Venture Debt: Is it right for your start-up or emerging growth company?

January 16, 2020 | Myron Mallia-Dare, Elsir Tawfik | Toronto

Access to capital is critical for start-ups and emerging growth companies to fund operations, finance working capital and develop and scale products and technology. These companies typically rely on invested capital to raise funds. However, equity financing may not be available and can be dilutive to founders equity. Venture debt can complement equity financing and offers a source of capital to bridge the gap until the company’s next equity round, cover expenses or support growth.

What is Venture Debt?

Venture debt is non-dilutive financing in the form of term loans or lines of credit available to venture-backed growth companies. These organizations typically have limited assets and are not cash flow positive. Thus, traditional loans are typically unavailable. There are three primary kinds of venture debt:

  • Equipment financing: This kind of financing is meant to fund the purchase of equipment, such as network infrastructure, hardware or research and development.
  • Accounts Receivable: A start-up borrows against their accounts receivable, thereby smoothing out their spikes in revenue.
  • Growth Capital: A catch-all category meant for loans that can be used to fund growth, such as M&A, a new round of hiring or working capital.

Benefits of Venture Debt

Venture debt offers benefits over other forms of financing. Unlike equity financing, venture debt is non-dilutive. It allows shareholders to create greater value by providing the necessary capital for the organization to achieve critical milestones and support growth prior to its next round of funding. Venture debt also allows founders and shareholders of the company to maintain control of the business as lenders do not generally require board seats or observation rights as a condition.

Venture debt can usually also be arranged much more quickly than raising capital through equity financing. Thus, growth companies can gain access to funds faster and with fewer requirements. In addition, organizations can structure their debt, including venture debt, to lower their overall cost of debt capital.

Is Venture Debt appropriate for your business?

While venture debt does offer certain benefits, it is not ideal for every organization.

Venture debt is typically ideal for those start-ups that lack sufficient tangible assets to be eligible for more traditional financing. As such, many venture lenders prefer start-ups with monthly recurring revenue. Venture debt is typically for fast-growing companies with low operating expenses for which revenue growth can ultimately exceed the cost of capital. These kinds of start-ups are frequently found in the technology space, where very little initial capital is needed before a steady stream of revenue is generated.

Venture debt is not suitable as a last resort for companies that already have a low cash balance and high operating expenses. If the debt payment ends up being more than 20% of the company’s operating expenses, it is probably too costly for the company. It is also not suggested for companies that have a very variable revenue stream or any company that does not have a very clear use for the funds.

What are typical terms for Venture Debt loans?

The terms of venture debt facility will vary depending on a number of factors, including: (i) the company’s current stage of growth; (ii) its current cash position; and (iii) the industry and market in which the company operates. Some key terms of which emerging companies should be aware include the following:

  • Interest rate: Interest rates tend to be higher than a normal commercial loan. Organizations can expect venture debt interest rates to be upwards of 10%.
  • Term: As the purpose of venture debt is to assist the start-up in reaching the next round of equity financing, the terms of the loans are typically short. Thus, the terms of these loans are typically 12 to 48 months.
  • Security: The loan will typically be secured by the company’s assets, such that the lenders have priority over the assets in case of insolvency.
  • Warrants: The lender will typically receive warrants allowing the lender to purchase shares in the emerging company at a future date.
  • Covenants: A loan will normally include both positive covenants and negative covenants. Common covenants include limits on raising additional debt and restrictions on the use of the loaned amount.

Conclusion

Emerging companies exploring venture debt should ensure that it is right for their organization. For mature organizations with assets that a loan can be secured against and a healthy stream of revenue, traditional commercial loans may be more attractive as the interest rates for loans from these traditional lenders will likely be much lower. Yet, venture debt offers an attractive source of financing for venture-backed organizations that are in a certain stage of growth.

Due to the significant variability between the terms of venture debt facilities made available, it is advisable that emerging companies seek expert advice to provide guidance on this form of financing.