How to Use Venture Debt to Complement Venture Capital
On the face of it, startups looking for funding to launch or grow their companies have two avenues to raise that capital.
They can take venture capital, which is equity funding that provides permanent capital in exchange for a stake in the business. Investors have the right to a percentage of future profits or a stake in proceeds from the sale of the company.
On the other hand, they can look to raise debt. Venture debt for startups is like any other kind of debt in that it has to be repaid according to the terms of the loan or at exit. It may include a small equity stake to the lender, however, it will save the company’s existing equity holders significant dilution relative to raising that same amount of funding in equity.
A common misconception about these two sources of financing is that it’s one or the other. In fact, venture debt doesn’t need to replace venture capital. It typically complements it.
The Appeal of Venture Debt
The growth of venture debt is currently outpacing venture capital, according to Pitchbook’s Venture Debt: a Maturing Market in VC. The U.S. venture debt market was sized at $28.2 billion in 2019, hitting all-time record at the time. With the onset of the pandemic in 2020 few would have predicted another record year, but venture debt continues to prove be a popular option for venture backed companies globally, setting another record for total loan volume, though we saw a slight decrease in the number of companies financed.
Specialist lenders like Partners for Growth are creating more options for startups to get the capital they need, whether they are venture funded, independently sponsored or bootstrapped high growth companies, or have raised early-stage funding from other non-VC sources. Venture debt is an increasingly common source of growth capital funding, whether provided by specialist lenders, commercial banks, or other private debt funds.
Types of Venture Debt Financing
Just like more traditional financing through a bank, venture debt offers several types of options.
These have a fixed repayment period, usually two to three years from funding date. The funds may be released all at closing, or in tranches, giving you some money up front and the rest later to manage interest expense and debt load as the company scales.
Line of Credit
This gives you access to a certain limit of money, like a credit card line for your business. You can take it all out, or some whenever you need it. You can pay back what you borrow and then have that available to borrow again.
This option combines the aspects of both debt and equity. You start off with a loan, which may then convert into equity at an agreed-upon outcome (like an event such as an IPO or sale of the business). Interest typically accrues until maturity or until the loan converts to equity.
When starting out, you may not be able to guarantee you can pay off a loan within a fixed amount of time or in a fixed amount each month, so you could consider a revenue/royalty share agreement where you sell a percentage of your future revenues, or you establish repayment of a loan based on future revenue. Payments may fluctuate with your revenue performance, and terms may be variable.
Using Your Debt with Venture Capital Funding
Even if you’ve received a round (or two) of funding from VCs, adding venture debt to the mix has many benefits.
You Can Optimize Your Funding Mix
Every time you take on a round of funding, you give away more equity in your startup. By having a balance of venture capital and debt, you can reach milestones while giving up less equity, or you can delay your next round of equity funding until you reach certain milestones.
It Provides a Cushion
Too many startups under budget what they think they’ll need to hit those milestones, and taking on venture debt can serve as insurance and a cushion to ensure you’ve got enough funding to hit goals without running into liquidity issues.
It’s the Most Cost-Effective Working Capital Finance
Especially in the startup phase, your equity funding can be very valuable. As your business proves its unit economics, funding the working capital needed for additional growth with debt rather than costly equity can save significant equity funding needs while still delivering growth capital to propel your business.
You Can Buy Equipment or Assets
If you need expensive equipment to run your business, you don’t have to wait for your next round of equity funding to cover it. There are even specific venture debt loans and equipment leases for this purpose.
Your Startup Can Reach Profitability Without Another Round
If you need just a little capital to help you reach profitability, you may not want to take on another round of VC funding to get there, since that will dilute your equity. Venture debt can close that gap.
It Can Increase Valuation
One of the biggest factors in taking on a round of funding is your startup’s valuation. If your valuation isn’t where you know it could be, maybe because you’re just shy of profitability, you may need capital to reach milestones to get there. Venture capital will dilute your equity at that lower valuation. However, taking venture debt allows you to reach the valuation you want with less dilution.
If you’ve received one or more rounds of capital and are looking for another cash infusion to fuel growth, venture debt can play nicely with the venture capital you’ve already received and put you in a stronger position for future fundraising.