One of the most frequent issues entrepreneurs encounter is how to sufficiently finance their ventures from start to finish. Many rely on stock raises to move up the J-curve, but the resulting dilution is frequently expensive. Apart from this, there are plenty of options available. Founders often underuse this potentially attractive alternative: venture debt. Venture debt plays a significant role in the capital structure of many venture-backed startups, whether seeking to extend their runway between equity financings, obtain expansion capital with minimal dilution, or both.
For entrepreneurs, venture debt can be extremely helpful in achieving goals in the early stages and securing capital later on while controlling cash flow. However, it’s not a universal solution. Although venture debt is more complex than the typical equity fundraising that founders are used to, many mistake it for “free money.” Debt, as opposed to equity, has additional constraints and requires interest-bearing repayment. Even though more lenders are involved, less capital is being used due to rising interest rates and a decreased willingness to take on risk, which might cause venture debt to cost more than anticipated.
The best part is that you may use venture debt to grow your company without being an expert in debt finance. However, knowing when and how to access the venture debt markets is important. Let’s understand everything about venture debt in detail.
What is Venture Debt?
Venture debt is a type of funding designed especially for startups. They give borrowers (your company) non-dilutive or very slightly dilutive cash in the form of debt.
The purpose of venture debt is to supplement conventional equity financing, not to replace it. In reality, a condition precedent to obtaining venture debt is having the support of a renowned venture investor. Lenders infer that your business will almost certainly secure additional funding rounds from both these and other investors. This presumption makes banks and other lenders comfortable offering relatively inexpensive debt to startups.
For early-stage companies, including venture debt in your financing structure may provide more flexibility. Debt can lengthen the time between rounds, which is important when achieving important benchmarks that may depend on one or two more months of execution. Additionally, it eliminates the need for an early equity raise if cash is desperately needed.
What’s in it for the Lender if the Borrower Isn’t Getting Diluted That Much?
Initially, venture debt is senior to equity in the event of a liquidation, meaning it is paid out before the latter. Lenders may be entitled to an all-asset lien, which covers intellectual property, as collateral. The second drawback for lenders is that it limits their capacity to share in the prosperity of a business. Because of this, many venture debt agreements include warrants, which allow the lender to buy equity shares at a fixed price (typically lower than or equal to the equity from the most recent round or the one that came before it). While only slightly diluting founders and early investors, warrants improve the deal for lenders.
When is the Right Time to Consider Raising Venture Debt?
1. Alongside an Equity Round
Raising a smaller round of venture debt after equity financing can avoid raising a business’s total equity. Thus, a company can continue to operate with more capital while minimizing dilution and having a longer runway devoted to execution rather than fundraising.
2. As a Financial Bridge to Reach the Next Milestone or Equity Raise
If something goes wrong and the company needs to prolong its runway to the next valuation driver, venture debt can act as a buffer. For example, if a business has clients who were supposed to sign this year but instead choose to sign next year, they might use debt to tide things over until then. It is sufficient in this instance to prevent a penalizing downswing.
3. To Finance Predictable Cash Expenditures
One effective technique to pay for working capital or other capital expenses is with debt. Venture debt might be helpful if a business needs quick funding to complete a product development project or make a critical leadership recruitment.
4. To Extend the Financial Runway Without Initiating a Priced Round
Debt can be utilized to get a business through to a turning point without thinking about how it will affect valuation, such as when it signs a big deal. It can add an insurance runway as a safety net and potentially reduce the need for additional equity financing.
Tips on Managing a Debt Fundraising Process
Choosing a lender and negotiating terms can be daunting when dealing with debt, as numerous options are available. This is particularly valid for first-time founders. This should not deter you. To make sure you choose the finest financing options for your company, remember these five points:
- Set Priorities: Consider your required capital amount, your anticipated short-term cash flow, and the level of dilution you can tolerate. This will enable you to calculate the amount of debt you should try to raise and create a payback schedule.
- Explore Your Options: Start by talking to venture banks about your alternatives. Their interest rates are usually the lowest. Although debt financing offers greater repayment flexibility, there is a price. Ask your investors for advice and introductions first; venture debt lenders will feel more at ease knowing that the business has the support of its investors.
- Ask Directly for Information: Venture debt can take many forms, so be aware of what you need and want and speak up about them. To gain an advantage, engage in frequent and early negotiations, aiming for three—to five-term sheets.
- Evaluate Costs: Create a matrix that compares term sheets side by side and distribute them to your board. To compare costs, graph interest rates, amortization schedules, and fees. After calculating the entire cost, the best offer will frequently become evident.
- Conduct Thorough References: Speak with current or past clients of the lender, particularly those who have experienced default or near default. Your potential lender needs to be able to supply reference data when asked.
Navigating Venture Debt Successfully
In summary, venture debt is a great tool that allows startups to extend their runway and minimize equity dilution. It is most beneficial when used with equity rounds, as a bridge, or for predictable expenses. By understanding its limitations and mastering the fundraising process carefully, entrepreneurs can make the best use of venture debt to support growth and maintain financial flexibility.
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