What Is Venture Debt & Is It The Right Type Of Financing For My Startup Business?
Finding the right business funding can be difficult for even the most established business. Those challenges multiply when you have a startup business that lacks revenue, business credit history, or collateral. For many startups, simply going to the neighborhood bank to get funding isn’t realistic, leaving many startups without funding or turning to lenders with high interest rates, low borrowing amounts, and short repayment terms.
Why get caught in a cycle of debt when you don’t have to? Whether you own a startup or you’re ready to get started but a lack of funding is holding you back, you do have other options. In this post, we’re going to take an in-depth look at one of these options: venture debt.
Is venture debt something you’ve been considering? Or maybe it’s a completely new concept. Either way, we’re going to break down what venture debt means, how it works, and help you decide whether or not it’s the right option for funding your startup.
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What Is Venture Debt?
Type the phrase “venture debt” into your search bar, and you’ll be inundated with definitions that leave you scratching your head. Instead of using technical terms, we’re going to break everything down throughout this post so it’s easier to understand.
Venture debt is a type of debt financing. This means that borrowed funds are repaid over a period of time set by the lender. In addition to paying back borrowed funds, the business also pays interest. While this may sound similar to traditional business loans, there are some differences that we will describe in more detail a little later.
Venture debt is best suited for startup businesses or growing companies that have already raised capital through fundraising rounds. It is obtained through venture debt lenders which include banks, private equity firms, and other investors and groups.
When & Why Businesses Use Venture Debt
As mentioned in the previous section, venture debt is primarily used by startups and early-stage businesses that have already raised at least some capital through one or multiple rounds of funding. Some lenders even take this a step further by only lending to businesses that are backed by a well-known investor. In other words, even if you raise $100,000 through GoFundMe or Kickstarter from your friends, family, and followers, this isn’t sufficient for some lenders.
However, if your company is backed by a known investor and other requirements are met, you may qualify for this type of funding. Now, why would you choose venture debt over another type of funding, such as a business loan? As a startup or early-stage business, qualifying for traditional funding is tough, if not impossible for some businesses. Banks and other lenders assess risk before handing over money, and new businesses haven’t yet established a good track record of success. This translates to rejected loan applications or loan offers with sky-high interest rates, short terms, low borrowing limits, and extra fees that significantly raise the cost of borrowing.
On the other hand, startups may consider equity financing — that is, the business gives up company shares in exchange for capital. There are pros and cons to this strategy. While it does offer startup businesses access to capital without high interest rates and fees, it does take away partial ownership — which means giving up some control of the business and full profit potential further down the road. Venture debt is a suitable alternative that many startups have taken advantage of.
How Venture Debt Works
Let’s take a more specific look at how venture debt works.
Reasons For Using Venture Debt
Capital from venture debt can be used in a number of ways. It can be used to fund a project or an asset needed to accelerate growth and help the business become successful. Some specific ways venture debt can be used include:
- Funding long-term projects
- Making a large purchase, such as equipment or inventory
- Extending the time between funding rounds
- Making an investment in an opportunity that will help the business grow
The interest rate and repayment terms vary from lender to lender, but you can generally expect to repay your debt over a period of two to four years with interest set anywhere from the prime rate plus 0% to 9%.
Depending on the terms you agree to with a lender, borrowed funds may be repaid in a number of ways, such as a period of interest-only payments followed by larger monthly payments or a balloon payment at the end of the repayment term.
While many types of funding require specific collateral — physical property that can be seized if the funds aren’t repaid as agreed — this is only sometimes true for venture debt. If the funds are being used to purchase a piece of equipment, for example, the item being purchased could serve as collateral for the loan.
However, if funds are being used for a project, such as a big marketing campaign, venture debt doesn’t require collateral in the traditional sense. This is where stock warrants come into play.
Venture debt allows a business to get the capital it needs for growth without diluting ownership. There is, however, an added incentive built into venture debt for lenders taking on high-risk loans in the form of stock warrants.
Stock warrants are given by any company that trades on an exchange. Stock warrants give the investor the right to purchase stock within the company at a set price. The opportunity to purchase stock at this price does have a deadline specified between the lender and the borrower. Stock warrants are a further incentive for lenders to take on the risk of working with startups and developing businesses.
