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Venture debt is an odd term for many founders. On the one hand, it sounds like venture capital and, therefore, should be great for a startup. On the other hand, the word debt carries the idea of a standard loan which seems inconsistent with a fast-scaling company. However, venture debt is exactly that – a loan offered by banks or lenders designed specifically for early-stage, fast-growing startups with previous venture backing. In this article, we will explore the role and uses of venture debt and when it is most useful.
The first thing founders need to know is that venture debt does not replace equity but is a tool that can be used after the startup has already raised a round or two. Equity is money that can be raised to expand a business generally. The founder needs to have goals in mind, but since there is no repayment plan, there is no specific timeline they need to meet. Additionally, equity rounds assume a liquidity event in the future but do not require cash flows now, which makes them much more flexible for the founder.
Loans are very different. The goal of the loan is to help the founder do something very specific or to bridge the startup to a specific place. While taking out the loan, the lender will always ask for specifics about the goals during the last funding round and if those targets have been met. It is a very risky business to lend money to a startup, so all steps will be taken to ensure the founder knows what the next steps are and that there are other investors backing the idea. Unlike equity, venture debt does not dilute the company’s cap table, and it requires a repayment schedule. Since the debt is designed for startups, the repayment schedule will be adjusted for their needs, but it still remains a loan that needs to be paid back.
Since the goal of debt is quite precise, the loan structure will also follow the stated use quite closely in terms of covenants, interest, and duration. Regarding size, most loans tend to be between 25% - 35% of the last equity round. The idea is that the larger the round, the further the company is in terms of progress, and therefore the larger the loan and risk can be. This also means that founders cannot raise debt to expand their business without a specific plan in mind generally.
There is another key difference to remember when considering venture debt – it is not regular deb, it is venture. This means that it is tailored for startups that are sacrificing profitability for growth. The terms and repayment plans are therefore customized for each startup plan. This is different from cash-flow-based bank loans or asset-backed lines of credit, which do not take into account specific business plans. Since venture debt is based on venture-style companies, they want to see VCs backing the startup to mitigate risk. A startup that has bootstrapped the entire way will unlikely be able to find any venture debt lenders who want to back them since they have no validation from other investors. Similarly, venture debt is usually unavailable for pre-seed and seed startups since they don’t have enough backing yet.
When founders need to consider if venture debt or equity is the better option, they need to think about what the cash will be used for. If it is to expand the company, equity is usually the typical option. However, if there is a specific project that needs to be done in a certain time frame and the firm is not ready for the next equity round, then venture debt can be a great option. Another time can be if waiting a few weeks or months will dramatically change the value of the equity round, such as waiting for FDA approval, then debt can also be useful as it will not dilute the cap table. Finally, debt can be used to help smooth the valleys and peaks of a business cycle for a startup.
Many firms are involved in the venture debt space, from large institutions such as J.P. Morgan to small family offices. Each firm will negotiate its terms differently and will require indicators to agree to a loan. However, it is important to find the right lender to work with since many enter the space without truly understanding. If they decide to stop providing venture loans suddenly, it can be very harmful to a startup relying on them. It is important to find lenders who have been in the space for many years and understand how venture debt truly works. This is why the collapse of SVB triggered fear in the startup world since one of the oldest and most reliable venture debt lenders in the world had closed its doors. Now founders need to find other lenders to trust for reliable venture debt.
When it comes to negotiating the loan, founders need to think in the same way they would with an equity round. There is a balance between what the founder wants and what the lender/VC wants. Founders should be very wary of lenders that “deal term drift,” which means they change critical deal terms between the term sheets and the loan contracts. This likely means they have a “winner-takes-all” mentality. On the other hand, founders should also be careful in forcing their position too hard since it can deteriorate a needed long-term relationship. At the end of the day, it is about working together to find a mutually beneficial agreement.
If you are looking for a venture debt partner, here are some well-known players in the space:
- Square 1 Bank (a division of Pacific Western Bank)
- Western Technology Investment (WTI)
- TriplePoint Capital
- Bridge Bank (a division of Western Alliance Bank)
- Oxford Finance
- Hercules Capital
- Runway Growth Capital
- Trinity Capital
- East West Bank
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