Venture debt is a type of debt financing obtained by early stage companies and startups. This type of debt financing is typically used as a complementary method to equity financing. Venture debt can be provided by both banks specializing in venture lending and non-bank lenders.
Venture debt is frequently used as an alternative to equity financing instruments like convertible debt or preferred stock. Unlike equity instruments, using debt financing prevents the further dilution of the equity stake of a company’s existing investors, including its employees.
Venture debt is a form of non-dilutive funding for early stage companies.
Many venture debt deals include warrants which may be exercised to purchase common stock in the borrowing entity.
As a debt instrument, venture debt has a higher liquidation priority than equity.
Covenants may be employed to help align incentives and increase the likelihood of repayment.
Breaking Down Venture Debt
Unlike conventional debt financing methods (like senior/secured lending), venture debt does not necessarily require specific, tangible, underlying collateral security.
Many startups and earlier stage companies generally do not own substantial assets that can be used as collateral. Venture debt lenders are often compensated for this incremental risk with warrants on the company’s common equity.
Venture debt is usually offered to companies that have already successfully completed several rounds of venture capital equity fundraisings. These are typically companies that have some history of operations but still do not have sufficient positive cash flows to be eligible to obtain a more conventional loan.
The financing is primarily used by such companies to reach anticipated milestones or to acquire the capital assets that are necessary to achieve those milestones.
How Does Venture Debt Work?
Venture debt works differently from more conventional loans. The debt is generally short- to medium-term in nature (1-3 years, often).
Funding strategies vary, but a common “rule of thumb” is that a venture lender may consider a loan amount of up to 30% of the company’s last equity financing round. So if management raised $10MM in their Series A and they later wanted to employ venture debt for a cash cushion, a venture lender may consider a credit facility of up to $3MM.
The majority of venture debt instruments involve interest payments only, as opposed to principal plus interest. The payments are based on either the prime rate or another interest rate benchmark.
In addition, in venture debt financing, the lenders often receive warrants on the company’s common equity as a part of the compensation for the high default risk. The total value of the distributed warrants generally represents 5% to 20% of the principal amount of the loan.
In the future, the warrants can be converted into common shares at a predetermined rate, which may be based on the price per share at the last equity raise, or at a discount to some future raise. Warrants can provide significant (potential) financial upside for the venture debt provider, although they also sometimes expire worthless, too.
Covenants & Liquidation Preference
Depending on the lender, the debt underwriting may include covenants. While non-bank lenders are extremely flexible regarding the debt issue and often only include a few covenants, some banks may add a number of covenants to the loan agreement to help align incentives and increase the likelihood of repayment.
One of the reasons venture debt is commonly used by venture capital investors is because of its higher liquidation preference. This limits the risk investors take on since there is a higher likelihood that they will be paid than if they owned common shares in the company, which fall at the bottom of the capital stack.
CFI offers a Venture Debt course for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources may also be helpful: