Venture debt can be appealing because it allows young companies to get cash without giving up too much ownership.
As more startups are seeking alternative finance sources, the demand for venture loans is increasing and more companies are turning to venture debt to raise additional capital.
Venture debt can be appealing because it allows young companies to get cash without giving up too much ownership, it provides a relatively quick way to access new funds, and it can help startups extend their runway between equity rounds — sometimes even helping them meet performance milestones set by VC backers.
In the midst of the economic uncertainty caused by the Covid-19 outbreak, a number of startups have turned to venture financing to assist them quickly adapt to new market conditions or to avoid raising from VCs at a lower valuation (a down round).
Despite these potential benefits, venture debt is not a direct alternative for VC-backed equity rounds, and it brings with it a number of key considerations – as well as some downsides.
In this blog we will discuss what venture debt is, how it differs from venture capital, why a company could raise venture debt, and the venture debt industry's prognosis.
Venture debt offers a way for VC-backed startups to raise funding by borrowing money.
A short term loan to an early-stage startups or companies between equity fundraising rounds known as venture debt . It is uncommon to use venture debt as a long-term financing option. These loans are typically repaid in 18 months, though this can occasionally go up to two or three years. Most frequently, lenders of private venture financing (funds or banks) anticipate repayment from the proceeds of the following funding round. However, venture debt lenders maintain a strong relationship with venture capitalists, and it is common for businesses to get such loans repeatedly as they grow.
Typically, venture debt is utilized for equipment finance or growth capital. Equipment financing is used to purchase equipment, such as machines for a manufacturing, that is only backed by those assets. Growth capital, which is secured by firm assets, can be used for any purpose.
Venture debt loans are designed for fast-growing, VC-backed firms and are frequently arranged at the same time as an equity round. As a result, firms typically use venture loan investment for growth, similar to how they would use VC financing. This might entail expanding sales teams, marketing, R&D investments, and much more.
Venture debt lenders generate their money primarily through interest payments, fees, and warrants.
Warrants enable a venture debt fund to participate in the upside that a VC fund has by purchasing options in the business (usually priced at the most recent round's value) and converting them into shares upon an exit— such as an IPO or acquisition. This method differs from traditional business loan lenders, who are often unwilling to take an equity part in a company (and often see young companies as too risky to lend to).
A rigorous underwriting process is used by venture debt lenders to choose investments. The management team, the product, investors, market traction, and other value drivers must all be examined during underwriting. Because the ultimate repayment source for venture financing is often future equity rounds, venture lenders must evaluate whether a company is well-positioned to raise future rounds.
Underwriting criteria are also based on a company’s life stage and capital strategy.
Early-stage companies, for example, with little operating history are frequently judged based on investor quality, recent equity rounds and projected cash burn rate. Companies with high burn rates are regarded as risky because they rely more on external funding.
Later-stage enterprises are typically evaluated based on their capacity to acquire non-dilutive financing from new investors. A history of non-dilutive capital also implies that a company has reached milestones related to product development and financial success, which may make them more appealing to lenders.
Venture debt is not a straight replacement for venture capital. The goal of venture debt is not to fully fund an early-stage company as it grows and prepares for an exit, but rather to supplement equity funding from VC companies — entrepreneurs typically cannot access venture debt without first receiving venture capital.
However, venture debt differs from equity funding in many respects, and some companies may choose venture debt to postpone or avoid raising another round of venture capital.
One notable distinction is that VCs take a large share in a company in exchange for financing, whereas venture debt is repaid over time at an agreed-upon interest rate. Venture loan transactions frequently include warrants, which can be converted into equity at a certain price at a later date, but these typically represent far less equity than a VC would request. Overall, this means that more stock can remain in the company, allowing founders to enjoy greater rewards in the event of a departure.
Another challenge for companies is how to repay venture debt while also investing in development – unlike venture funding, which does not have to be repaid directly. In some situations, a company with significant venture loan obligations may have a more difficult time raising funds from VCs since investors may balk at funding debt repayments rather than development prospects.
Venture capital also provides a number of value-adds that venture debt often does not. These include promoting partnership opportunities, providing access to networks, providing business advice, assisting with crucial role filling, and assisting with media exposure.
Both financing options are generally free of financial covenants and can be utilized for any corporate purpose.
The venture capital business model is based on the Pareto principle, which states that 80% of earnings originate from about 20% of startups. Because the top performers generate the majority of a fund's return the VC model relies on a few huge wins to offset a lot of losses. Venture debt, on the other hand, is almost certainly repaid by startups, but lenders do not earn as much from large IPOs or acquisitions. Overall, venture loan returns are lower than VC returns, but individual investments are less risky.
The main differences between the venture debt business model and venture capital business model include:
The failure rate of venture loans is substantially lower with approximately 1-8% of invested money being written off. This is most likely owing to debtors having previously raised VC money, which entails a thorough due diligence procedure.
The internal rate of return (IRR) of venture financing is determined by interest rates, fees, payback schedules, and warrants. Capital given to companies should be returned to a venture debt fund during the first 15-18 months of a three-year loan. VC funds, on the other hand, often have holding periods of 5 to 8 years before they anticipate to make a return on their investment by selling equity.
Venture loan lenders typically evaluate a firm based on its near-term viability rather than its growth potential. Because venture debt lenders are concerned with a company's ability to repay a loan over a few years, they place less weight on a company's future growth trajectory than a VC might.
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