If you run a fast growing early stage business, chances are that you’ve considered venture debt financing before. Perhaps you’ve heard others in the industry fund growth strategies that way, or perhaps you’ve tried unsuccessfully to secure a bank loan and need other options. If so, the problem isn’t unique to you: Many businesses struggle to get their hands on working capital from traditional lending sources.
Since the 2008-09 financial crises, increased government regulation has left banks hesitant to lend to small and medium-sized enterprises (SMEs). That is particularly true for companies with inconsistent cash flow, poor collateral, and an unfavorable debt-to-income ratio.
To make matters more complicated, SMEs have the unfair burden of having to grow revenues while keeping costs down, which is often well nigh impossible for new companies.
In response to the gap left by traditional financing institutions, private credit extended by lenders unaffiliated with banks has exploded in popularity. Business development companies (BDCs), wealthy financiers, and private equity firms now provide SMEs access to flexible financing options, including venture debt financing.
As of 2018, already 40 percent of private credit managers were willing to lend to companies with EBITDAs lower than $25 million. And this figure will only continue to climb as federal regulations for banks grow more stringent.
In particular, venture debt has become one of the most popular routes for SMEs to meet their financing goals.
But what exactly is venture debt? Below, we’ll dive into what venture debt is, how it can be procured, and how to select the best venture debt providers.
What is Venture Debt?
Broadly speaking, venture debt refers to an entire ecosystem of debt financing options provided to early growth-stage capital-backed companies. In the United States, the market for venture debt financing is estimated to range from $10 billion to $20 billion annually.
Companies may seek out venture debt financing in order to roll out new products, reach profitability, onboard new staff, or upstart product-development efforts. A business that seeks out venture loans may not yet be profitable, and thus falls outside the lending criteria set by banks.
Even so, the company’s risk profile is still appealing to lenders — such as business development companies (BDCs), private equity or hedge funds — since it promises high projected earnings.
Venture debt functions similarly to a standard loan, wherein money is invested into a company, that is then paid back over a predetermined time period plus any accrued interest. Typically, the debt is paid over a set period of three to five years.
Before closing the deal, lenders focus on forecasted metrics to determine the company’s probability of future growth. Investors want to be sure that the company can pay off the debt within the period of the loan agreement, focusing on a borrower’s ability to raise additional capital to fund growth rather than metrics like historical cash flow.
Moreover, venture loans do not require sacrificing any board seats or company control. Company leaders don’t have to forego any stake in the business’ direction or future earnings past the period of the loan.
In contrast with equity, venture debt can be drawn up much more efficiently even though it’s usually organized alongside an equity provider. As a streamlined agreement, venture debt can be conceptualized as a term loan not unlike a mortgage.
So, how did venture debt first originate? In the ’70s and ’80s, pioneering firms like Kleiner Perkins and Sequoia Capital launched several knock-out startups like Sun Microsystems, Genentech, and Apple.
The birth of a digital age ushered in a swath of entrepreneurs seeking out alternative financing, which was much more flexible than traditional bank loans. New financing sources provided for a more efficient, less costly capital structure.
However, new companies struggled to meet the historic cash flow and credit requirements posted by financiers. During this time period, Dun & Bradstreet estimated that 80 percent of startups failed.
Unsurprisingly, the issue wasn’t with the companies themselves. The capital required for growth couldn’t be easily funneled into high-tech businesses. Rather than provide businesses 50 percent equity for equipment purchases, pioneering firms realized it would be advantageous to offer 100 percent financing repaid over a set period.
The result? Flexible financing options with a comparatively lower risk profile and elevated returns. Since new companies most often fail after the four-year mark, the default risk for debt lenders is mitigated over the loan term.
Types of Venture Debt
Venture debt encompasses a broad array of loans, ranging from capital revolvers to synthetic royalty loans.
Most loans fall into four distinct types: lines of credit, term debt, equipment financing, and royalty monetization.
- A line of credit helps to fund a company’s investment in short-term assets, which may include equipment or accounts receivable. The capital is flexible enough to finance the daily operations associated with overhead and payroll, which is especially important in the early growth phase.
