Venture Debt Financing: How It Works, Terms, and Best Alternatives

What Is Venture Debt Financing?

Venture debt is a type of debt financing that’s available only to venture-backed startups. 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.

With the immense number of business startup costs involved in launching a company, founders are always concerned with financing their ventures. But securing traditional financing as a startup is among the most difficult challenges within small business lending, so many startups turn toward equity investors instead. Companies aren’t always in a position to give up more ownership, though, which is when venture debt financing can be a crucial instrument.

Venture debt financing is a type of small business loan in which a company takes on debt, rather than accepting money from an investor in exchange for equity. But venture capital loans are different from traditional small business loans. We’ll go through how these two types of financing differ, whether your business is eligible for either, and some alternative types of loans to consider.

How Does Venture Debt Work?

Venture debt—also called a venture capital loan—is a type of debt-based financing. Venture-backed companies often seek these loans between equity rounds, or to finance specific opportunities.

However, this capital isn’t issued by venture capital firms, but rather specialized venture debt lenders, which include banks, hedge funds, private equity firms, business development companies (BDCs), and a few other outlets. More importantly, the capital is issued in the form of debt, not equity. So, founders don’t need to give away sizable percentages of ownership in their company—one of the distinct advantages of venture capital loans.  

Venture debt financing is generally structured similarly to traditional medium-term business loans, with three-to-five-year repayment periods. Occasionally, they’re issued as business lines of credit or equipment financing.

It’s much less common for business owners to raise venture debt than to raise venture capital. Although it’s not officially tracked, one figure for 2017 puts VC investments at $84.2 billion, and VC loans at just about $8 billion.

Why Venture Capital Loans Can Help Startups

Many business owners are surprised to hear that mixing equity and debt isn’t only possible for financing their businesses, but an underappreciated key to growth. Major businesses—including Sweetgreen, Airbnb, and Uber—have leaned on venture debt to propel their seemingly unstoppable growth trajectories, rather than raising additional rounds of funding.

That’s because every time you raise money with traditional venture capital, you’re giving away more ownership in your company. To secure venture capital funding, you’ll need to exchange equity for that capital, and cede control of a little bit more of your company. If you don’t want to slice up your equity any further, especially if you’ve already diluted your control more than you feel comfortable, taking on a venture capital loan can be an excellent idea.

Venture Debt Financing Pros and Cons

On top of the price of raising equity, raising a round of venture capital takes an immense amount of time and strategy. Founders are limited in how much effort they can spend on fundraising. Plus, after a fundraising round, investors want to see you meet certain milestones before agreeing to front you more money.  

Advantages of Venture Debt

Venture loans can be exceptionally helpful when you need to:

• Extend runway between rounds
• Finance a specific project, like a marketing campaign
• Finance a purchase, like equipment or inventory
• Invest in a specific opportunity to accelerate growth
• Limit dilution of ownership

As we’ve mentioned, the main reason founders rely on venture debt is that they’ve already given away a fair bit of equity in prior rounds. In that case, raising another round might dilute their ownership so far that they’d no longer have company control, or would have to give up board seats and voting rights.

Disadvantages of Venture Debt

Although venture debt is less expensive than equity financing, it isn’t inexpensive (more on that in a bit). But, most importantly, it’s risky for companies that aren’t in secure phases of hyper-growth.

Venture debt is generally what’s called “senior debt.” This means that this debt takes precedence over other outstanding obligations if you default on your loan. In traditional business loan terms, the venture debt lender would be first lien position, meaning they’d collect before any other lender. In the event of a default, venture capital lenders can seize control of the company or its assets, or force it to liquidate.

So, if a company isn’t totally sure it can repay the loan, a venture capital loan isn’t the right financing tool.

The other downside to venture debt is that this option is only available to companies that have already raised venture capital.

Venture Debt Financing vs. Regular Business Financing

In some ways, venture capital loans and business loans are similar—after all, they both fall under the category of debt financing. But there are some crucial differences between the two. Understanding the fundamentals of how these products are underwritten, secured, and assessed will explain who ends up qualifying for either.

Underwriting

The small business loan underwriting process can seem like a mystery, but there’s actually a lot you can learn about it as a business owner. If you apply for a traditional business loan, your lender scrutinizes your business and personal credit score, yes. But they also spend significant time looking at your cash flow, revenue numbers, and DSCR to determine the financial health of your business—aka whether or not you can pay back your loan.

Startups don’t have these figures to provide underwriters. And, what’s more: If underwriters focused primarily on cash flow, most startups—if not practically all—would never get a cent of financing. Many aren’t generating revenue because their products or technologies can take years to develop and go to market, and they’re quickly burning through cash.

