Qualifying for venture debt from traditional providers, often depended on three factors: who your backers were, how much capital you had raised, and how long it had been since your last raise. With the disruption in the venture debt markets following the collapse of SVB in early 2023, things have changed slightly. Yes, these things still matter, but not nearly as much as they did! In this guide, we break down the typical set of eligibility criteria, as well as the hard requirements of most lenders. Please note: these are the “hard and fast” rules, even though you may not meet the elements we’ve outlined below, you may still qualify for venture debt! Let’s dive in!
A quick refresher on venture debt and its benefits
As the name implies, venture debt is a form of debt financing that must be repaid. Startups receive capital on a lengthy term (often 36-48 months) in exchange for making interest payments on the principal throughout the life of the loan, a bullet payment upon maturity, and in most cases, equity in the business via warrants. These loans are structured to accommodate the unique needs of startups, particularly during their growth phases, more specifically the benefits include: equity preservation, liquidity management, flexibility, runway extension, and speed & efficiency.
- Equity preservation: One of the most significant advantages of venture debt is that it allows startups to secure funding without relinquishing much (or any) of their equity. This is especially valuable for founders who want to maintain control over their company's direction.
- Liquidity management: Since most venture debt deals have interest-only periods, startups can effectively put the entire principal balance to work, growing top-line revenues or investing in R&D and product development.
- Flexibility: Venture debt is one of the most flexible financing options, meaning that startups can use it to fund product development, launch marketing initiatives, or kick off expansion efforts. This is because as mentioned above, it doesn’t need to be immediately repaid.
- Runway Extension: Technically speaking, no forms of debt financing extend a startup's runway since they need to be repaid plus interest. That said, startups often encounter a funding gap between their initial seed funding or Series A and subsequent equity rounds. This is where venture debt steps in as a bridge, allowing startups to maintain their momentum and execute strategic plans.
- Speed and Efficiency: Compared to the lengthy process of raising equity financing, securing venture debt is typically quicker and more streamlined. This speed can be crucial for seizing time-sensitive growth opportunities.
For a more in-depth look at the current landscape, check out the startup founders' guide to raising venture debt in 2024.
Exploring venture debt eligibility criteria & requirements
Securing venture debt requires meeting specific eligibility criteria that lenders use to assess a startup's potential to repay the loan. In this section, we'll dive into the key factors lenders may consider when evaluating whether a startup qualifies for venture debt. Ultimately, lenders consider different factors, which is why you may qualify for venture debt from one provider, but not another.
- Backer quality - Historically, one of the most important factors in qualifying for venture debt, was the quality of your investors. Backing from a tier-one VC was an almost surefire way to qualify for venture debt. Nowadays, it doesn’t matter nearly as much (or at all).
- Cash balance - Most venture debt providers will lend up to 35-40% of a startup's current cash balance regardless of whether it's “new” or “old” capital. Startups with minimal cash balances may still qualify for venture debt if they have a large amount of non-cash collateral, such as equipment or intellectual property.
- Collateral - Most venture debt providers require collateral that is valued at 1.25-1.5x the outstanding loan balance. Startups often pledge inventory, equipment, accounts receivable, and intellectual property.
- Current ratio - the current ratio measures a startup's ability to satisfy its short-term debts, it compares the company’s current assets to their current liabilities. Generally speaking, venture debt providers will not lend under a 1.5 current ratio.
- Debt service coverage ratio (DSCR) - The debt service coverage ratio (DSCR) compares a startup’s operating income to its debt payments and indicates the startup’s ability to meet its debt obligations. Generally speaking, venture debt providers will not lend over 1.25x a startup's forward operating income.
- Existing debt or pledged collateral - Generally speaking, startups will not qualify for venture debt if they have other senior debt on their balance sheet if they have already pledged their IP to a junior debt facility, or if they have outstanding all-asset liens.
- Minimum liquidity and working capital ratios - Liquidity and working capital ratios measure a startup’s short-term financial health. These ratios ensure the startup has enough liquid assets to cover its immediate obligations. Breaching these ratios could signal financial distress and prompt lender action.
- The recency of funding - Generally speaking, venture debt providers who come in immediately following an equity raise will loan up to 40% of a funding round. So, if XYZ startup raised $20M, they would be eligible for up to an additional $10M venture debt facility. Other venture debt providers that specialize in other sub-forms of venture debt don’t care about how much funding a startup has raised.
- Revenue - Venture debt providers may or may not require a startup to generate revenue to qualify. Providers that act as follow-on capital providers for equity raises, for example generally do not require revenue. That said, most venture debt deals come with covenants that specify the minimum quarterly revenue that the startup must generate.