- Term debt is a loan set to be repaid over several years that typically features fixed interest rate payments. As a senior term loan or second-lien term loan, venture debt is highly predictable for both borrowers and lenders alike.
- Equipment financing is used primarily for provisioning expensive capital goods. The repayment period most often aligns with the expected life of the equipment provisioned. However, equipment financing is not very useful for asset-free SaaS (Software as a Service) companies.
- Royalty monetization is structured based on the borrower’s projected revenue stream. As the borrower’s revenue performance changes, the loan payments fluctuate relative to a predetermined multiple of the original loan. Not only does the borrower not have to be capital-backed, but the financing is non-dilutive and features no minimum principal payments. However, the borrower has to have generated revenue and feature strong gross margins to attract royalty-based financing lenders.
You may be wondering: How does venture debt differ from convertible debt and a working capital line? While convertible debt may be dilutive, venture debt is more flexible and doesn’t entail sacrificing shares of the borrowing company.
Venture debt has a higher interest rate and may vary according to loan terms or default clauses. Compared to a revolving line of credit, venture debt isn’t secured by working capital and is not bound to current company performance.
The Benefits for Borrowers
Companies in an early and rapid stage of growth benefit tremendously from taking on venture debt. In the span of thirty years, venture debt has arisen as one of the integral components of a balanced capital structure.
Big-name businesses, like Airbnb, Uber, and Spotify, fueled their initial growth efforts through venture debt. In the US, venture debt now accounts for 15 percent of the entire venture financing market.
Most compellingly, venture debt doesn’t require board governance or financing stake in the borrowing company. The financing is often used in between rounds of equity, providing quick infusions of capital that don’t require drawing from the equity reserves of current investors.
So, when should a borrower opt for venture debt rather than undergoing an equity financing round? Venture debt often functions as a safety net, providing a buffer against oncoming financial risks and extending the cash runway of the current funding cycle. Purchasing equipment, onboarding staff, or financing day-to-day operations all require sufficient (and quickly provisioned) capital.
Through providing a bridge between equity financing rounds, companies can achieve growth milestones, such as higher valuation, in time for the next equity round. Venture debt is utilized to leverage growth to a point when less expensive capital is available.
Perhaps the most salient advantage is that debt is invariably cheaper than equity. While equity shifts based on company valuation, venture debt is provisioned according to more favorable terms for the borrower.
Startups focused on meeting profitability goals rather than focusing on immediate growth are very well-served by venture debt. Unlike venture capital, debt lenders are purely focused on the financial viability of the company over a predetermined period, meaning they don’t saddle the borrower with an expectation of continuous growth.
Moreover, the borrower doesn’t have to adhere to “rockstar” stats concerning historic cash flow, debt-to-income ratio, or structured top-level leadership. Venture debt lenders fund flexibly and work with borrowers banks won’t touch. That’s probably for the best, since large and small banks don’t have the expertise, patience, or resources to closely monitor the growth of a startup.
What types of companies seek out venture debt? All sorts. In June of 2020, more than 60 startups had already accrued $2 billion in venture funding — businesses ranging from biotech to fintech, software and IT.
The Northampton company Clean Crop Technologies agreed to a $2.75 million seed round to develop new equipment that monitors for crop loss and food waste. GreenLight Biosciences joined them, accruing $102 million in funding to deliver RNA products to farmers.
In the cryptocurrency space, Floating Point Group, a company that provides algorithmic systems that optimize trading, raised $2 million from several asset management executives.
Notably, jSonar, a database security startup founded in Waltham, closed a $50 million debt round from Goldman Sachs — and this was the company’s first round of funding.
There’s no shortage of early phase and SaaS companies who have benefited from favorable venture debt agreements.
When Is It Best to Pursue Venture Debt?
While venture debt allows for highly favorable financing arrangements, it’s not suitable for all businesses at all growth stages.
Venture debt is most suited for early startups and mid-sized companies that seek to extend the cash runway in order to achieve higher valuation in future equity rounds.
By extending that runway, you can avoid raising equity during periods of economic turbulence. Take, for example, the effect of the coronavirus pandemic on capital markets: Many companies experienced a protracted loss of profitability, making equity lending terms much more lender-friendly.
