December 10, 2019

What is Venture Debt?

Venture Debt

Venture debt is capital that is loaned to equity-backed companies that provides a supplemental form of financing. Startups that seek venture debt typically do so in between fundraising rounds, using it as a tool to either buy time or accelerate growth.

But, it’s not for every startup. And, it’s highly differentiated from more traditional business loans, which are usually out of reach for startups because they lack the financial infrastructure of established businesses.

Venture debt is meant to complement existing equity; only companies that have successfully raised venture capital have access to it. This is largely because venture capital loans can’t rely on a company’s cash flow like small business loans do. Instead, underwriters use alternative credentials, including investor track records, a company’s business plan, and capital strategy.

These debt loan amounts are typically around 30% of the last fundraising round. In other words, if you can convince venture capitalists to fund your company’s big idea, there are lenders who will help to fund it to. But, at a cost.

Here’s how this debt came to be, and the pros and cons to consider before pursuing it.

Why Venture Debt Is An Innovative Capital Model

Venture debt emerged in the early 1980s when lenders, including Silicon Valley Bank, created a new type of venture debt financing that did not have the usual loan requirements of physical assets and cash flow. These lenders instead provided loans to startups based in part on their ability to secure funding from well-known venture capital firms.

The venture-debt market has grown enormously since then, particularly in the past ten years. Silicon Valley Bank, for example, had $3 billion of commercial loans outstanding to tech companies in 2008 compared to $10 billion in 2018.

Not only has the capital that banks focused on this debt grown, the number of institutional investors offering loans has grown, as well. After the Great Recession of 2007-2009, institutional investors seeking higher yield lending opportunities began to offer venture debt, leading to the expansion of not only the number of lenders, but also the types of loans made available.

Although this debt is most commonly structured like traditional, medium-term business loans, with three- to five-year repayment periods, there are more than twenty types of venture loans. These include: lines of credit (working capital financing or MRR line of credit), term debt (senior term loan, second lien term loan, revenue-based financing, mezzanine financing), equipment financing (equipment loan, equipment leasing), and in some cases royalty monetization (royalty-based financing, royalty sale).

Why Pursue Venture Debt?

For the right startup, this debt has a lot of advantages. For one, it’s typically less expensive than equity financing. Also, it can facilitate the financing of specific projects, purchases, or opportunities. More so, it extends the time that startups have in-between fundraising rounds. And, perhaps most notably, it doesn’t require a startup to give up additional ownership. This ability to secure cash while preventing further dilution can be the deciding factor for startups considering taking on a loan.

Still, this debt only accounts for a fraction of venture capital. In 2017, for example, venture capital investments were estimated at $84.2 billion and venture capital loans at just about $8 billion.

While venture debt can be a useful tool, it’s not for every startup. Unlike other venture capital, venture debt needs to be repaid with interest, which can add up quickly.

It can also be particularly risky for startups that aren’t securely in a phase of hyper-growth. If a company is to default, venture capital lenders have the first lien position, allowing them to collect before other lenders. This means that if a company defaults, venture capital lenders can seize control of the company or its assets, or force it to liquidate. Even more, a venture debt lender’s blanket lien for high-risk startups cab even extend to its definition of collateral the company’s intellectual property. The stakes are high.

This debt is a solution for startups that need more time or more capital to fuel growth. And, with more startups staying private for longer than ever, the market for venture debt is poised to grow and to help many startups succeed.