What is venture debt? It’s a loan from a bank or nontraditional lender offered to a company that has recently secured venture backing. Lenders see backing from an institutional investor as validation of the company, giving them confidence to underwrite a loan that founders can use to bolster cash flow, fund capital expenditures, or extend a runway between funding rounds.
Companies with little or no revenue or operating history struggle to get traditional loans because they are seen as risky in the eyes of banks who need to be confident their loans will be paid back. However, some lenders will see lower risk due to the vote of confidence an investment from a venture capitalist brings.
This makes venture debt a valuable source of financing. But all debt comes with risk. Consider the pros and cons of venture debt:
Pros
- Less Dilution – Perhaps the biggest argument in favor of venture debt is that it involves accessing additional cash while giving up less equity than traditional fundraising. Founders can tap into a funding source without significantly diluting their ownership. Typically the equity given up is in the form of options or warrants, but some lenders will request common or preferred stock. In either case, the portion of equity should be much smaller than you would be giving up by raising a full equity round.
- Extend Runway- By using a venture loan, your company has access to additional funds which can extend the time between your funding rounds and buy you valuable time to prove out your business model, acquire that high value customer, or finalize the necessary tech development.
- Favorable Terms – Depending on the lending partner, Venture debt can have low interest rates relative to the amount of risk lenders are taking (more on the below) and a small equity component making it much cheaper than traditional equity fundraises.
Cons
- Future Funding – Future investors might see having any debt on the balance sheet as problematic, either because of the financial covenants or simply because their investment will go to pay the debt. While the risk of venture debt jeopardizing future funding might be small, it’s a risk that can’t be ignored.
- Financial Covenants – Venture debt will likely come with requirements to meet certain financial performance metrics to maintain access to the capital the lender is providing. The penalties for failure can be very harsh, from the lender charging higher interest rates on outstanding balances, requiring you to pay back the entire balance immediately, or even forcing you in to renegotiation/bankruptcy.
- Operational Covenants- In addition to financial covenants, the lender will likely put operational restrictions on the business related to restricting what types of businesses you can operate, to maintaining all of your financial accounts in one central location. These restrictions can hold back a company trying to stay agile and adjust based on market conditions and customer demands.
- Added Compliance Costs- Because venture debt is a legal agreement between you and a lender, you will likely want an attorney to review all of the documents prior to you signing. Additionally, the bank may require you to increase your cadence of financial reporting which may increase your costs of accounting.
- Repayment Requirements – Just like any debt, Venture debt must be repaid plus interest. Having the right amount on hand every month can get challenging for companies with unpredictable cash flow, raising the risk of a default due to an unexpected downturn.
Some startups need venture debt while others do not. Likewise, some are in a good position to pay off their venture debt while others are not. Taking on venture debt could be an excellent decision to give you more flexibility to grow your business and extend your runway or a disastrous one– so which side does your startup fall on?
Proseer is here to help find the answer. After looking closely at your company, we can help you decide if venture debt is a wise choice or if you should pursue alternative funding sources instead. Fine-tune all aspects of your startup strategy with our help – contact Proseer.
