Venture debt provides a solution to the challenges startups and small businesses face when acquiring investors. This type of financing helps businesses that are just getting started to avoid having to give up precious equity in the company and instead provides a debt-based loan. Let’s look deeper into this process and how it works for startups.
What Is Venture Debt and How Does It Work?
Venture debt is an example of debt-based financing often used by startups between rounds of equity investments or when a specific monetary goal needs to be reached. It can be provided by a number of different entities including banks, hedge funds, business development companies, and private entity firms. These lenders will give a small business or startup money in exchange for stock warrants.
The amount of each loan and the specific rules of repayment are different for each agreement and depend on the size of the business, the predicted scale and growth of the business, the amount of equity already raised, and the objective of the loan. It tends to be calculated based on the amount of equity that has previously been raised, usually around 25%-50% of the principal amount from the most recent equity round.
Venture Debt vs. Regular Financing
Most venture debt loans are structured along similar lines to traditional loans with a three to the five-year repayment period. They can also be used as a business line of credit, depending on the agreement between the lender and the venture-backed company.
The differences between venture debt and regular small business loans and financing come in how they are underwritten, how they are secured, and how they are assessed. For example, startups often don’t have the numbers that traditional small business loan officers are looking for in the underwriting process, while venture lenders look at the equity raised in previous rounds of investment.
Venture debt also doesn’t require a startup to have collateral, which helps those small businesses that don’t have substantial assets. Rather than collateral, this relies on stock warrants, which allows the lenders to buy the stock at a fixed price. Warrants last longer than stock options and can help lenders profit from the loan, as they can be converted into common shares in later financing rounds.
Venture Options for Startups
Oftentimes, the key to successful startup investment requires a combination of equity and debt. Venture debt can help startups reach specific monetary goals or fund exponential growth without business owners needing to give up control and ownership in the form of equity. That makes it a great option for businesses where the equity is already diluted.
Venture Debt Pros and Cons
Like all forms of investment, there are pros and cons to venture debt. As a startup or small business, it’s important that you understand the different options you have when it comes to raising capital and the agreements you are making. Let’s take a look at some of the biggest pros and cons of it.
Pros
Venture debt works as an extension between different rounds of equity investment. It can help you finance specific objectives like a marketing campaign or an expensive purchase, or help you reach monetary milestones that you have set out. Reaching those milestones can help other financial institutions and investors see the value in your business before another fundraising round.
One of the biggest appeals is it helps you avoid further dilution of the business's ownership. If you’ve already given away a significant portion of your shares and still need to raise more money to grow, this can fill in the gaps.
Cons
While this doesn’t require further dilution of shares, it does have a cost. Venture debt is a form of senior debt, meaning that it takes precedence when it comes to repayment. If you have any other outstanding obligations, your payments take priority. If you can’t make your payments, the venture lender can take the company or force you to liquidize.
That means that if you aren’t expecting serious growth or have any concerns about your ability to repay the loan, venture debt might not be for you. Without full confidence that the loan can be repaid, this can be an extremely risky choice of financing option.
Find the Best Partner for Venture Debt
Finding the right lender can seem overwhelming. However, when you find the right partner you can get the support you need and find a financial institution that can see the potential opportunity of your business. At 5th Line Capital, we want to become your innovative partner for growth. We offer advising and financing services that can help you raise capital, expand your bandwidth, and discover new tools.
Get started on your venture debt journey and help your business reach the next level you’ve been seeking. Contact 5th Line Capital today.