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Venture Debt for Startups: What You Need to Know

In the startup world, there is so much emphasis on venture capital when, in reality, less than 1% of startups actually receive VC funds. There’s actually another, lesser-known option to consider:

Venture debt. What is venture debt financing exactly? Read on to find out.

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What is Venture Debt Financing?

Venture debt financing is funding to augment the venture capital that you’ve already raised, or, in the case that you don’t want to give up equity to investors, your primary source of funding for your startup.

It’s typically senior debt, meaning it’s got the first position on the assets of the business. If the business files bankruptcy down the road, venture debt has the highest priority to get paid.

There are two types of venture debt providers: regulated and non-regulated. Regulated lenders, such as banks, are lower on the risk curve, and there may be more structure, potentially, in terms of financial covenants. On the plus side, they may be more favorable on pricing and offer multiple debt products, but sometimes banks are not able to provide the full amount of financing you’re looking for.

On the other side, we have non-regulated providers or private fund lenders. These lenders are more willing to take on risk, provide more creative structures, and cut larger checks for startups.

The good news is that you don’t have to choose between the two; you can work with both regulated and non-regulated venture debt firms.

For example, Partners for Growth can provide secondary funding junior to a bank like Silicon Valley Bank and provide a solution to the client that’s less dilutive than raising equity, but can get the client the capital they need. And we can price that risk as a non-regulated entity and provide an affordable financing solution for the client, reducing dilution for existing shareholders.

You get incremental capital beyond what a bank can do as a senior lender. You get the capital you need to launch or grow your startup saving dilution compared to raising equity funding, and the lenders get a return on their investment.

Benefits of Venture Debt

Taking on investors—if that’s even an option—can dilute your own equity in the company and bring on more opinions on how you run the business. It is not unusual for founders to give up 10 – 25% of their company to investors in each equity financing round. Many founders aren’t interested in that, or at least, want to minimize their dilution. Venture debt is less dilutive, meaning you give up less equity to get the same amount of financing.

Who Is Venture Debt Good For?

While there are a variety of industries that can benefit from venture debt, tech and innovation startups tend to be among our most common clients. Many have already raised institutional Series A funding, though that’s not a requirement. Partner for Growth focuses on funding companies with at least $3 – $5 million of revenue but there are also funders who can provide debt financing to early-stage and pre-revenue startups.

The Structure of Venture Debt

While the structure may vary from one venture debt firm to another, generally you will see a repayment period of two to four years.

The financing may have equity options or warrants to compensate for the high risk. A warrant is similar to a stock option providing an option to buy stock at a fixed price for a fixed period of time. This compensates the lender to take the risk of making the loan, and aligns incentives with the startup as everyone hopes that the stock will one day be worth far more than its original value. The options or warrant will be priced to be much less dilutive than raising equity funding for the same amount of capital.

In terms of underwriting, venture debt firms will look at several factors to consider whether to lend to a startup, and to determine how much to lend and at what rate. These factors include the company’s business model, if it sees sticky revenues (recurring revenues, such as from a subscription), as well as whether the startup has any intellectual property or assets, and how much capital is needed to achieve future profitability.

Finding the Right Fit

It’s important to choose the right venture debt firm for your startup’s needs. Start by looking at your startup’s risk factor. If it presents a high level of risk, regulated venture debt firms may not be interested, but non-regulated might be an option.

If you’re just starting out at the seed stage, there are funding companies like Lighter Capital that specialize in debt financing for companies with as little as $15K in recurring revenues, so explore those options as well.

Look at terms for the loan because, remember: unlike with venture capital, you will need to pay back this loan. Don’t borrow more than your company can afford. Also, pay attention to the structure of warrants or covenants to make sure you’re comfortable with them and be sure to understand all fees associated with the loan. Lastly, and importantly, get to know your lender and make sure you are comfortable that they understand your business and will be a reliable partner to help you achieve your growth plans.

Posted on Monday, March 8, 2021