Pros and Cons of Venture Debt

In the previous article, we have already studied about the concept of venture debt. We know that venture debt can prove to be a viable alternative for a start-up company that is looking to raise cash for a relatively short period of time. We also know how venture debt is different as compared to venture equity.

However, the decision to raise venture debt is not a small one. There are several pros and cons which need to be considered while raising venture debt. Some of these pros and cons have been mentioned below:

Pros of Venture Debt

Venture debt is widely used by the entrepreneur community. This is because there are several distinct advantages of using venture debt. Some of these advantages have been mentioned below:

1. Helps in Avoiding Dilution: The first and most obvious benefit of using venture debt is that it helps entrepreneurs in avoiding the dilution of their firm. It is possible that the investor may be confident of the ability of their firm to generate revenues and to repay the debt over an extended period of time. However, if banks are not willing to lend to such a firm, then they generally have no option but to raise a round of equity funding. In the case of venture debt, this is not the case. The founders can take on some debt for a short amount of time. Later they can pay off the debt and still be in control of their firm.

2. Cheaper Source of Funding: Now, it is a known fact that venture debt costs anywhere between 12% to 30% per annum. This is a very high-interest rate compared to traditional bank loans. Hence, if we consider traditional bank loans as a benchmark, this loan may begin to sound expensive. However, it is important to note that the other alternative available to the entrepreneur is to sell their equity. Now, the cost of equity is much more than the cost of venture debt. Also, equity must be repaid for the rest of the firm’s life whereas debt can be extinguished within a short period of time. Hence, it would be fair to say that venture debt is a much cheaper source of funding as compared to equity.

3. Helps in Avoiding Downrounds: Start-up funding rounds can be significantly influenced by bargaining power. If the prospective investors know that a company is running out of cash, they tend to drastically lower the valuation of the firm. This is because they know that the founders do not have many options. Venture debt proves to be a viable alternative in this case. Venture debt allows the start-up firm to raise money between investment rounds. This ensures that entrepreneurs are never desperate to raise funds from the market. They can survive on their own for some time and hence are in a position to find investors who are willing to offer them a reasonable valuation. Venture debt helps investors in avoiding down rounds which can be detrimental to the future of the firm.

4. Quick and Convenient: Venture debt also tends to be quick and convenient. The paperwork required to obtain venture debt is much less as compared to a traditional bank loan. Also, the terms are much less restrictive. This is the reason entrepreneurs prefer to raise venture debt whenever they need a quick injection of cash.

Cons of Venture Debt

Although venture debt is quite popular amongst various entrepreneurs, there are also many cons related to it. Some of these disadvantages have been listed below:

1. Deterrent to Growth: Venture debt can act as a deterrent to growth. Start-up companies that are in their growth phase want to ensure that they do not have cash outflow commitments. This is because their cash inflow tends to be uncertain and also, they require funds to support their growth. Venture debt is a contract that binds the start-up company to a repayment schedule.

2. Conflict with Existing Investors: Even though venture debt is not supposed to be based on the assets of the firm, the reality is that a lot of the time, it does take the company’s present assets into account. Hence, if in the future, there is any form of economic turmoil and the firm is unable to do well, conflict is likely to break out between the equity partners and venture debt investors. The start-up must ensure that the rights and responsibilities of all parties in each situation have been carefully drafted and communicated to all parties.

3. Can Cause Bankruptcy: As mentioned above, venture debt has to be repaid in accordance with a repayment schedule. If the company is unable to make the payments on the agreed-upon date, they will contractually be in default. Hence, in such cases, venture debt investors can approach the court and take legal steps to declare the firm bankrupt.

4. No Flexibility in Repayment: Venture debt investors are known to have a ruthless business model. This is because venture capital firms know that half of their investments will fail but they will make enough profit from the other half that they will be able to cover their losses. On the other hand, venture debt investors have a limited upside. Hence, they cannot afford to let any of their investments fail. This is the reason that they are very rigid when it comes to repayment terms and schedules.

The bottom line is that venture debt is generally preferred by start-up firms in the short run as a stop-gap arrangement. However, at the same time, the same firms would not want to use venture debt over a longer period of time.