Understanding Venture Debt Financing

The Basics

Venture debt is a type of loan that is designed specifically for early-stage, high-growth companies with venture capital backing. The purpose is to offer companies between three to nine months of extra funding to cover infrastructure needs and any other core functions that are required to meet critical milestones.Additionally, it may be used to employ or reinforce a sales staff, enhance marketing, invest in R&D, or purchase capital equipment to reach commercialization and begin growing

Raising debt while a firm is loaded with cash may seem contradictory, but in many situations, the debt may be structured with a longer draw term, allowing the loan to be funded later. Regardless of when a firm wants to fund the loan, creditworthiness and bargaining leverage are usually at their peak just after fresh equity is closed. 

Debt vs Equity

Understanding the underlying distinctions between debt and equity is essential. 

In most cases, repayment of equity is not required under contract. While some sort of liquidity event is expected within a decade, equity is generally long-term capital. The deployment of equity is extremely versatile, as it may be used to support nearly any legal company need. However, if the execution does not match the company strategy, it is tough to reprice or restructure stock.

Debt, on the other hand, may offer both short- and long-term capital. The capital’s structure, price, and duration are all linked to its function. Financial covenants, set payback terms, and other characteristics can be added to debt to help lenders manage credit and other risks. These features limit debt’s use to a specified set of business objectives from the borrower’s perspective, but they allow the lender to arrange and price the loan to match the borrower’s present circumstances.

Details of Venture Loan Funding

Venture debt is a different type of loan created specifically for the venture capital industry. Venture debt relies on a company’s access to venture capital as the primary repayment source for the loan, instead of focusing on historical cash flow or working capital assets. The core value proposition of venture debt is reducing dilution for founders and management.

Most venture debt takes the form of a growth capital term loan. These loans usually have to be repaid within three to four years, but they often start out with a 6- to 12-month interest-only (I/O) period. During the I/O period, the company pays accrued interest, but not principal. When the I/O period is complete, the company begins paying down the principal balance of the loan. The duration of the I/O period and the terms under which the loan can be drawn are key points in the negotiation process.

As access to capital is the primary source of repayment, venture lenders evaluate your company through a similar lens as equity investors, such as:

  • Will additional equity be needed?
  • Which metrics will influence the next-round valuation?
  • What level of performance will allow non-dilutive access to capital?

Lenders closely monitor a company’s burn rate and liquidity to determine the resulting number of months of capital available (often referred to as runway). Companies with enough momentum and liquidity to achieve milestones for the next financing are more likely to attract non-dilutive term sheets from outside investors. Companies with a shortfall in either category are likely to struggle to attract a new lead investor and may have to resort to an inside-led, possibly dilutive round, to continue funding the company.