When to Raise Venture Debt? - Part 3
So far, we have discussed the lifecycle of venture debt. How it starts with Identifying the startup’s need, choosing a corporate structure, identifying a lender, negotiating terms, receiving financing, and making interest payments where the startups have three options whether to repay the principal or refinance or default.
In the last blog, we discussed how venture debt can be used creatively in situations where debt financing is required and, what are steps to prepare for venture debt. We also discussed how venture debt is cheaper than equity by at least 25 times. Many businesses seek to secure venture debt funding to help them grow and expand their business, especially in the early stages when capital is tight, and lenders are often more hesitant to provide loan programs for new companies.
In this blog, we will discuss further questions related to venture debt.
Table of Contents
Do investors focus on a particular sector or stage of startup for venture debt?
What is the typical duration of debt investment by venture debt funds and what is the average IRR?
Do investors focus on a particular sector or stage of startup for venture debt?
Venture debt helps startups focus on profitability. Companies can reach growth milestones by financing operations or equipment. Debt invariably costs less than equity. Loans from venture debt lenders are flexible and work well with other borrowers.
We've seen entrepreneurs begin to take advantage of this opportunity, but more can be done. To fully realize its potential, venture debt should develop into a meaningful financing option for startups – not only for founders looking for short-term capital but also for investors seeking loans to make follow-on investments. In the next few years, venture debt will likely grow, and the market will mature to add additional providers and varieties of debt products that cater to a broader range of risk profiles and company needs.
In later stages, investors may be more interested in companies that are building out a technology stack or product offering to support their vision. You'll often see investors from venture firms investing in this type of company as well because they're able to see how the technology will play into their overall strategy.
The types of startups that receive venture debt include:
Healthcare: Biotech, medical device, pharmaceutical, and life sciences companies.
Software: Software-as-a-service (SaaS) companies, web applications, or software-as-a-service (SaaS) providers.
Energy: Energy companies such as solar or wind power companies or oil and gas exploration firms.
Investors with experience in venture debt financing are the best to help you with your startup. They can advise you on what kind of venture debt is best for your business and make sure that you will get a good deal.
There are several factors that investors consider when deciding to fund your startup. These include:
Business idea (or business model): This is the most important factor, as it will provide a better understanding of the potential success of your company.
Market opportunity: Investors will look at how big the market is, how much competition there is and how much money could be made from it.
Financial plan: Investors will want to see where your money will be coming from and how you plan to spend it once you start making money from your venture.
The team behind the business: Investors want to see a good team with a great track record in the industry or field you are entering. This can also help them understand what kind of experience they have with running similar businesses and what their strengths are as an entrepreneur or business owner.
When and why should any startup look to raise venture debt?
Every startup has a different situation. Some startups are bootstrapped, some have raised venture debt, and others are still in the early stages of growth. Regardless of how you got to where you are, there will come a time when your startup needs to raise more money.
As you can see in the above picture 91.3% of startup companies use it as an increasing runway to make the company more valuable in the next round.
Venture debt is generally used as a bridge to larger funding rounds, and as an option for startups that have already raised equity or debt from investors. Venture debt is a type of debt that is used by startups to pay for things such as equipment, inventory, and other startup expenses.
The basic concept behind venture debt is that it provides a company with access to the capital it needs at a lower cost than traditional sources, such as banks or angels. Venture debt can be seen as a cheaper alternative to raising capital from traditional investors.
The amount of money you need to raise depends on how much cash you've already spent developing your product or service and how much time it would take for you to earn profits from its sale. If your business is new and hasn't started paying for its operations yet, then it may not yet have enough capital available.
You should raise venture debt when your business has reached a certain size and has demonstrated that its products or services have value to many customers. It's also important to raise venture debt when you can demonstrate how much money your business will need over the next year or two to continue growing at a rapid pace.
Here are some questions you should consider before taking on venture debt:
What is your business plan? Do you have an exit strategy? How much money do you need to get your business off the ground?
What does your pitch look like? Investors want to see a well-written business plan that includes financial data, market research, and projections about the future. You can use this document as a guide when preparing your pitch deck.
How much money do you need? Most startup loans have an 80% or greater debt-to-equity ratio, which means that 80% of the total amount borrowed goes toward paying off the loan and 20% goes toward equity. So, if your loan has an 80% debt-to-equity ratio, then $100 in cash will be offset by $80 of debt with only $20 of equity.
Is venture debt ever an alternative to venture capitalists?
Venture debt is not an alternative to venture capital and should be considered in combination with it.
Venture debt is an unsecured loan and can be taken out by a startup company to finance their business, or as part of an acquisition strategy. The key differentiator from traditional bank loans is that it does not require collateral.
It's important to note that venture debt is not necessarily bad for a startup company — it's just not the right fit for all situations. Here is something you should consider before deciding whether venture debt might be right for your business:
How much cash do you have left? If you aren't yet profitable, it may make sense to take on some unsecured debt so that you can focus on building your customer base and increasing revenue while still paying down your other debts (like credit cards). But if you're already profitable, then it probably doesn't make sense to take on any new debt right now (even if interest rates are low).
If a company meets certain criteria, venture debt can be much cheaper than traditional bank loans or venture capital financing. In addition to providing financial support, venture debt also provides access to expertise by allowing companies to tap into the network of lenders and investors who are familiar with their business model and industry.
The best scenario for a startup company would be to use a combination of venture capital and venture debt. A startup in general won’t get venture debt directly. But if it raises funds from venture capitalists then it has a good portfolio that has been backed by a VC or Investors. Based on the funds raised it can approach venture debt. This can save the dilution of the startup company.
As you can see in the above graph, when startups raised funds in series A, series B, series C and series in combination with venture debt, the insiders got more percentage of ownership saving the dilution.
What is the typical duration of debt investment by venture debt funds and what is the average IRR?
Venture debt funds invest in businesses that require cash infusions at various points during their lifecycle so that they can grow through these stages. This requires them to invest in businesses that have already proven themselves through prior build-outs/product releases/etc., which creates an opportunity for venture debt investors to earn returns on their capital.
The typical duration of debt investment by venture debt funds is anywhere between 3-5 years. The IRR on a venture debt investment is a function of the capital deployed and the timing of the investment.
The average IRR of venture debt is 22%. As you can see in the above graph the interest income is around 16%, warrants and participation rights around 4%, and re-investment is 2% giving the gross IRR of 22%.
Conclusion
Venture debt helps startups focus on profitability. Companies can reach growth milestones by financing operations or equipment. Debt invariably costs less than equity. Loans from venture debt lenders are flexible and work well with other borrowers.
We've seen entrepreneurs begin to take advantage of this opportunity, but more can be done. To fully realize its potential, venture debt should develop into a meaningful financing option for startups – not only for founders looking for short-term capital but also for investors seeking loans to make follow-on investments. In the next few years, venture debt will likely grow, and the market will mature to add additional providers and varieties of debt products that cater to a broader range of risk profiles and company needs.