That means that underwriters use different credentials to qualify startups for venture debt financing, and also to determine their repayment terms. That’s where their investors come in.

Among other factors, venture lenders will actually underwrite based on the investors’ track records, how much they’ve committed to the company in previous financing rounds, as well as how much financing the company has raised overall. The company’s business plan, quality of its technology and team, and capital strategy also factor in—which is quite different than the process of a traditional business loan.

Collateral

Collateral works differently with venture debt financing, too. Collateral for loans generally comes in the form of property, savings, or a blanket lien with traditional working capital loans; or, for asset-based lending, like equipment financing or inventory financing, the assets themselves act as collateral.

Venture capital lenders also place blanket liens on borrowers. But, somewhat unusually, collateral might also include an exclusive pledge to the company’s intellectual property, especially if the lender deems the company as potentially high-risk.

Warrants

Another feature exclusive to venture capital loans is that their price structure includes stock warrants.

In short, whoever holds a warrant has the right to buy stock at a fixed exercise price, as indicated by the strike price on the warrant, up to a certain point of expiration as noted. Unlike stock options, a company issues warrants rather than an exchange; warrants also last substantially longer than options. Basically, it’s another financial incentive for the lender.

Warrants are built into the terms of venture debt financing because it’s inherently risky for new, rarely profitable businesses to take on these loans. Even the repayment terms that venture lenders do provide to borrowers don’t accurately reflect the risk that they’re taking on; if the loans did, the interest would be insanely expensive and eat so much of a company’s cash flow that they’d defeat the purpose of the loan altogether. Allowing lenders the chance to opt in with a warrant, even years down the line, sweetens the deal for the lender should the company do exceptionally well, while simultaneously lowering the cost burden on the borrower.

Cost

Let’s compare the terms of traditional small business loans for the most qualified borrowers against the best venture capital loans.

Probably the most coveted small business financing products are SBA loans, which are backed by the U.S. Small Business Administration. These loans are desirable for their low rates and long repayment terms as compared to other business financing products. As such, they’re competitive to qualify for, and only the strongest borrowers—with high credit scores and solid business financial histories—get them.

Typical terms for SBA loans

• SBA 7(a) loan: Maximum interest rate of 2.75% + Prime Rate; 7-year terms for working capital, 10 years for equipment, 25 years for real estate
• SBA 504/CDC loan: Typically 5-6% interest rate; up to 25-year terms

And it’s worth reiterating that with SBA loans, you don’t cede any kind of equity stake in your company.

Typical terms for venture capital loans

• From banks: Prime Rate + 0% to 4%, 3 to 5 years
• From funds: Prime Rate + 5% to 9%, 3 to 5 years

Remember that within these terms are also stock warrants. Very little equity dilution occurs with venture debt financing—that’s exactly why many opt to raise debt rounds over financing rounds, of course—but the issuance of warrants is dilutive by definition. Because of the higher interest rates that funds charge, they usually issue fewer stock warrants and often dilute close to 1%. Banks, with lower interest rates, will generally issue more warrants and dilute slightly more than 1%.

Access

If you don’t have VC or a similar institutional backing behind you (say, a university incubator), then venture debt financing won’t be a viable option for you. And that comes down to the number one difference between venture capital loans and traditional business loans: access.

Venture capitalists and venture firms don’t issue venture debt financing themselves—that comes from a venture debt lender, like a bank or a hedge fund. Since the vast majority of new businesses are not venture-capital backed, they not only don’t have access to these venture lenders—but they also don’t have the proper credentials to be underwritten by venture capital lenders, anyway.

But it’s more than just exclusivity that leaves bootstrapped startups out of the conversation. All of the above factors combine into the most overarching takeaway here: Only a fraction of business owners can even consider venture capital loans to finance their businesses.

Your Best Business Loan Alternatives to Venture Capital Loans

For many startups, venture debt financing isn’t a viable option to get the capital they need. If you’re a bootstrapped operation and need to consider another route, here are a few types of loans to examine, which may be more accessible to you. We’ll start with options open to startups with more time in business, and end up with brand-new operations:

Best for Revenue-Generating Startups: SBA Loans

We touched a little on SBA loans and their desirability earlier, but let’s explain further. The U.S. Small Business Administration guarantees these loans by up to 85%, which mitigates some of the risk for their partner lenders and banks. The SBA’s guarantees allow lenders to offer lower rates, higher capital amounts, and borrower-friendly repayment terms.

There are some guidelines you’ll have to meet in order to qualify for an SBA loan. You’re required to be an established, US-based, for-profit business. Those who qualify generally have strong personal credit—we’re talking scores of 680 or higher, although there is technically no minimum. Typically, the SBA also wants to see a solid financial track record over several years in business, so early-stage startups will be too green to qualify (especially those that are pre-revenue).

