Exploring Venture Debt: Benefits, Risks and Tradeoffs
Most entrepreneurs are comfortable with the concept of venture capital, but many founders are fuzzier about its loan-based cousin, venture debt. Venture debt has exploded in popularity in the last few years. Tomasz Tunguz notes that it’s 16x as popular as it was only six years ago. For some startups, venture debt can be a solid option to boost their cash flow and supplement their VC round with very little dilution to their remaining equity. But like anything, there are trade-offs and you need to educate yourself on the basics.
What is venture debt?
Venture debt is, as the name implies, a debt funding mechanism available only to venture-backed, early- and growth-stage companies. It’s provided by tech banks and dedicated venture debt funds, typically in a three- or four-year term loan that’s generally interest-only for the first year and then fully amortizing for the remainder. It’s secured by a company’s assets, including IP or equipment. In other words, you’re borrowing a lump sum of cash up front, and in exchange for the cash, the loan will have to be repaid or refinanced. This repayment usually happens in monthly payments over the course of the loan, at interest rates in the 10 to 15 percent range.Of course, lending to early-stage companies is far riskier than what these interest rates reflect. So, venture debt lenders take warrants in either common or preferred stock to help combat the risk while allowing them to charge lower rates. Should your startup have an exit, they walk away with a small slice of equity and a big upside.Venture debt providers are betting, essentially, on your company maintaining a high growth rate, and on VC firms’ continued willingness to fund it—or at least work to recover their investment. Because of this, venture debt providers have very close ties to the VC community. There is no venture debt without venture capital.
How is venture debt different than convertible debt?
Convertible debt, too, is a loan, but it’s one in which you agree to convert your loan amount to equity at a specific date, instead of repaying the full amount. Usually, that conversion occurs with your next round of funding, but convertible debt also has a maturity date—if you don’t raise before that date, you have to repay the loan.Convertible debt can be appealing for early stage investments—you avoid debates about valuation, which is hard to gauge so early in the game. (You do have to pick a strike price, and the note generally converts at a discount to the valuation, usually 20%.) Plus, interest rates for convertible date are far lower than venture debt deals—typically in the 2 to 8 percent range—so the ROI here is coming from the conversion to equity. Additionally, the interest is generally PIK (paid in kind), so no actual cash is paid out yearly—it’s just added to the balance of the loan at maturity.Venture debt tends to be a more balanced mechanism for investors: ROI comes from both higher interest rates and equity warrants.
The advantages of venture debt
So, other than cash appeal, why would startups sign on for venture debt? First, it’s an easy add-on after raising a venture capital round and can significantly help you extend the runway of your existing raise without giving up a lot more upside. You have your materials in order, the details are fresh in your mind and you have a funding friendly growth plan that you’re acting on.But the biggest advantage is that debt is cheaper than equity, and it always will be. Whereas the price of equity shifts based on your valuation, venture debt leverages equity to take on debt at far better terms than what traditional lenders—who are notoriously skittish about early-stage software companies—could provide. Plus, venture debt lenders don’t take board seats and there’s less equity dilution.
The disadvantages of venture debt
Venture debt comes with a few big potential downsides. The most concerning is the possibility of dangerous financial covenants. For example, if you don’t grow as fast as you anticipated, then may not meet certain metrics required in your loan document like net income losses or coverage ratios. This can lead to a default. When you are in default, your loan is due and payable (all of it including accrued interest) right now. This could be a show-stopper for many startups.Think of this as venture debt providers taking the backdoor in and seizing a slice of control. Although they’re not on your board telling you how to run your business, if you don’t run it according to the metrics they set forth in the loan terms, they’ll pull their investment.Before you commit to venture debt, make sure you’re comfortable with every aspect of the deal.Molly Otter is the CIO of Lighter Capital. She has been an investment professional for 10+ years with a focus on providing debt for middle market companies. She was previously a VP at AEA Investors LP as a member of both the Mezzanine and Senior Debt teams. She has her BA from Dartmouth College and her MSc from the London School of Economics.