- Runway - generally speaking, venture debt providers will not extend a facility to startups with under 18 months of remaining runway.
- Venture-debt-to-company-valuation ratio - generally speaking, venture debt providers will only extend between 6% and 8% of the company's last post-money valuation.
Tips for crafting a convincing venture debt application & nailing the raise
Your loan application should be organized and comprehensive, providing lenders with a clear understanding of your startup's financial health. Before starting the loan process ensure that all of your financial documents are up to date and accounting data is accurate. Also, ensure that you have modeled out how much capital you need, the implied revenue growth, and the impact on your runway and cash flow. Ultimately, your goal is to convince the lender that you have a plan for the capital and that your startup will be able to repay the facility. To that end, check out the guide we put together a guide on comparing and negotiating venture debt term sheets.
Here are a few more related tips:
- Start early, especially when you don’t need it - the end-to-end venture debt process takes 8-12 weeks to complete, so the earlier you start the better. The ideal time to apply is when you do not need the funding, because you’ll have a much easier time qualifying for the funding and even if you don’t pull it immediately you’ll have access to it at a later date (assuming no major adverse changes to your business).
- Run a tight process - identify your business need, select your target providers, know your numbers inside and out, leverage your connections to land a meeting, and nail the application. For more on running a tight process, view the startup founders’ guide to raising venture debt.
- Prioritize key terms - Rather than focusing on the headline interest rate or warrant coverage, focus on the covenants and terms of the deal that can significantly impact the day-day operations of your startup. Check out this guide for the venture debt covenants, clauses, and provisions to avoid.
- Consider the true cost of capital - the true cost of capital is inclusive of the interest rate, the warrants, and fees, the restrictive covenants, and the investor rights that come along with the facility. Consider these factors as well when comparing various term sheets.
- Take only what you need - Just because you’re approved for $10M doesn’t mean you need to pull the full $10M. Pull only what you need upfront and as you reach the end of the draw-down period re-evaluate whether you need more capital.
- Add a buffer of 25% - When modeling your needs and assumptions, add in a buffer of 25-30% to account for things not going as planned, because as they say “if something can go wrong, it will go wrong”.
- Select the right partner - as with all forms of permanent capital, you’ll want to trust the partner you choose to work with. The right partner will consider your interests, be there for you during the good times and the bad, and be willing to work with you if things don’t go as planned.
Frequently Asked Questions (FAQs) on qualifying for venture debt
As you delve into the world of venture debt and eligibility criteria, you might have some burning questions. Here are answers to the commonly asked questions.
- Can early-stage startups with limited revenue qualify for venture debt?
- Yes, early-stage startups can qualify for venture debt if they can demonstrate strong growth potential, a clear path to profitability, and a compelling business plan. Lenders assess various factors beyond revenue, such as market traction, recent funding, cash balance, and runway.
- How do lenders assess a startup's ability to repay venture debt?
- Lenders evaluate a startup's cash flow, financial projections, and the sustainability of its revenue streams. They also consider the management team's experience and risk mitigation strategies.
- Is having collateral essential for securing venture debt?
- Collateral is often required for secured venture debt, but not all lenders have the same collateral requirements. Collateral can enhance your eligibility and impact the terms of the loan.
- Are all venture debt facilities have a bullet structure?
- No, not all venture debt facilities have a bullet structure. But the bullet structure is typically the most beneficial for startups, which is why it's used so often.
- What covenants should I avoid when pursuing a venture debt deal?
- Great question, check out the guide we wrote on the venture debt covenants, clauses, and provisions to avoid.
- Do all venture debt providers require warrants?
- No, not all venture debt providers require warrants.
Final thoughts on qualifying for venture debt
Navigating the venture debt landscape can be challenging, but by understanding the factors that lenders evaluate and taking strategic steps to meet these requirements, you can position your startup for success. As you embark on your journey, remember to start early especially when if you don’t need it, run a tight process, prioritize the key terms, take only what you need, and add a buffer of 25% to your estimates. Also, remember that different lenders prioritize different factors, so don’t be discouraged if you are turned down by the first few lenders—keep applying until you find the right partner who meets your needs and aligns with your values.
We’re by no means legal professionals, and this guide is by no means legal advice, but if you’d like an extra set of eyes (or hands) reviewing your venture debt application, or if you’d like introductions to an accounting firm to shore up your books or a venture debt firm, we’d be happy to help out. Get in touch with us!
Happy Building!
