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why your startup needs venture debt advantages and disadvantages by vestbee
29 April 2022·9 min read

Ewa Chronowska

CEO, Vestbee & General Partner, Next Road Ventures

Why Your Startup Needs Venture Debt? - Advantages and Disadvantages of Venture Debt Funding

One of the main startup founder's goals is to make sure the company never runs out of cash. There are a lot of funding sources to finance your startup - it can be business angels, VC funds, accelerators, online matchmaking platforms like Vestbee as well as many fundraising tools like pitch deck, elevator pitch or startup one-pager that should be used to draw investors’ interest and raise funds. 

A lot has been written to help founders think through venture capital or equity financing but not much on venture debt for startups yet. However, when financing a fast-growing startup, venture debt can be just as good (if not better) than venture capital in some cases. It is also a great funding source supplementing traditional venture capital. 

In this article, we provide definitive information about venture debt, its advantages, and disadvantages and answer most common questions about its impact on companies at various stages of development. So what should you take into account while considering venture debt as a source of your startup funding? Let’s find out!

What is venture debt?

Venture debt is a type of debt for fast-growing startups previously backed by venture capital funds. Typically, venture debt is provided by banks, institutional investors, or dedicated venture-debt funds as an addition to equity financing. Unlike standard debt financing, venture debt investors are also interested in the company’s long-term growth prospects. Moreover, it is usually granted at an interest rate higher than the interest rates on bank loans and bonds. Venture debt is a form of “capital-in-residence” for a specific period with the expectation that the company will grow its business and generate revenue to repay the loan. In most cases, venture debt is provided for three to five years.

Why should your startup consider venture debt financing? 

Let's consider the situation when a startup needs more cash earlier than expected or achieving the milestone takes longer than expected. What about the case when you need more money after the initial investment? There's no going back without finding another investor who will invest in your startup at a discounted rate (meaning a down round for your startup) and then taking out more loans from those investors at even higher rates.

There are multiple reasons to need extra capital for your startup. The first choices are allocating capital from other parts of the business (i.e., slow down some departments) or taking an inside round/equity bridge investor - founders and management might not like these ideas. In this case, venture loans could help by urgently providing quick solutions for additional capital needed without slowing things down within the company by distributing internally allocated funds. So, to fund growth projects when necessary, startup founders can borrow between rounds with loan interest costs and then amortize into future periods, which would prevent setting valuation until the next equity raise.

What are the common uses of venture debt for startups? 

In some parts of the business journey, it will be necessary to extend the cash runway of a business to hit its next milestone, and it won't be possible by simply giving more equity away as it may lead to dilution. Moreover, while going through tough periods, startups are looking for a way to hide negative signals and, consequently, try to prevent a need for a bridge or down round. Why is venture debt the right solution in such cases? Let's dig into the details.

Extending the cash runway for your startup

A venture debt round is the best way to top up an equity round for a startup to extend the cash runway. Adding a significant venture loan to the funding round will give the company a few extra months of runway. If there is a delay in development, for example, having this kind of lending option means you have some spare time to reach your goal. The cost is much lower than when adding a few months-worth equity into the round. So the startup can get funds quickly while still keeping its eyes set on what's most important i.e., business development.

Preventing the need for down round 

Reaching your startup milestones will allow more equity to come in at a higher price while raising the next investment round. However, if the goals have not been met, your startup might face the option of taking a lower price from an investor. One solution is to extend the previous investment round - the current investors would enjoy this option as much as it can be done quickly and on preferable terms. However, the management and founders might disagree due to the level of progression that has been recorded within their business development since the last round.

Avoiding bridge round

Compared to a bridge round, venture debt can be more favorable as there is no signaling risk. Startup investors don't typically see a venture debt loan as a bad sign if it was raised close to the prior equity round. A company might use this loan money to get them through until raising fresh funds at an upcoming investment round, releasing up all of its equity for this effort instead of using some raised in credit rounds before that one. 

