What is Venture Debt?
Venture debt is a type of debt financing obtained by early-stage companies and startups. Such type of debt financing is usually used as a complementary method to equity venture financing. Venture debt can be provided by both banks specializing in venture lending and non-bank lenders.
Venture debt can be a viable alternative to equity venture financing. Similar to other methods of debt financing, the main benefit of venture debt is preventing the further dilution of the equity stake of a company’s existing investors, including its employees.
Breaking Down Venture Debt
Unlike conventional debt financing methods, venture debt does not require any form of collateral because startups generally do not own substantial assets that can be used as one. Instead of collateral, the lenders are compensated with the company’s warrants on common equity for the high-risk nature of the debt instruments.
Venture debt is usually provided to startups that have already successfully completed several rounds of venture capital equity fundraisings. They are companies that have some history of operations but still do not have positive cash flows to be eligible to obtain conventional loans. The debt financing is primarily used by the companies to reach anticipated milestones and to acquire the capital assets that are necessary to achieve them.
How Does Venture Debt Financing Work?
Venture debt works differently from conventional loans. The debt is short-term in nature (up to three or four years). The principal amount of debt is usually determined using the amount raised in the last round of equity financing. The commonly acceptable principle amount is 30% of the total funds raised in the last round of equity financing.
The majority of venture debt instruments involve interest payments. The payments are based on either the prime rate or an interest rate benchmark such as LIBOR. In addition, in venture debt financing, the lenders 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 the per-share price of the last equity financing round. The warrants often provide the biggest returns to the borrowers relative to the appreciation potential of the company’s common shares.
Depending on the lender, the venture debt process can include covenants. While non-bank lenders are extremely flexible regarding the debt issue and usually include only a few covenants, some banks sometimes add a number of covenants to the loan agreement.
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