What is venture debt financing?

What is venture debt financing

Venture debt is a type of debt financing that is available only to startups that are backed by ventures. Venture debt is typically less expensive than equity financing and is often used by startups between equity rounds or to supplement equity financing. Venture debt lenders evaluate a startup’s growth rate, business plan, and track record with investors.

How does Venture Debt Financing work?

Venture debt financing is identical to a loan, but not in the traditional way. It’s usually offered by a venture capital group that has already paid equity capital for your startup. For example, assume you start a company. In the beginning, you own 100% of the shares. After a small seed round, your share of equity is reduced. You then have a Series A and raise more money, but also significantly reduce your share of ownership.

At this point, you need more capital, but aren’t ready for a Series B and don’t want further dilution. One of your venture capital investors may offer venture debt. Typically, the maximum loan amount is 30% of the last round of investment. So if you raised $5 million in your last round, you may be able to receive up to $1.5 million in debt financing from one of your venture capital investors.

Venture debt financing usually has a very short repayment term, often three to five years. They also come with much higher interest rates than traditional loans. It’s not unusual for venture debt borrowers to pay the prime rate plus five to nine percent annually. Over the course of a three-year venture debt loan, you could pay 20% or more in interest.

Benefits Of Venture Debt Financing

If venture debt financing is costly, why would a company accept it? There are a few reasons. First, as mentioned, it’s a way to access capital without further diluting ownership. You can continue to grow your business without giving up voting shares, board seats, or equity.

The biggest upside of venture debt financing, perhaps, is simply that it’s a way to finance growth without equity, which is always more expensive than debt long-term. If there is a gap between when you purchase inventory and collect revenues you may want to use traditional debt, a line of credit, or venture debt to cover your working capital needs, rather than burning through equity.

Your company might need to finance a capital purchase or an investment that has very predictable or stable cash flows. In these cases, venture debt is often more attractive than using equity capital to fund these expenditures.

Conclusion

Generally, companies are engaging in venture debt financing alongside an equity round and seeking to balance the two funding arrangements. This type of financing is best used as an instrument for stable investments like buying inventory, funding working capital gaps, or financing long-term projects. This isn’t a stop-gap or something to be undertaken lightly, since sophisticated investors are unlikely to lend if you’re running out of cash and need significant capital investment.

Used in parallel with traditional funding methods, however, venture debt financing can give your startup the extra boost it needs to survive and thrive.

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About the Author: Paul Taka