Venture Debt in Startup Funding

Whenever the subject of startup funding is mentioned, the audience automatically assumes that equity investments are being discussed. This is because it is the big equity deals that are mentioned in the newspapers which catch the attention of the world. However, equity funding is not the only way in which startup founders can raise capital. There are many investors who are willing to lend money to startup firms in the form of venture debt.

It is surprising that the general investor population is not very well versed in the concept of venture debt. This is surprising because of the fact that the venture debt industry is about 40% of the size of the venture capital industry. Hence, their scale of operations is quite large. However, these operations are much less glamorous and tend to happen behind the scenes.

In this article, we will have a closer look at this concept and explain it to our customers in more detail.

What is Venture Debt?

Venture debt is an alternative way to raise capital for startup firms. Venture debt means giving loans to companies that have already raised equity from venture capitalists. Venture debt is very different from regular bank finance. Banks are willing to lend money on the basis of certain types of collateral viz. assets, cash flow, etc. However, venture debt is about making debt investments in companies that may not have a sizeable asset base or may not even be cash-flow positive.

Just like bank loans, venture debt investors expect their loans to be paid back with interest. This interest is expressed as some function of the prime lending rate in the market. However, since these are high-risk investments, venture debt tends to have very high spreads and interest rates. It is common for venture debt funds to expect anywhere between 12% to 25% of interest on their invested funds.

The term of venture debt can be anywhere between one year to four years. However, since startup firms are considered to have an existential risk, most providers of venture debt tend to prefer financing loans with shorter tenures. If a loan has a longer tenure, founders can expect to pay a significantly higher interest rate on the same since the risk increases exponentially.

The repayment schedule of venture debt can be more complex as compared to regular debt. This is because of the fact that venture debt repayments can be linked to business milestones such as revenues or accounts receivables instead of being due on a particular date.

How is Venture Debt Different from Venture Capital?

It may appear like venture debt is the same as venture capital since both types of investments are made by the same types of investors. However, there is a huge difference in the mindset of the investors and the way in which they approach these two types of investments.

While investing in venture capital, investors know that every venture will not be successful. Hence, they budget for the fact that some ventures will not be successful and have cash flow pressures.

Successful investments make so much money that they cover the loss from the unsuccessful ones. However, when it comes to venture debt, investors expect to get paid each and every time. There is no room for loss in their calculation because they are lending money in the form of debt. Hence, they have a limited upside. In such cases, the profits from successful investments cannot make up for the loss from unsuccessful investments. Hence, investors are very careful in trying to ensure that they do not lose money.

Venture capital investors tend to be very flexible. They may provide certain concessions to companies that are undergoing a bad economic phase. This is because they are concerned about their reputation amongst other startups in the market. This is also because their interests are aligned with that of the startup company. However, when it comes to venture debt, investors tend to have no qualms in taking an aggressive stance. This is because they expect to be repaid as per the agreed-upon debt schedule. Startups tend to run into cash flow issues very often. Venture debt investors cannot afford to be lenient on these companies or else they will stand to lose a large amount of their capital.

Types of Venture Debt Repayments

Just like regular bank loans, founders can choose from different terms when it comes to repaying their venture debt.

  • If the founders expect to have cash flow problems in the near future, then they can choose to take an interest-only loan. This helps them reduce the cash outflow in the near term. The last installment can comprise of principal as well as interest payment

  • Founders can also choose to have a repayment schedule wherein they pay neither interest nor principal for a short period of time. After a certain amount of time elapses, they will be expected to pay both components of the loan

  • Similarly, founders can decide on an amortization schedule wherein the monthly payment amount will remain the same. However, the principal and interest components that together make up the monthly payment will keep on changing on a regular basis.

The bottom line is that venture debt is a very useful tool. It is also widely used by startup founders all across the world. However, for some reason, it is not commonly known to the general public.

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Startup Finance