Every start-up founder has a goal that the company must have enough cash and investment. There are multiple sources to get funds for the business, such as Angel Investors, VC funds, etc, along with fundraising tools that help to draw investors’ interest in the business.
In certain circumstances, venture debt may be equally advantageous as venture capital for fast-growing businesses. It’s also a fantastic way to supplement traditional venture financing with additional funding.
Venture Debt – Financing tailored to your start-up
Venture debt is a kind of financing historically provided by venture capital funds to rapidly expanding start-ups. In addition to equity financing, banks, institutional investors, or specialized venture-debt funds typically offer venture loans. In contrast to traditional debt funding, venture debt investors also consider the company’s potential for long-term growth.
Furthermore, it is typically awarded at an interest rate higher than bonds and bank loans. Venture debt is a form of “capital-in-residence” given to a firm for a set amount of time with the hope that it will expand and make enough money to pay back the loan. Venture debt typically has a three- to five-year term.
How does Venture Debt Work?
Compared to other loans, venture debts operate differently, like no collateral is needed to approve the loan. Even though your previous equity round decides the principal amount. Roughly 30% of the money raised during the most recent equity transaction goes toward the principle. The loan period is typically short or medium-term, up to three or four years.
Interest rates on venture debt are higher than those on bank loans. This is because lenders face a higher default risk when they provide these loans to start-ups and businesses that are not (yet) profitable or do not have substantial assets. In addition, as payment for their increased failure risk, the lenders would get warrants on the company’s equity.
Venture Debt Warrants
Warrants are particularly relevant to venture debt. They turn venture debt into a costly choice for companies. Using warrants as collateral, a lender can purchase business stock at a certain price within a predetermined time frame. Additionally, warrants make a business or start-up less valuable in future funding rounds.
When is venture debt right for your business?
After equity financing (generally round A or B), borrowing venture debt is typically a great approach for most companies backed by a venture capital fund with a proven product, market fit, and business model. Because of the recent fundraising round, all of your due diligence materials are current and easily accessible, and your investors are feeling positive about the potential; the process timing can’t be more ideal.
Nevertheless, this guideline is extremely broad because there is no “one-size-fits-all” strategy for venture financing. Instead of getting bank financing, start-ups might find it simpler to finance their operations with venture debt:
- To extend your cash runway: If you want to extend the time during which your company can remain solvent without raising additional funds and your burn rate is substantial, venture debt can be a suitable option. Fast-growing IT companies constantly looking for funding find that venture debt works well for them. If you need funds because you spend a lot of money. Venture debt is a convenient and speedy source of funding. It enables you to concentrate on expansion as a firm.
- As an addition to equity: You may consider venture debt in addition to equity. However, a 100% debt-based investment round is not the best option if you are not making enough money. A debt-to-equity ratio will yield better results. It will guarantee you receive the capital you require without causing the dilution that a 100% equity round would cause your company.
- To achieve a higher valuation: If you use your venture debt well, you can postpone your last investment round. This will support you for a year or two when you dilute your shares for a specific price X with the venture debt. Your company’s shares have the potential to double in value during that time. Delaying your last equity round by a year or two will result in a greater valuation and a larger profit share for you.
- For expansion into new markets: Venture capital is a valuable tool for rapidly expanding businesses looking to expand into new areas. In recent years, venture debt has created a new cross-border facility market, providing equity-sponsored funding.
Things to Consider When Deciding Venture Debt
Here are some considerable points to keep in mind while deciding on venture debt:
- Speak to multiple lenders: Discussing your price and agreement conditions with several lenders is a good idea. Lenders can benefit your company even though they might not have any control over it. Examine the lender’s background, reputation, and experience with other lenders carefully. This will help you determine whom to trust.
- Sum total of the loan Vs. Lender’s fee: Before choosing, carefully weigh the loan amount and the lender’s fees. Experts advise you to take a payment that extends the runway by around half a year.
- Legal fee for undertaking a venture debt: Remember that if you take on a venture debt exceeding the loan amount offered, you must pay legal expenses. Remember this detail when determining whether or not to accept a venture debt.
Venture Debt Advantages
Below are the advantages of venture debt:
- Extend company runway – Venture debt may extend the startup’s cash runway until the following round of funding. Along with the company, existing investors gain from less equity dilution.
- Aim for cash flow positivity – Venture debt has the potential to prolong a company’s cash-flow positive runway. This lowers stock dilution for current investors and employees, making it an excellent method of reducing debt. It facilitates the company’s progress during a crucial stage of expansion.
- Provide a safety net for potential issues – When there is a problem, the venture loan may be used as security. It supports the business until it gets back on track.
Venture Debt Disadvantages
Here are the disadvantages of venture debt that businesses should know about:
- Risk of missing deadlines – The bleak potential of failing to meet your goal by the deadline you set.
- Debt payment consequences – Not making debt payments on time is possible. The loan agreements typically contain a list of requirements the company must meet. Missing these deadlines might be disastrous for startups.
- Venture debt eligibility limitation – Venture debt is not available to businesses that have received angel funding.
Deciding on Venture Debt
Venture debt is the loan amount offered to business owners for their early-stage startups with venture capital backing. Further, it can be used as performance insurance, a lower-cost runway extension, or a short-term bridge for next-round equity. However, with venture debt, there is no guarantee that the debt payments will be on time, and it’s not available for businesses with angel funding.
However, a growing and fresh start-up requires venture debt to achieve higher evaluation and expand its new markets.
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