Note that the SBA does offer a microloan program specifically to help finance new businesses, with loans from intermediary lenders of up to $50,000. This capital is prioritized especially for business owners like women, people of color, and veterans who often have less access to business financing (much like in the venture capital ecosystem).

Best for Early-Stage Startups: Business Lines of Credit

In its nascent days, your company doesn’t have the financial history that many lenders are looking for to make sure you can pay back your business loan. Without that time-in-business stat, revenue history, and a business credit score, your lender can’t get the read they need on your business. That’s why most lenders won’t work with early-stage startups on term loan products.

What you do have, however, is a personal credit score, business bank statements, and a few basic business documents—and for some business lenders, that’s enough to decide if you’re qualified for a business line of credit.

This can be an excellent financing product for early-stage startups that need capital to take on expenses as they come. As a sort of hybrid between a business credit card and a traditional business loan, business lines of credit provide you with a pre-approved amount of loaned funds to draw from as you need. You only pay interest on the funds that you use.

Best for Specific Purchases: Asset-Based Loans

If you have a specific need for the capital you’re seeking—for instance, to finance a new piece of equipment, inventory, or supplement cash flow tied up in accounts receivable—you have another option. Rather than seeking general working capital, which is generally a bit harder to secure, look into asset-based loans.

These loans are often more accessible for early-stage startups, and businesses with less operational history in general, because they’re self-secured. This means that the purchase that the debt is financing itself is the loan’s collateral. For instance, if you default on an equipment loan for a 3D printer, the equipment lender will seize the printer and liquidate it to recoup their losses.

The two most pertinent types of asset-based loans to consider for specific purposes are:

• Equipment financing: For the purchase of gear, machinery, or anything you tangibly need for your business. This can include something as small as computers and desk chairs, or as large as an MRI machine for your med-tech company.
• Invoice financing: Also called accounts receivable financing. A lender will advance you a substantial portion of an outstanding invoice to help free up cash tied up in trade credit. You’ll get the remainder of the invoice, minus the lender’s fee, when your customer pays their balance.

Asset-backed loans are by no means easy to secure. Lenders will still look at your credit score and business financials. But with collateral built into the loan, the risk is much lower for the lender, so you don’t necessarily need to provide them years of stellar performance.

Best for Pre-Revenue Startups: Personal Loan for Business

The theme you might be sensing here is that business lenders need the business’s financial history off of which to make risk assessments. If you’re pre-revenue and burning a lot of cash, you might want to consider putting your own money into the business with a personal loan. Many early startup founders do; in fact, many new business owners across all industries do.

With personal loans for business, you’ll want to keep one important thing in mind. Make sure you’re building a separate business credit history while your personal loan is outstanding. Be sure to apply for a business credit card and pay off your bills in full and on time to establish business credit. You also should have a separate business bank account to separate your finances if you haven’t already.

Best in Startup Planning Stages: 0% Introductory APR Business Credit Card

Begin with a business credit card to start building your business credit as soon as possible, so you can be eligible for the financing products we covered. (You’ll also need to file documentation establishing yourself as a company—do that if you haven’t yet.)

For nearly all startups, a 0% introductory APR business credit card is a versatile choice that ticks a lot of boxes. With these cards, you can carry a balance for a predetermined period without paying a fee before the variable APR kicks in—think of it as an interest-free loan. And, as long as your personal credit score is solid enough to qualify, you don’t have to meet any time-in-business minimums.

Among the 0% intro APR cards, we particularly like the American Express Blue Business Plus for its 15-month introductory period. After that, a variable APR sets in according to your creditworthiness and the market Prime Rate, so just check with the card issuer for any details. Not only is 15 months the longest intro APR period we’ve ever seen (the Amex SimplyCash has it, too), but Amex Blue is also a fee-free card.

If you want the power to finance some purchases in your early days, not pay a fee, and build business credit, Amex Blue Business Plus is an excellent move.

If Venture Debt Isn’t an Option, Try Business Loans 

Financing a startup is tricky, full stop. And although the pool of business loan options can seem small—especially when venture debt financing isn’t accessible to the vast majority of founders—you should feel a little relieved to know that you can finance your business.

Even if you’re starting with a business credit card or a personal loan, you actually have very good options—especially if you’re strategic about their implementation. As for other business financing products? SBA loans, business lines of credit, and asset-based loans are not only great options for your startup, but some are structured similarly to venture capital loans, anyway.

The absolute most important thing is that you finance your company sustainably. If you can’t afford your loan, you’ll put yourself out of business. Slower growth is better than no growth at all.

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from Fundera Ledger https://www.fundera.com/blog/venture-capital-loans/