Most borrowers don’t intend to borrow money without repaying it, but unfortunately, sometimes the inevitable happens: a business isn’t making a profit and is unable to afford paying off its debts. If this happens, what should you expect from your lender?
Venture debt is also known as senior debt. This means that your lender takes first position over other lenders or investors in terms of liens. Now, if a piece of equipment was purchased with the capital you received, it can be seized and sold if it was used as collateral.
But what if no specific collateral was attached to your debt? It’s likely that your terms included a blanket lien, which allows the lender to legally seize and sell business assets in order to pay off the debt. In many cases, this doesn’t just include your physical assets — it may also include your intellectual property.
This is why it’s recommended that businesses that already have financial backing and are starting on solid ground use venture debt as a source of capital. As with any other type of business funding, make sure that you fully understand the terms set forth by the lender before signing anything.
Venture Debt VS Business Loans
So, how is venture debt different from your everyday business loan? There are a handful of similarities between venture debt and business loans, but there are also a few significant differences between the two types of funding.
First, let’s look at the similarities between the two.
- Debt Financing: Venture debt and business loans are both types of debt financing. In other words, funds are repaid over a period of time without giving up shares of the business.
- Lender Options: Both types of funding can be obtained from a bank or from a non-bank lender.
- Access To Capital: One of the most obvious similarities is that both forms of funding give businesses access to capital to continue operations, grow, and to improve the odds for success.
Now, let’s compare the differences between these two types of financing.
- Requirements: To receive a business loan, banks and other lenders look at factors including personal credit history, business credit history, time in business, and annual revenue. In some cases, collateral may be required. Venture debt lenders, on the other hand, look at factors such as the amount of money raised, investors, the product/service being offered, and even the business’s team.
- Term Length: Most venture debt lenders require debt to be repaid over a period of 2 to 4 years, although this may vary slightly. Depending on the type of business loan you apply to receive, repayment terms could be 10 years, 20 years, or even longer.
- Usage Of Funds: Venture debt is most often used for a specific project or asset that is used to grow the business. Business loans — in most cases — are more flexible in terms of how they’re used. Business loans can be used as working capital, to hire employees, or even to pay off existing debt.
- Borrowing Limits: How borrowing limits are determined is also a difference between venture debt and business loans. Business loans take into consideration things like personal credit history and debt-to-income ratio. Venture debt lenders usually base your borrowing limit on a percentage of the capital earned in your most recent round of fundraising.
- Reporting Requirements: Once you’re approved for a small business loan, the loan is simply repaid as agreed. You typically don’t have to provide more documentation to your lender unless you’re seeking additional funds. With venture debt, however, you may be required to report regularly to your lender through documentation such as monthly income statements, balance sheets, and tax returns.
Is Venture Debt Right For You?
With a grasp of what venture debt means and how it works, you might still be wondering if it’s the right financial option for your business. Before taking the plunge into venture debt, consider these factors:
- Fundraising: Have you already raised venture capital funds through one or more rounds of funding? Venture debt is best suited for startups and other businesses that have already raised capital and will be able to pay off the debt. Some lenders may even require backing by a known investor or group of investors.
- Understand Risk Of Default: Venture debt is best for businesses that are growing and need more funding to hit their next milestones. Businesses that aren’t in this position are at higher risk of default, which means that the business could be liquidated or seized by the lender.
- Know Your Terms: Getting capital through venture debt has terms similar to a short- or medium-term loan. Generally, you’ll have 12 to 24 months to repay the funds. If you’re looking for a funding with longer terms, consider other options — which we’ll go into more in the next section.
- Have A Purpose For Your Funds: Looking for working capital or don’t have any specific plans for the funds you receive? Keep looking at other financing options. Venture debt should be taken on for a specific purpose, such as making a large purchase (like equipment), funding a project, hitting a specific milestone, or growing the business without further diluting shares.
Learn About Other Types Of Financing For Startups & Entrepreneurs
Does venture debt not seem like the right fit or you’re still on the fence? Don’t worry — this type of funding certainly isn’t best for every business. The great news, though, is that you do have other options. While startups and new entrepreneurs may find it a bit challenging to find funding, it’s not impossible, especially if you’re willing to get a little creative. Unsure of where to start? Check out The 20 Best Ways To Finance A Business Startup to find out how you can get your business off the ground — or take it to the next level. Good luck!