Venture debt tends to be a catch-all term used to refer to loans that are tailored to the needs and risks associated with investor-backed start-ups. The start-ups looking for venture debt tend to be high-growth companies with a strong equity-based funding history in high-growth industries, such as technology, life science, and the innovation economy. These loans look for companies with equity raised from venture capital firms or similar institutional sources. Many venture-backed companies raise venture debt at some point in their lifecycle from specialized banks and financial institutions for a variety of reasons.
Unlike other, more traditional forms of debt financing, venture debt tends to be considered loans provided by lenders willing to take on a higher level of risk. The higher level of risk means the return for the lending institution tends to be higher, with shorter terms than other debt financing. And unlike equity financing, venture debt does not typically involve offering ownership in the company and therefore does not dilute existing shareholder equity but comes with a higher interest rate. Some venture debt instruments can convert interest rates to equity shares, depending on the terms of the deal.
Another difference of venture debt is that, unlike most forms of credit available to commercial borrowers, venture debt is not underwritten based on the amount of cash flow they generate or the liquid assets (such as accounts receivable and inventory) they emphasize the borrower's ability to raise additional capital in further equity rounds and to fund growth and repay the debt.
Venture debt first appeared in the 1960s and 1970s in California, where it was generally used for leasing machinery, back when Silicon Valley was focused on silicon and chip production. In the 1980s, the Silicon Valley Bank and other private funds began to provide companies with venture debt to give those companies a break from raising new equity rounds. As venture capital continued to grow as an industry, more boutique banks and small funds started to provide small loans to early-stage companies and developed from an instrument to finance instruments to the modern version of venture debt used to finance growth.
There are a few reasons an early-stage company would select debt over equity. While for equity, repayment is not usually contractually required and is generally considered to be long-term capital, with flexibility built into the terms; debt offers those companies a chance at short-term (and in some cases long-term) capital, which does not dilute ownership shares and can be configured to include financial covenants, defined repayment terms, and other features to mitigate credit and other risks borne by the lender. These characteristics can limit the utility of venture debt but can also be used to align with the borrower's circumstances and their need for acquiring the venture debt.
The primary benefit of venture debt is that it leverages equity raised by a start-up and reduces the average cost of capital required to fund a company's operation. Venture debt also offers flexibility, as it can be used as insurance against operational glitches, against issues in fundraising or unforeseen capital needs, and as a performance bond requirement.
Venture debt is also best optimized for companies that prioritize growth over profitability. But there remain certain stages of a company's growth in which venture debt is raised, and that tends to be on the heels of a large equity raise. In this case, many venture lenders follow venture capital firms and investors they trust and will invest depending on the number raised in the company's last funding round. Venture debt is generally not available to a company at its seed stage.
Regardless of the amount raised or if the company can source a loan with an angel-backed profile, debt this early in the lifecycle of a company is generally suboptimal, especially if the company requires additional equity capital to fund the company. Especially as institutional venture capital firms do not want to see a company with a large amount of debt use fresh equity to service that debt.
In this case, if a company raised a Series A of $10 million—which provides the new investor with 20 percent ownership and the existing shareholders is valued at $50 million—with a monthly cash burn of $1 million, a venture debt loan of $3 million might require warrants the dilution of the equivalent of 25 to 50 basis points. In such an example, venture debt provides additional runway while only carrying 1/40th the dilution.
Most venture debt is offered by banks and financial organizations that specialize in working with early-stage companies and the investors who lend to these companies. Some commercial banks will also offer venture debt, although this is generally not done with any regularity. Otherwise, the remainder of the venture debt market may be serviced by debt funds. Debt funds are used by banks for their lending activities and are separated by the bank's regular type of lending, which is heavily regulated in terms of the amount of risk the bank can take. The debt fund allows the traditional commercial bank to take more risk, as it has less regulation and regulatory oversight, and allows those banks to blur the distinction between debt and equity. However, the cost of these loans tends to be much higher compared to the venture debt offered by specialized venture debt banks.
The underwriting criteria used in venture debt correlate to the applicant's life stage and capital strategy. For early-stage companies with a limited operational history, this can include a focus on the investors and characteristics of the most recent funding round with the amount of venture debt calibrated to the size of that equity round and the company's current and projected cash-burn rate. A company with a high burn rate will be considered riskier than a company with a low burn, especially as a high-burn company will be more dependent on external capital. The lending company also considers the applicant's track record, the amount of committed capital of each existing investor has for follow-on rounds, and the ability to attract non-dilutive capital from new investors. This last part, along with a proven track record of hitting milestones (such as product development or financial milestones), can be an important part of the consideration when a loan price and term are set.
Pricing venture debt comes with three components: the interest rate charged on the loan balance, an origination fee, and stock purchase warrants granted to the lender. The cost of any of these varies on the lender's assessment of risk. The assessment of risk will depend, as noted above, on the stage of the company. It can also depend on the industry the company is in. For example, companies in sectors with binary risks, such as regulatory oversight or unproven technologies, will prove less attractive to a lender. The loan structure will also influence the pricing. For example, loans with more structure—including financial covenants, or milestones regulating loan draws and broader lien rights—will reduce lender risk and increase the price.
Venture debt loans are also offered generally on a timetable that starts at eighteen months and extends to three to five years. The variables in a venture debt term sheet can include the length of time during which advances can be made, known as the draw period, and the length of time before the borrower begins making principal payments to amortize the debt, known as the interest-only period. Many term sheets also offered deferred pricing, which can require a back-end loan fee that is not paid until the loan matures or is refinanced. This can allow a company to pay a portion of the all-in cost of the loan with the money raised in another equity round rather than liquidity at the time of the venture debt loan raise.
In a lot of cases, venture debt lenders will write conditions into the terms in which the lender will consider either common or preferred stock as a form of compensation for the principal. The use of this stock, and the preference of common or preferred, depends on the evaluation of that stock, the ability or inability of the borrower to pay back the principal or interest on the venture debt, and the potential advantages for the lender in the voting rights enjoyed by preferred stockholders.
Common venture debt loans provide a 25 to 35 percent of a recent equity round and generally try not to overburden a business with debt overhangs. The four key cost components of a venture debt deal include the following:
- An upfront fee to arrange the facility
- Interest rates, which range from 7 to 12 percent with repayment flexibility
- A back-end or final payment fee
- A warrant component
A warrant component, as noted above, is unique to a venture debt provider, as it gives them the option to buy shares in the business at the point of exit. Some financial institutions will offer their own version of venture debt that includes a financial covenant, which also removes the flexibility from the loan. This leads some to consider this kind of loan from a financial institute to not really be venture debt.
