You’ve just completed your Series A, bringing in much-needed capital to your fledgling startup. You have cash available to expand your business. You may have new board members. And you have a set of lofty expectations from investors and employees.
There’s only one problem – you still need more capital.
Often, one round of venture capital funding doesn’t resolve all of a startup’s challenges. For example, your Series A may provide enough capital to hire employees, advertise your business or even purchase supplies, but it’s entirely possible that you may need additional funding for other needs as you grow, like making a long-term investment or shoring up your operations in areas that will bear fruit over time.
To fill this gap, often in tandem with an equity round, many startups will engage in venture debt financing. As the name implies, it’s debt supplied by a venture firm. However, it’s structured differently than traditional business loans.
Venture debt financing isn’t right for every company, but it can be a smart strategy in some instances. Below is some information about how venture debt works, along with the pros and cons.
How Does Venture Debt Financing Work?
Venture debt financing is a loan, but not in the traditional sense. It’s usually offered by a venture capital group that has already contributed equity capital for your startup. For example, assume you start a company. In the beginning, you own 100% of the shares. After a small seed round, your share of equity is reduced. You then have a Series A and raise more money, but also significantly reduce your share of ownership.
At this point, you need more capital, but aren’t ready for a Series B and don’t want further dilution. One of your venture capital investors may offer venture debt. Typically, the maximum loan amount is 30% of the last round of investment. So if you raised $5 million in your last round, you may be able to receive up to $1.5 million in debt financing from one of your venture capital investors.
Venture debt financing usually has a very short repayment term, often three to five years. They also come with much higher interest rates than traditional loans. It’s not unusual for venture debt borrowers to pay the prime rate plus five-to-nine percent annually. Over the course of a three-year venture debt loan, you could pay 20% or more in interest.
Pros of Venture Debt Financing
If venture debt financing is costly, why would a company accept it? There are a few reasons. First, as mentioned, it’s a way to access capital without further diluting ownership. You can continue to grow your business without giving up voting shares, board seats, or equity.
The biggest upside of venture debt financing, perhaps, is simply that it’s a way to finance growth without equity, which is always more expensive than debt long-term. If there is a gap between when you purchase inventory and collect revenues you may want to use traditional debt, a line of credit, or venture debt to cover your working capital needs, rather than burning through equity.
Your company might need to finance a capital purchase or an investment that has very predictable or stable cash flows. In these cases venture debt is often more attractive than using equity capital to fund these expenditures.
Cons of Venture Debt Financing
Venture debt financing may be a creative way to raise capital, but that doesn’t mean it’s right for every startup. There’s one obvious hurdle. You need to have a venture capital investor who offers venture debt financing. Not all VCs do offer debt. And it’s not the type of loan that you can apply for with any bank or VC. If you don’t have a VC who offers debt financing, this isn’t an option.
This type of financing is also problematic for startups that may be unable to repay the loan. The repayment schedule is short and costly. You’ll need consistent cash flow to make the payments. Since venture debt is usually “senior debt,” your lender can take control of your business and even liquidate it if you default. If there’s a reasonable chance that you won’t be able to repay the loan, this type of financing may not be right for you.
Make certain when agreeing to anything that you are paying attention to the terms of any kind of agreement as it relates to note conversion, warrants and other potential hangups.
Finally, venture debt financing could impact your ability to raise future funding. Your next round of investors will ultimately be committing money to pay off any remaining balance. They may not feel comfortable with that idea. Also, your lender may have warrants that could further dilute ownership in the future. Again, that could be problematic for future investors.
Venture debt financing is a creative and unique way to raise capital, but it can have some nasty consequences if you’re unable to make the payments. Consult with your accountant or other financial consultant to analyze your cash flow and see how the debt payments may impact your path to profitability.
Is Venture Debt Financing Right for Your Startup?
Generally, companies are engaging in venture debt financing alongside an equity round, and seeking to balance the two funding arrangements. This type of financing is best used as an instrument for stable investments like buying inventory, funding working capital gaps, or financing long-term projects. This isn’t a stop-gap or something to be undertaken lightly, since sophisticated investors are unlikely to lend if you’re running out of cash and need a significant capital investment.
Used in concert with traditional funding methods, however, venture debt financing can give your startup the extra boost it needs to survive and thrive.