The interest on loans doesn't indicate any valuation, so founders and management will be able to keep higher valuations in future rounds and increase their profit shares with the following equity investments. 

Achieving lower dilution

A venture loan for a near break-even business can be an excellent low dilution option for investors and management. It is recommended to consider a structure with longer interest-only or longer repayment amortization – ideally long enough to allow free cash flows to service the loan. If a company is close to breaking even, investors may want to avoid putting in more equity. The founders will likely find a less dilutive option attractive at this stage of a company's life management. 

When should your startup raise venture debt?

Usually, raising venture debt is an excellent strategy for most companies backed by a VC fund with proven product, market-fit and business model following equity financing (usually round A or B). The timing of the process can be perfect, with your investors feeling optimistic about the opportunity and all of your due diligence materials fresh and readily available, thanks to the recent funding round. 

However, this rule is very general, as there is no "one-size fits all" approach to venture debt. Startups may find it easier to fund their operations with venture debt rather than obtain bank financing. However, larger companies may also find it useful to take out a venture debt loan, as it can help finance a rapid growth period. When considering a debt round at this stage of a company's life, more repayment options may be available than at earlier stages. Once a company can be self-sustaining, a debt structure with longer amortization schedules comes into play once a company has the scale and ability. However, the right time depends on various factors, such as how long it will take your company to reach its revenue projections, how much your customers are willing to pay for your product, and how much cash you have at your disposal to cover the loan. 

Nevertheless, there are a few common use cases when a startup might benefit from venture debt financing:

  • Accelerating growth with venture debt either instead of an equity funding round or in conjunction with an equity round to provide additional capital without increasing dilution.
  • Reaching additional milestones to close the next equity round at a higher valuation.
  • Venture debt can also be considered when the amount of needed startup financing is not enough for an equity round.
  • Venture debt can help extend the cash runway, fund significant capital expenses and acquisitions or act as an insurance policy if raising equity takes too long.

On the other side, there are also a few situations where venture debt financing will not work. When the company has short runway, the terms and costs of the venture debt won't be satisfying. Or, when the monthly debt payments exceed 25% of the startup's operating expenses, that will discourage future equity investors. Another case is when a company records stable revenue streams that would allow taking a cheaper loan in the bank.

Advantages of Venture Debt

Venture debt can be very attractive for startups meaning liquidity, less dilution than traditional equity investments, no control loss, and a more straightforward process that doesn't require your startup to set the valuation and lengthy negotiations. It can help you fund your operations and generate revenue to expand necessary operations while also gives precious time to develop your business plan and find a suitable operating model. Venture debt can be also used to conduct meaningful due diligence on your potential partners and other investors. The difference between venture debt and equity financing is that a valuation doesn’t need to be set for the business, meaning less dilution. Venture lenders don't have board seats or governance requirements, but debts do need to be repaid with interest over time. 

Disadvantages of Venture Debt

When compared to equity, venture debt has some downsides. A loan creates a cash expense for the company and needs to be repaid or refinanced in the future. Also, venture debt has a higher interest rate than standard loans, so it is a pretty expensive funding source. Raising venture debt may result in difficulties in finding suitable partners for acquisition or strategic alliances. 
Negotiating properly is important when looking at venture debt because if you don’t do so correctly, costly fees and restrictions could negatively affect what decisions founders can make with their companies as they grow. However, keep in mind that while there are some disadvantages here too-venture loans have many benefits which also give them an advantage among other types of financing tools like grants or investors.

 

So is a venture debt the right funding source for your startup? There is no straightforward answer. However, before making a decision consider all of its advantages and disadvantages and make sure you understand all the potential outcomes. 

Related Posts:

Startup Fundraising: How To Craft Startup One-Pager For Investors? (Olga Chechłacz, Editor, Vestbee)

ESG In Venture Capital: How ESG will affect VC funds and startups? (by Ewa Chronowska, Partner, Next Road Ventures)

Startup Fundraising: Due Diligence (by Ewa Chronowska, Partner, Next Road Ventures)

 



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