Venture Capital Funding: Essential Things to Know About Venture Debt

Raising venture capital is soul-sucking work. You travel around pitching your company over and over to funds that don’t want to lose money. You answer thousands of needling questions and, finally, after months of effort you might get some money -- but not without strings attached. Sometimes you have to give up 20% or more of the equity in your business to raise the capital.

What if I told you there was a different way to grow?

Overview: What is venture debt?

Venture debt is an alternative to venture capital (VC). Instead of selling a portion of your business for money, you take on debt. In a traditional VC round, you would agree on a term sheet and raise funds based on a pre-money valuation. The round can take months to organize and finalize, and the equity you give up can cost you a ton of money in the long run.

Venture debt can take a fraction of the time to raise, but it’s still expensive. Venture debt rates routinely range between 15-25% and often have a small amount of equity attached as a sweetener. Venture debt providers have to compensate for the increased risk they’re taking on by working with startups.

3 benefits of venture debt for startups and investors

Here are three reasons to consider using venture debt instead of venture capital.

1. You don’t have to give away equity

The main reason to entertain venture debt is to avoid giving away equity in your company. When you start out, giving away 20% ownership doesn’t seem like that much of a loss. At that point, 20% of zero is still zero.

But you need to plan for the future. If your company eventually has a valuation in the millions or even billions, you will rue the day you gave away equity.

There is convertible venture debt, or venture debt that has attached warrants, that can still take away from your equity position. But the equity in these scenarios is far less than what you’d give away for an equivalent venture capital investment in the company.

2. It isn’t necessarily forever

If you do raise venture debt that is not convertible, a huge positive is that once you pay it off, you’re done. If you raise capital by recruiting investors, you’ll likely always have a board of directors and a lead investor looking over your shoulder.

The only way to rid yourself of venture investors is to go public or buy them out. Going public could multiply the number of investors by tens of thousands and invites the government to join the party. Buying out your investors is not easy. Usually, you raise startup capital because you don’t have the money. Now the investment is potentially 50 times what you didn’t have before, and all your money is still tied up in the company.

Having smart investors involved isn’t a bad thing. It just may not be your thing, and using venture debt can give you an easier route to independence.

3. It’s an alternate form of growth capital

You shouldn’t raise capital through debt or equity unless you have a clear way to use it to grow. When you’ve hit a plateau in growth because you can’t fund the next piece of equipment or block of podcasts ads without outside money, venture lending can get that money to you quickly, albeit expensively.

3 types of venture debt

Here are the main types of venture debt.

1. Convertible

The most common type of venture loan is either directly convertible to common stock or comes with warrants attached that can be exercised to become common stock. Venture debt funds don’t want to take on the risk of a startup without at least a piece of the upside.

Warrants are like the stock options that trade on public markets. The warrant gives the investor the right but not the obligation to buy the common stock at a certain strike price. For example, if you recently raised a round of venture capital at a $25/share post-money valuation, you might issue some warrants allowing the debtholder to potentially buy shares from you at a $50/share valuation.

This gives the fund an upside but doesn’t have the same hit on equity that a direct investment would.

2. Term loans

Term loans are just like the mortgage on a house. You get a certain amount of money to be used to purchase an asset, and then you make payments on the loan over a set term. The difference is the interest rate.

In the current rate environment, you may be able to find a mortgage at 2.5% over 30 years. You’d be lucky to pull off a venture term loan with a term of more than 10 years and a rate below 15%. It’s more likely the rate will be 25%.

Term loans are best used when you can directly link an asset and its cash flow to the payment of the loan. Think about buying equipment that produces a predictable amount of inventory, and the resulting cash flow can easily make the debt payments.

Big banks are probably your best bet for venture debt providers for term loans, many of which have venture departments. If you already have a relationship with one, ask your branch manager how to contact the venture department.

3. Factoring

Factoring also typically has a direct relationship between use and payment. It’s the term for selling accounts receivable (AR) to fund the production of items sold to the customer. Let’s look at an example.

Frank’s Fanny Packs has an innovative new fanny pack that wirelessly charges your phone and, due to its proximity to your stomach, is able to text you reminders to eat when you’re hungry. These are certainly necessary functions.

Frank just got a massive order from a big box retailer for 15,000 fanny packs to be shipped across the country. He now has a big AR on the balance sheet for the purchase and an ulcer trying to figure out how to manufacture 15,000 fanny packs.

So Frank goes to a factoring company and sells the AR for 85 cents on the dollar so he can pay his vendors and manufacture the packs. He knows he may end up with a negative gross margin on this deal, but getting his fanny packs across the country is worth it.

When to (and not to) use venture debt

There are ideal times to use venture debt, but you may need to be wary.

In between rounds

It’s common for startups to use venture debt to make ends meet between venture capital rounds. Rounds are typically tied to benchmarks. Sometimes it’s revenue dollar amounts, and sometimes it’s user count or cash flow. If your company hasn’t hit the next benchmark but needs more capital to get there, venture debt is one way to accomplish it.

For a specific use

Venture debt financing should be used when you need capital for a very specific one-time purchase. This is the same strategy we talked about before with term loans. If you need to buy a big piece of equipment to get to the next tier in your business, you’re better off trying to quickly arrange for venture debt than go through the whole process of a VC round.

You can’t make the payments

You should always be your business’s biggest critic, at least in private. Know your financial position and keep a strict budget. It will be impossible to stick to the budget exactly, but you should be able to use it to guide decisions.

If your venture debt terms would push you into a payment of more than a quarter of your operating expenses, it probably isn’t worth it. You would then be stressing your business past the point that the loan makes sense. Of course, it changes things if the use of the proceeds will directly cause your revenue to increase by enough to make the payments. The budget should be dynamic.

Pay it off

Debt financing for a startup is complicated. You need to keep track of how and when equity might be involved and when to make massive debt payments. That said, it wouldn’t exist if it wasn’t worth it.

For many startups, growth is coming so fast and returns are so high that even exorbitant rates are OK for now. Just make sure to make your payments on time (early if you can) because lenders will do everything they can to make a profit on the deal.