will depend on the scenario in context. Just like any other instrument, Venture Debt is optimal only in some specific situations. We will highlight the prominent benefits of Venture Debt below:

1. Less Underwriting effort: Since Venture Debt firms work with Venture Capital firms, most of the preliminary validation is already done via the startup’s previous investors. It means that the startup doesn’t have to put a lot of effort into due diligence processes. However, it might vary based on the situation in context.
2. Lower Equity Dilution: Beyond interest and principal payments, the investor has a chance to get equity stake only through warrants, which is quite minimal even if exercised. Getting such funds from VC firms would lead to significant equity dilution, which can be avoided here. 
3. No Involvement in Startup’s Activities: Funding by a VC firm would also mean that the startup has to give a seat on the board of directors, keep the investor apprised of any significant activities, etc. However, with Venture Debt, the investor won’t interfere in any of the startup’s activities, in any way whatsoever. 
4. No need for Valuation: Raising funds at such scale via a VC firm would mean the firm needs to know the startup’s valuation, and then provide equity based on the amount raised. All of this takes a lot of time and effort. However, none of this is required when securing funds through Venture Debt.

Though Venture Debt has its share of advantages, it’s not accessible to everyone. The startup should have undergone a few rounds of fundraising before they can target Venture Debt, since Venture Debt validates the startup based on its previous funding. Moreover, funding through VC Firms brings in a lot of network, technical and management expertise, and many other useful resources none of which are available via venture debt. Furthermore, since Venture Debt is a debt based instrument, the company is obligated to pay its dues, and not paying within the specified timeframe might even lead to Bankruptcy. The startup should choose this option only if it can really meet these obligations.

Choosing between Venture Debt and Venture Capital

As the startup scales its business, it needs both funds and expertise to reach the next milestone. Venture Capital Firms bring both to the table, and can help startups achieve their goals. However, as the startup goes to later stages, it would prefer to limit equity dilution, so that the founders have enough equity, and they use it only at significantly high valuations. In such cases, Venture Debt can be a very valuable instrument.

For example, consider the case of a startup that’s really close to reaching the next milestone, but is running short of cash. They need some funds to handle current circumstances, and can pay back easily later. In such cases, startups might choose to go for Venture Debt instead of bridge financing, which prevents equity dilution. Likewise, to increase their runway, a startup can get Venture Debt just after a funding round, since they have more leverage, and can get favourable terms. In such scenarios, Venture Debt can be quite useful for startups.

Usually, startups can get Venture Debt of upto 25-30% of previous funding round, but it can vary according to the situation. Taking too much debt would not look good, since the investors for the next round would feel that most of the funds raised are being used for debt payments instead of startup growth. In general, a balance of Equity based funding and Venture Debt will be most favourable for startups in late stages. 

In the Final Analysis

Venture Debt provides startups access to funds at no or minimal equity dilution. This is quite favourable for startups with a proven track record, and has significant revenues, but needs urgent funds to finance critical activities. Startups in late stages can consider financing through a combination of Venture Debt and Venture Capital to create an optimal deal and limit their dilution, thereby benefiting in the long run.