2022 A Comprehensive Guide on Venture Debt – Part 1
Venture debt can be a great investment for a business looking to get off the ground. However, it is not as simple as it may appear.
Venture Debt is a financing program that provides an opportunity for growth in the field of business. With the right venture debt, it helps entrepreneurs who are looking to raise capital through offering as a smart move.
Venture debt is provided by a venture capitalist. Venture capitalists are also known as “Secondary Market Debt Lenders” and “Private Equity Financiers”. They provide venture debt to many startup companies, or when a private equity firm purchases a company that has some type of equity investment issue that must be dealt with. Venture debt provides access to capital at a lower cost than other forms of financing, especially compared to financing that would have been available from commercial banks (considered high-risk and high-cost financing sources). As such, many early-stage companies utilize venture debt to help them grow their business and reach the next stage of their evolution.
Table of Contents
Why Venture Debt is Important? Or Where is Venture Debt Used?
What is the Difference Between Equity Fund and Venture Debt?
What is Venture Debt and How is it Structured?
Venture debt is a form of non-recourse financing that allows companies to borrow money from investors to fund their business. It is typically used to cover the costs of initial operations, such as the purchase of new equipment or supplies, marketing costs, and legal fees.
Venture debt is designed to help start-ups grow their business, rather than risk it all on an early-stage investment. Venture debt is normally provided by venture capital firms and angel investors or private lenders, but some lenders offer it directly to companies who are looking for short-term funding.
Venture debt is typically available in the form of unsecured personal loans or business loans. It's important to note that these loans come with interest rates that are often higher than a standard bank loan.
It allows you to access capital at a low cost. When you take on venture debt, you are agreeing to pay interest rates between8% and 20% every year, with principal repayment due at the end of your term. It is usually repaid within 3-7years.
The good news is that venture debt has some advantages over other types of loans: It usually doesn't require collateral and can be used as collateral in rare cases where it makes sense (such as when you're buying out another company). You also won't have to pay taxes on it until it's paid off — unlike traditional loans, which are typically taxable at the time they're received.
Why Venture Debt is Important? Or Where is Venture Debt Used?
The primary purpose of venture debt is to finance the expansion of a business.
Venture debt can be used for many purposes, including:
Acquisitions: Acquire new businesses or assets that can be monetized in the future (i.e., selling them for more than you paid for them).
Expansion: Acquire new businesses that may not yet have proven themselves on their own (i.e., acquisition arbitrage), or expand existing operations through mergers, acquisitions, and joint ventures.
Financing: Venture debt can be used to finance a bridge to the next round of funding or an initial public offering (IPO) or secondary offering (sometimes called a follow-on offering). The proceeds from these offerings can then be used to repay existing loans or as seed capital for further growth initiatives.
What is the Difference Between Equity Fund and Venture Debt?
Equity funding is when you, as an investor, put money into the company as shares of stock. You receive a percentage of the company's ownership on top of your initial investment, which may be several shares or just one share. Equity financing can be used to fund any type of business activity, from making products to marketing them to selling them on the market.
Debt financing is when you use the money borrowed against your assets or borrowed from other private lenders. This type of financing is often used by start-ups because it allows them to get going with minimal upfront costs and pay more interest on the money they borrow.
Types of Venture Debt
Term Loan
A term loan is a loan that has a fixed maturity date and a fixed interest rate. It’s often used to fund operations and working capital needs during the early stages of a startup.
A term loan allows you to borrow money from the bank in exchange for an interest rate and repayment date that aligns with your business's needs with interest rates ranging between 3% and 12%. You'll pay off this loan within three to five years at a set amount per month or a fraction thereof. The term length will be agreed upon by the lender and borrower at the time the loan is secured.
Revolving Credit Facility
Revolving credit facilities are like term loans but allow for less flexibility in repayment terms and larger amounts of money. In this type, the lender provides funds to your company on an ongoing basis. These loans are typically shorter in duration than term loans. Private equity firms often use this type of loan when they need more than $10 million per month.
It is used by small to medium-sized businesses looking for short-term financing to bridge gaps between cash flows or pay off debts on existing lines of credit.
A revolving credit facility allows businesses to borrow money from their bank in exchange for an interest rate and repayment date that aligns with their business's needs based on a predetermined formula. This type of debt is repaid in equal installments over a defined period, usually one year to five years.
Interest rates are typically higher than a term loan and are based on LIBOR plus 3 percent or LIBOR plus 2 percent (depending on your creditworthiness).
Revenue Loan
Revenue-based lines of credit can be used for working capital purposes or larger projects.
A revenue loan is a short-term loan used to fund operations for a new business that has not yet received any revenue from customers or product sales.
Advantages of Venture Debt
The following are the advantages of venture debt:
Less Equity Dilution: Venture Debt doesn’t require giving away much equity, meaning founders can retain more of their company while still raising capital.
Extends Cash Runaway: Startups sometimes use venture debt to quickly raise cash to help hit milestones between raising equity rounds. A great way to speed up growth and scale.
More Adaptability: Venture Debt can support startups facing short-term challenges or unexpected market conditions.
Helps Avoid Down rounds: Some companies use venture debt to put off raising additional equity rounds until they can gain more favorable terms like a bigger valuation.
Flexible Working Capital: Venture debt is a type of loan that can be secured against the equity in the company. This means that if a company doesn't pay back its debt, the lender can sell off its shares and recoup some of its investment.
Flexible repayment terms: You can take out a loan from anywhere between 6 months and 8 years depending on how much money you need and how long you want to repay it (longer-term loans carry higher interest rates).
Secured by your assets: The most common type of venture debt is an unsecured loan, which means you don't have to put up collateral such as property or stock ownership to get one. However, companies will often require that you put up some form of collateral such as equipment or inventory for the loan.
Disadvantages of Venture Debt
The following are the disadvantages of venture debt:
Expensive: venture debt can be expensive. For example, if you want an SBA loan, you'll need to pay a fee for every month that you keep paying interest on your loan (20 percent interest is typical). The fees can add up quickly.
If your company doesn't make money or loses money for some reason, you'll have to pay back all or part of the loan before you get paid by the investors who lent you the money. If your company goes belly up, there may not be enough left after paying off your debtors to allow you to pay yourself a salary or other compensation.
Risky: The lender must be willing to invest in a company, which means their investment could be worth much less than the amount owed by the company.
Venture debt is often not available to start-ups without close connections with investors or other entrepreneurs. A lack of venture financing can make it difficult for small businesses to grow and expand.
High-Interest Rates: Venture debt also typically has high-interest rates, which means companies may have trouble paying off these loans on time. In addition, if a business fails to raise more money through venture debt, it may find itself unable to pay off its existing debts or unable to fund future expansion plans.
Conclusion
Venture debt is a senior term loan that can be used like equity and includes warrants. It is generally repaid in monthly payments over the life of the loan. The approximate interest rate ranges from 10 – 15%. Dilution is generally a small fraction of equity less than one percent due to warrants. The default clauses vary but are often limited to failure to repay. Generally, there are no financial covenants. It is usually used by startups for growth and expansion.