Obtaining the necessary funding for your small business expansion may seem unattainable. Every day, you must make dozens of decisions about hiring new staff, selecting the best software, and locating clients interested in your offering.

Many small business owners choose to stay with what they know and obtain funding through a traditional bank loan because they have too many options. Although it’s one of the most popular methods, other options exist for raising money. Another way to raise money in a short time is through venture debt.

In this article, we will share the pros and cons of venture debt so that you can decide if it’s the best option for your business venture.

What is Venture Debt?

A type of debt financing provided to startups and companies supported by venture capital during their initial phases is called venture debt. This type of financing enables these enterprises to access capital between rounds of equity funding. Venture debt differs from a long-term source of funding.

Venture debt loans are typically returned in 18 months, but they can take up to 3 years to pay back. This is because venture capital lenders anticipate being paid back by the money businesses make from their upcoming round of funding. Let’s go and see the venture debt pros and cons in detail.

Pros of Venture Debt

Venture debt is used by the entrepreneurial community widely. This is because using venture debt has many unique benefits. Listed below are a few advantages of venture debt:

1. Less Dilution

One of venture debt’s strongest arguments is that it allows for more funding access at a lower equity cost than traditional fundraising. Founders can access a source of funding without having their ownership substantially diminished. Commonly, the equity surrendered takes the form of warrants or options, but certain lenders may ask for common or preferred stock instead. Either way, the percentage of equity ought to be substantially less than what you would forfeit by raising the entire equity round.

2. Extend Runway

Your company can access additional funds through a venture loan, allowing it to take longer between funding rounds. This extra time can be used to validate your business model, find a high-value client, or complete other important tasks for technical development.

3. Less Expensive Funding

Venture debt is known to incur annual costs ranging from 12% to 30%. Comparing this interest rate to standard bank loans, it is extremely high. Therefore, this loan might seem pricey if we compare it with conventional bank loans. It is crucial to remember that the entrepreneur also has the option of selling their equity. These days, the price of equity is substantially higher than that of venture debt. Additionally, debt can be paid off quickly, but equity must be repaid for the duration of the company. Therefore, it’s reasonable to conclude that venture debt is a significantly less expensive funding source than equity.

4. Helps in Preventing Setbacks

Bargaining power greatly impacts startup financing rounds. Prospective investors frequently significantly reduce a company’s valuation if it is nearing financial ruin. This is due to their awareness of the founders’ limited options. In this instance, venture debt turns out to be a practical substitute. A start-up company can raise capital between investment rounds using venture debt. This guarantees that business owners never have to beg for money from the public. They can find investors willing to give them a fair valuation because they can sustain themselves independently for a while. 

5. Quick and Convenient

Venture debt is frequently expedient as well. When obtaining venture debt, significantly less paperwork is needed than applying for a conventional bank loan. Furthermore, the language is far less restrictive. For this reason, entrepreneurs tend to raise venture debt whenever they require an emergency cash infusion.

Cons of Venture Debt

While venture debt is a popular option for many entrepreneurs, there are also several drawbacks. A few disadvantages of venture debt are enumerated below:

1. Growth Deterrent

Venture debt has the potential to hinder growth. During their growth phase, start-up companies want to ensure they have no cash outflow obligations. This is because they need money to support their growth, and their cash inflow is often unpredictable. A venture debt contract imposes obligations on the startup company regarding repayment schedules. 

2. Relationship with Current Investors

Even though venture debt isn’t meant to be determined by the company’s assets, in practice, it frequently is. Thus, tensions between venture debt investors and equity partners are likely to arise if there is any kind of economic unrest in the future and the company struggles to perform. The startup needs to ensure that every party’s rights and obligations in every circumstance have been thoroughly outlined and shared with everyone.

3. Can Lead to Bankruptcy

As previously stated, venture debt must be paid back according to a repayment plan. The business will default under the contract terms if it cannot make the payments by the scheduled date. Therefore, venture capital investors can file for bankruptcy on behalf of the company with the court in these situations.

4. No Repayment Flexibility

Investors in venture debt are notorious for their brutal business practices. This is because venture capital firms are aware that while half of their investments will fail, the other half will generate enough revenue for them to offset their losses. Investors in venture debt, however, have less profit potential. They, therefore, have no means of letting any of their investments go bad. Because of this, they are extremely strict about the terms and schedules of repayment.

Venture Debt: Pick the Right Path for Financial Success

After reading the pros and cons of venture debt for startup financing, the pros include quick and convenient ways to raise money, less dilution, and less expensive funding. On the other hand, the cons of venture debt are that it is not flexible, leading to bankruptcy and affecting the relationship with investors.

However, as a founder, if you know how to choose venture debt in the right manner, you can understand the importance of venture debt, which can align with your company’s financial strategy and growth plans.

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