There are a variety of ways to capitalize on new or existing business ventures. Options include grants, debt finance, and equity finance. For a bit of clarification, debt finance involves loans where the borrower pays back the principal amount plus interest. Whereas equity finance involves fundraising from investors in exchange for ownership in your company. In some circles, you will hear people call equity finance “venture”. What many people don’t know is that the lines do blur between debt and equity. When that happens the type of capital is referred to as venture debt.
While there are firms that provide venture debt capital to ideation-stage startups, it is usually used to finance the growth of a startup that has raised money from investors, has traction, and wants to leverage non-dilutive capital.
Venture Debt – its characteristics and benefits
Venture debt largely has the characteristics of debt finance. Here are some of those characteristics that you will need to consider in determining if venture debt is a good fit for your business:
- The debt is expected to be paid pack through regular, usually monthly, payments
- You may need to provide the lender with some collateral, e.g. real estate, equipment, inventory
- The owners, usually defined as any owning more than 20% equity in the business, may be required to sign a personal guarantee. Which means that the lender can ask the owners to make the payments if the business fails to do so
There is a tradeoff with everything. If you are willing to accept those terms then venture debt could be right for your situation as there are some benefits of venture debt versus equity finance. Some of the benefits include:
- With venture debt, you may not have to give up any ownership in your company. If you do give up equity it is generally less than when raising a normal equity round of funding. Keep in mind, since venture debt often follows equity funding, your company may have already given up significant pieces of ownership.
- With equity finance, the investors often request for additional conditions when investing in your business. That usually manifests itself in the form of seats on your Board of Directors, which you will have to form, and possibly other conditions such as liquidation preferences (meaning investors get paid back before anyone else)
So, how does venture debt differ from normal debt finance? Where the venture component comes into play is that the typical venture debt borrower has many of the same characteristics of a startup, or new venture, that might raise capital from investors.
What does that mean for you? Venture debt is usually reserved for new ventures, hence the name, that are yet to reach profitability. Traditional lenders are focused on one thing when it comes to debt finance for businesses – sources of repayment. That is a fancy word for ways in which the lender gets paid back.
With traditional debt finance the primary source of repayment is almost always excess cash flow that the business is putting off. With a new venture, that usually doesn’t exist. The business could be generating revenue but it is plowing all of it back into trying to scale the business. With venture debt, the lender is more focused on what is normally considered the secondary source of repayment, which is collateral.
How To Know if Venture Debt is Right for your Business
Now that you have an idea of how venture debt is typically structured, let’s talk a bit more about when venture debt is right for your business. Our attorneys are standing over our shoulder telling me to say it depends. But, we are going to ignore them for a moment because we want you to get this right.
Venture debt makes sense for companies who are new in their journey but not so new that they are pre-revenue. I’m not talking about net revenue. By pre-revenue I mean companies who are so new that they aren’t ready to start selling their product or service. Companies that are generating revenue are able to show that they have a working model and that they have a path that can take them to profitability.
When venture debt doesn’t make sense is for companies whose margins are so tight that they need every last dollar they make to go back into the business. If you take on debt prematurely then some of your cash flow is going to be going toward loan payments rather than being available to put that cash flow back into growth. As alluded to earlier, pre-revenue companies should avoid venture debt because there simply isn’t enough money coming in to make the payments. You might find a few lenders who are willing to extend your business capital with an interest-only period. However, if you’re at the pre-revenue stage then you are starting a timer that is eventually going to expire.
There are companies that specialize in venture debt. One of the most recognizable is Silicon Valley Bank. Many of the venture debt deals they put together are offered to well-funded startups that have been growing at incredible rates and are backed by prominent venture capital firms. These companies meet many of the characteristics that I mentioned above. They have revenue, oftentimes significant sales, are very close or are profitable, and have the support of investors.
One last thing we wanted to point out. Venture finance can feel free. But it isn’t. In fact, some would argue that venture finance is one of the more expensive financing vehicles available. Startups don’t have to make regular payments with venture finance. But that money still has to be paid back. If you have given up 20% ownership in your company in exchange for funding and your company is valued at $100M then that financing will cost you $20M.