Is Venture Debt Financing Right for Your Business?
What is Venture Debt Financing?
If your company is backed by venture capital, you might be eligible for debt financing from other venture-specific banks or firms. Venture capital financing is all about equity and milestones. For example, if your company is developing a new piece of computer hardware, one typical early milestone is completion of a prototype. Once you reach this milestone, more equity financing is triggered as the company’s value is likely increasing thanks to the successful prototype. From there, further milestones might be for production goals or some form of regulatory approval. But what happens if funding runs low before a milestone is reached?
Think of venture debt a little like cement = it fills in exposed cracks, giving you a solid bridge to your next destination. If your company is struggling to hit the milestone needed to secure another round of venture capital, venture debt can bridge that financing gap without further diluting ownership. Venture debt loans usually have a duration of 3 to 4 years and borrowers are charged the prime rate plus an extra 4 to 9 percent. Additionally, because of the risk involved lending to companies with minimal revenue, venture loans can come with stipulations called covenants (although they’re rare for debt financing following a Series A equity round).
What Are the Drawbacks of Venture Debt Financing?
Venture debt financing isn’t suitable for founders looking to avoid dilution. For starters, venture debt financing is expensive because you’ll pay far beyond what you would for a traditional business loan through the SBA. Plus, venture debt can come with considerable stipulations.
If for some reason you can’t meet the obligations of the loan, venture debt financiers could re-negotiate the deal to take equity away from the founders or force liquidation of business assets to pay off the loan. Venture debt is also senior debt, meaning it gets repaid before anything else during a liquidation event.
The lender will also want warrants, which can be converted to equity if the company goes public or is acquired by another firm. Warrants are usually priced according to the most recent round of equity financing. If the company goes public later, the lender can exercise the warrants and buy stock at a deep discount.
When Should You Consider Venture Debt Financing?
Despite the drawbacks, venture debt can still be a great option for some companies. For example, if you need a cash infusion to reach the next milestone in an equity financing agreement, venture debt can ensure operations keep running smoothly. This is called “increasing the runway” and you should have a very specific reason for doing it, like an important equipment purchase.
Also, if your company has a low cash burn rate, venture debt financing can be quite attractive. You’ll get access to more working capital without surrendering equity and the chances of default will be minimal. If an unexpected business opportunity presents itself, venture debt would allow you to pursue it without diluting ownership or having to apply for a bank loan.
Venture debt financing isn’t right for everyone, so you’ll have to consider several variables before acting. Venture debt usually supplies between 20 to 30 percent of the amount raised in the previous equity round, so make sure you’re getting enough cash to make it worthwhile. Also, consider the terms and duration – are there obtrusive covenants that could slow down your business? Will you be able to repay the loan completely by the end of the agreement? If you don’t like your answers to these questions, you might want to pursue a different funding avenue.
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