Venture debt can act as a bridge to future profitability. Lenders view venture debt as neutral since it doesn’t denote any worrisome signs about the company’s current financial status. This is in contrast with bridge rounds, where a company is forced to seek out short-term funding to coast until another large round.
In some cases, venture debt is used to fund an acquisition in order to accelerate growth. Companies are able to use the influx of capital to make the transition seamless, finance daily operations and launch new products.
It is ideal to seek venture debt after receiving venture capital, institutional funding, or seed money. Along those lines, it’s best to seek out venture debt for funding growth after the business has achieved some predictability in long-term goals. Financial institutions will also consider your revenue and may grant asset-backed loans in coordination with venture debt as a factor of MRR (monthly recurring revenue).
During the COVID-19 pandemic, venture debt has remained a popular form of alternative financing. Of the 65 lenders surveyed, 92 percent stated that they are still negotiating new opportunities for fresh startups requiring capital. However, lenders have introduced more stringent approval terms for borrowers.
Even so, as of late April 2020, $10 billion worth of venture debt deals were made and the year is set to close at roughly $25 billion. As the equity market grows less friendly, borrowers have sought out fast capital infusions without sacrificing company shares.
This all goes to show that venture debt remains robust in the wake of global economic crises and industry-wide declines.
While venture debt has grown tremendously popular, it should be noted that some lenders are unwilling to extend debt financing to certain early-stage startups or even companies with a proven track record of success.
An interested borrower should be sure to clearly communicate their current mission and how funding would help accelerate growth. It’s important that the company remains transparent with the lender as an unwillingness to share information pertaining to creditworthiness breaks borrower-lender trust.
Lenders expect a certain level of commitment, communication, trust, and time from the borrower. Though the lender has no stake in the company, it’s still a financial risk on their part.
During the negotiations phase, companies need to verbalize their intent and develop clarity around the immediate use of the funds.
How to Select a Provider
Even the most promising, growth-oriented companies can fail. Companies seeking venture debt should carefully select the right investor, as an inexperienced one can saddle them with burdensome repayments.
It’s best to reach out to several lenders at once to discuss pricing and agreement terms. While lenders may not be involved in day-to-day operations, they can still serve as an asset to the borrower. What level of experience does the lender have? What can the lender offer the company during a sensitive phase of growth? What reputation do they have with other similarly positioned borrowers?
Typically, venture debt lenders will focus on mitigating risk rather than seeking out “unicorn” yield. Lenders will consider factors like EBITDA, recurring revenue, projected growth, gross margins, and total debt obligations before extending an agreement.
Companies should favor lenders that can extend their cash runway while structuring warrants, or contracts that offer the right to buy a security, in a favorable way. Often, lenders will request warrants that can be converted into equity when a company is acquired or goes public.
Carefully consider factors like the sum total of the loan and the lender’s fees before coming to an agreement. On occasion, lenders may seek the right to invest or certain cash flow covenants.
Experts recommend accepting a sum that extends the company’s runway by six months, which is enough to finance daily operations, onboard staff, or accelerate growth for a larger financing round.
Borrowers should also be aware of the potential downsides that come with venture debt. While the interest rates are low, venture debt does — ultimately — have to be paid off. Certain lenders, such as banks, may require monthly reports such as income statements, compliance certificates, annual tax returns, and collateral audits. Companies will also have to cover the legal fees associated with accruing venture debt, which is in addition to the loan agreement itself.
Finally, consider your eligibility before applying for venture debt. On the whole, startups backed by angel investors will not be considered for this form of alternative financing, as lenders are more inclined to work with companies that have reliable capital reserves.
Final Thoughts
For small and mid-sized businesses alike, venture debt provides a flexible, efficient, and non-dilutive way to achieve funding goals. It allows startups the opportunity to build a solid foundation, realize their potential, and accelerate growth for future equity financing rounds. And it empowers mid-market businesses to fund acquisitions, reach profitability, and roll out new product offerings.
And this all comes without the cost of sacrificing long-term vision or company control over daily operations.
Of course, finding the right venture debt lender is key. Make sure to explore all your options, rigorously review the terms and fees, and find a lender that can offer sage advice.