The purpose of this article is to explain what venture debt is, who provides venture debt, why venture debt may be preferable to equity, and the key terms and covenants that are often associated with venture debt.
What Is Venture Debt?
Venture debt is a loan for a business that has received equity funding from professional investors but cannot yet access traditional credit markets due to a lack of extended profitability, a firm customer base, or valuable assets that can be used as collateral for the loan. Venture debt is usually provided by institutions that specialize in lending money to small businesses. Often, the best time to obtain venture debt is immediately following an equity round while the pitch materials are still fresh
, and investors are optimistic about the company.
Although venture debt can bridge the gap between rounds of equity funding, it should not be confused with bridge loans. Bridge loans often come in the form of convertible debt and send negative signals to investors because most companies seek bridge loans when funding needs are desperate. Venture debt, on the other hand, is often raised proactively with the intent of obtaining cheaper financing, so it does not carry the same negative message.
Who Provides Venture Debt?
Venture debt providers can be classified into two main groups: venture debt banks and venture debt funds.
Venture Debt Banks
Venture debt banks are commercial banks that specialize in providing debt to small companies. This group also includes commercial banks that have a small, venture lending arm within the overall bank.
Venture Debt Funds
Venture debt funds are structured similarly to venture capital (VC) funds. The funds are often backed by third-party limited partners (LP), and the money received from the LPs is loaned to small businesses. Venture debt funds are orchestrated and carried out by VCs that specialize in providing debt to small companies, although VCs that specialize in equity investments may also open debt funds to diversify their portfolios.
Venture Debt Banks vs. Venture Debt Funds
At a high level, venture debt banks are less willing to take on risk than venture debt funds are, due to greater regulatory oversight. The following chart outlines some of the key differences between venture debt banks and venture debt funds:
|Venture Debt Bank||Venture Debt Fund|
|Cost of Capital||Lower — 5-8%||Higher — 9-13%|
|Covenants, Clauses, and Collateral||Yes||Few to none|
|Equity Stake||Less — Venture debt banks require less equity. Some banks may not require any equity at all. Most, however, will contain an agreement of 2-5% warrant coverage.||More — Venture funds want some equity stake in the arrangement, such as warrants, convertible debt, or both. Remember that this dilution is still much less than the dilution that occurs in equity funding. Funds typically ask for 8-10% warrant coverage.|
|Reporting Requirements||Likely More — For example, your company may be required to provide full financial results every month or lists of partners, suppliers, and stock levels that your company works with.||Likely Less — For example, your company may be required to provide quarterly updates to the VC board.|
|Lender Stipulations||More — Some banks may require your company to open and maintain all operating accounts with the bank.||Less|
|Initial Loan Paperwork||More||Less|
|Additional Services||Banks can help process payments and wire transfers, create complex credit products, provide letters of credit, conduct foreign exchanges, and other financial services.||Funds may act as advisors based on their internal industry expertise and small-business connections. These advisors may make recommendations on operational and strategic decisions.|
What Is Advantageous About Venture Debt Funding?
Debt financing has several advantages:
- causes little to no dilution
- allows a company to retain its stake in future profits
- is often cheaper than equity
- utilizes leverage to achieve more profits
- provides tax benefits due to deductible interest payments
Additionally, smaller companies often utilize debt to extend the runway between rounds of equity funding, reach the next milestone or project, finance the acquisition of a new company, or expand into a new product line or market.
Venture debt is particularly attractive for smaller companies because it does not require the company to obtain a valuation, give up seats on the board of directors, or spend a large amount of money trying to raise equity. Smaller companies also may secure venture debt more quickly than equity. Avoiding a valuation is particularly useful when a company anticipates its current valuation is lower than the prior valuation (i.e., a down round). Companies try to avoid down rounds if possible because a down round can be expensive and send a negative signal to investors.
What Are the Common Terms and Covenants Associated with Venture Debt?
Key Loan Terms
- A key component of a venture debt loan is a drawdown period. This refers to a period in which the company is allowed to exercise the option to borrow money, up to the predefined limit. Once the company has decided to borrow money, the loan is created and will need to be repaid over time. Drawdown periods can be anywhere from 9-18 months. In this sense, venture debt can serve as a line of credit.
- Most venture debt loans require the company to pay only interest for the first 6-18 months after the loan has been issued.
Length of loan
- After the interest-only period, the company is required to pay off the remainder of the loan. Venture debt loans typically last only 3-5 years.
- The amount of the loan varies by company. Often, the amount of the loan is calculated by taking 25%-50% of the equity value from the most recent round of funding.1 Larger companies can obtain larger loans than smaller companies.
- Most venture debt agreements require the company to give up some equity. Often, the equity comes in the form of warrants. Warrants give lenders the option to purchase shares, often within 7-10 years, at a specified price. The warrant coverage percentage, amount of debt, and strike price determine how many shares the lender can purchase. For example, if the warrant coverage percentage is 8%, the amount of debt is $1M, and the strike price is $1.00, the number of shares the lender can purchase is calculated as follows:
# Shares = Warrant Coverage % * Loan amount / Strike Price
= 8% * $1M / $1.00
= 80,000 shares
Although warrants can be an attractive option, companies should note that accounting for warrants can be complex and costly. See our article Warrants for more information on the accounting for warrants.
No prepayments / early payments
- Venture debt lenders don’t want to be replaced by a bigger bank if the company does well, so they may insert loan terms that discourage prepayments. A prepayment penalty is frequently set at 1% of the loan amount.
Fees and other closing costs
- Loans often include fees or other closing costs. These costs run anywhere from 1-3% of the loan.
Key Loan Clauses or Covenants
- An important negotiation point of venture debt is collateral. Most small businesses do not have sufficient assets to collateralize the entire value of the loan, so the lender will want to include as many tangible and intangible assets (e.g., intellectual property (IP), trademarks, patents) as it can as collateral on the loan. Owners of small companies should also be conscious of loans that require personal liability. Venture debt funds are less likely than banks to require collateral from your company.
- Most venture banks add loan covenants to restrict specific company actions. For example, banks may require the company to obtain approval before selling certain assets or to maintain a specified current ratio. Venture debt funds set few to no covenants.
- Material Adverse Change (MAC) clauses are most often found in bank agreements (not venture debts funds). These clauses allow the lender to recall the loan if the company has materially changed in a way that affects repayment of the loan.
Because of its unique advantages and market, venture debt can be a worthwhile option for many companies, but especially those companies that may struggle to access the traditional credit markets or are looking for funding alternatives to equity. Understanding more about venture debt, including who provides venture debt and its associated terms and conditions, will help companies negotiate beneficial debt agreements.
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- Murray Jean. “What Is an SBA 7(a) Loan?” The Balance Small Business. 01 April 2021.
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- Square 1 Financial, Inc. 14 March 2014. Form S-1. Page 3, 41.
- Timmons, Jeffry A., et al. How to Raise Capital, McGraw-Hill Professional Publishing, 2004. ProQuest Ebook Central, https://ebookcentral.proquest.com/lib/byu/detail.action?docID=4655378.
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