Securing venture debt can be a strategic step for early-stage companies that want to grow but don’t want their equity diluted. However, understanding eligibility and requirements is crucial for success. In this guide, we dissect the usual set of qualifying standards and the strict requirements of most lenders. Note that these are the “hard and fast” guidelines; you can still be eligible for a venture debt even if you don’t satisfy the below requirements! Now, let’s get started!
A Brief Overview of Venture Debt and Its Advantages
As the name suggests, venture debt is a type of repayable loan funding. Startups receive funding for a long period (often 36–48 months) in exchange for warrants that typically grant them equity in the company, as well as interest payments on the principal balance throughout the loan and a lump sum payment at maturity. These loans are designed to meet the special requirements of startups, especially in the early stages of their expansion. To be more precise, the advantages include preservation of equity, flexibility, liquidity management, extension of the runway, and speed and efficiency.
- Preserving equity: One of venture debt’s most important benefits is that it enables businesses to raise capital without giving up much, if any, of their equity. This is especially beneficial for entrepreneurs who wish to continue influencing their business.
- Managing liquidity: Since most venture debt agreements include interest-only periods, entrepreneurs are able to utilize the whole principal amount to fund R&D, product development, or other strategies to stimulate revenue growth.
- Ensuring flexibility: Among the most adaptable forms of funding, venture debt enables entrepreneurs to finance the creation of new products, the initiation of marketing campaigns, or the beginning of growth plans. This is so because, as already mentioned earlier, it doesn’t need to be paid back immediately.
- Extending runway: Since debt finance must be returned with interest, technically, no financing can extend a startup’s runway. Between their Series A or early seed fundraising and later equity rounds, firms frequently experience a financial gap. Venture debt bridges this situation, enabling entrepreneurs to keep up their momentum and achieve their strategic ambitions.
- Optimizing speed and efficiency: Securing venture debt is usually faster and more efficient than the drawn-out process of raising equity financing. This speed can be essential for grabbing time-sensitive growth opportunities.
Understanding Eligibility Criteria and Requirements for Venture Debt
To obtain venture debt, a startup must fulfill particular requirements used by lenders to evaluate the startup’s ability to repay the loan. In this section, we’ll examine lenders’ main criteria to determine if a firm is eligible for venture debt. Lenders consider various things, so you can be eligible for venture debt from one supplier but not another.
1. Investor Quality
Previously, having high-quality investors was crucial to being eligible for venture debt. Having tier-one VC support almost guaranteed approval for venture debt. These days, it hardly matters, let alone nearly as much.
2. Cash Reserves
Whether the funding is “old” or “new,” most venture debt providers will lend up to 35–40% of a startup’s cash balance. If a startup has a lot of non-cash collateral, like equipment or intellectual property, even with a little cash balance, it might be able to get venture debt.
3. Collateral
Venture debt providers typically require 1.25–1.5 times the outstanding loan total as collateral. Pledges of inventories, machinery, accounts receivable, and intellectual property are common among startups.
4. Current Ratio
This ratio examines a business’s current assets and liabilities to determine how well-positioned a startup is to pay down its short-term debt. Venture debt providers often will only make loans with a current ratio of 1.5.
5. Debt Service Coverage Ratio (DSCR)
This metric assesses a startup’s capacity to pay off debt by comparing its operating income to debt payments. Venture capitalists often lend up to 1.25 times a startup’s projected operating income.
6. Existing Debt or Pledged Collateral
Generally speaking, businesses with ongoing all-asset liens, other senior debt on their balance sheet, or a junior debt arrangement in which they have already pledged their intellectual property will not be eligible for venture debt.
7. Liquidity and Working Capital Requirements
Working capital and liquidity ratios assess a startup’s immediate financial health. These ratios ensure the startup has adequate liquid assets to pay its bills immediately. Lender action may ensue if certain ratios are breached, which could indicate financial hardship.
8. Funding Recency
Venture debt providers typically lend up to 40% of a capital round if they enter the market right after an equity raise. Thus, if XYZ startup raised $20 million, it would qualify for a further $10 million in venture debt. Other venture debt providers that specialize in different sub-forms of venture debt are not concerned about the funding a startup has raised.
9. Revenue
A firm may or may not need to start making money to be eligible for venture debt. For instance, revenue is typically not required by providers who serve as follow-on capital providers for equity raising. Nevertheless, most venture debt agreements have covenants that set a certain amount of income the business must bring in every quarter.
10. Runway
Venture debt lenders generally don’t offer facilities to entrepreneurs with less than 18 months left on their runway.
11. Venture-debt-to-company-valuation Ratio
Venture debt providers typically only lend between 6% and 8% of the company’s most recent post-money valuation. This is known as the venture-debt-to-company-valuation ratio.
Tips for a Strong Venture Debt Application and Successful Funding
Your loan application must be well-structured and thorough so that lenders can assess the financial stability of your firm. Make sure your accounting data is correct, and all of your financial paperwork is current before beginning the loan application procedure. Ensure you have modeled the required amount of capital, the impact on your runway and cash flow, and the projected growth in revenue. Convincing the lender that you have a plan for the funds and that your firm will be able to repay the facility is ultimately your aim. Here are a few additional related tips:
1. Begin Early, Particularly When It’s Not Urgent
The venture debt process takes eight to twelve weeks to finish, so start as soon as possible. Applying when you don’t need the money is the best approach because it will be much easier to qualify for, and even if you don’t get it right now, you can still access it later (as long as your firm doesn’t undergo any significant negative changes).
2. Maintain a Structured Approach
Decide which providers to target, pinpoint your business need, be well-versed in your data, use your connections to arrange a meeting, and submit a strong application.
3. Give Priority to Critical Terms
Pay more attention to the covenants and conditions of the contract that have the potential to have a big influence on your startup’s daily operations than to the warrant coverage or headline interest rate.
4. Assess the Actual Cost of Capital
Consider the true cost of capital, which includes the interest rate, fees, and warrants associated with the facility, restrictive covenants, and investor rights. Using these factors, compare different term sheets.
5. Borrow Only What’s Necessary
Although you are approved for $10M, it doesn’t mean that you must draw the full $10M. Draw only the amount that you need in the beginning and re-evaluate if you need more capital when you are approaching the end of the draw-down period.
6. Include an Additional 25% Buffer
When modeling your needs and assumptions, factor in a buffer of 25–30% to accommodate the possibility that things won’t go according to plan; as the saying goes, “If something can go wrong, it will go wrong.”
7. Choose the Appropriate Partner
Much like all forms of permanent capital, you should trust the partner selected to work with. A partner of integrity will respect your wishes, aid you in difficult times as well as in good times, and be willing to share your concerns and help if your plan fails.
Key Takeaways on Securing Venture Debt
Venture debt is a good option for startups that want to preserve their equity while they grow. However, obtaining venture debt requires a thorough understanding of lender requirements and strategic planning. Start early, run a tight process, prioritize key terms, take what you need, and include a 25% buffer. Diverse lenders have different preference factors, so continue your search for the right lender who suits your goals and principles.
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