Luckily, there’s an in-between option, one where founders can raise venture debt financing from venture capitalists without giving away equity.
In this post, we'll review what venture debt financing is, so you can determine if it might be a solution for your company’s capital constraints.
What Your Business Should Know About Venture Capital:
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 vc 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 stage 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 growth 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.
In addition, 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 term 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 venture debt 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.
Essentially, warrants protect the borrower from getting charged significant interest payments, while also protecting the lender. Plus, if all goes well and the business, succeeds, it puts the lender at an advantage.
What Are the Benefits of Venture Debt Financing? And When Should You Consider It?
Despite the drawbacks, venture debt can still be a great option for some companies. For example, if you need a cash flow 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 needing equipment financing or having significant cash in your accounts receivable.
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 commercial bank loan.
Is Venture Debt Financing the Right Option for Your Business?
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 equity 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.
Editor’s Note: This post was updated for accuracy and comprehensiveness in June 2019.