Types of venture debt
Venture debt is a type of financing that startups can use to fuel their growth without giving up equity. There are different types of venture debt, each with its own unique characteristics. One type is amortizing debt, which involves paying back the principal and interest over the loan term. Another type is interest-only debt, which allows startups to defer paying back the principal until later. A third type is convertible debt, which can be converted into equity if certain conditions are met. Overall, venture debt offers startups a flexible and cost-effective way to finance their growth.
Senior Debt
Senior debt refers to a type of loan that is borrowed by a company or organization from a bank or financial institution. What makes senior debt unique is that it is considered a priority payment over other forms of debt, meaning that in the event of a liquidation or bankruptcy, it is repaid before all other debts.
Because of this, senior debt is generally considered a safer investment for lenders. Additionally, senior debt typically comes with lower interest rates due to its priority status. For businesses looking to secure financing, senior debt can be an attractive option to help them grow and expand.
Subordinated Debt
As businesses grow and expand, they often need to find ways to finance their operations. One option that many companies turn to is subordinated debt. Subordinated debt refers to a type of bond or loan that is lower in priority than other forms of debt in the event of bankruptcy or default.
This means that in the worst case scenario, subordinated debt holders will only receive their share of the company's assets after other creditors have been paid. While this may seem risky, subordinated debt can also offer higher yields to investors who are willing to take on the added risk. For businesses trying to raise capital, subordinated debt can be an attractive option to supplement other forms of financing.
Convertible Debt
Convertible debt is a type of financing that offers both debt and equity features to investors. It gives investors the opportunity to convert their debt into equity in the future, usually when the company reaches a certain milestone. This type of financing can be advantageous for startups that need immediate cash but may not be ready for equity financing.
Convertible debt can also lower the risk for investors, as they have the option to convert to equity if the company starts to perform well. It’s important for entrepreneurs to carefully consider the terms of convertible debt before accepting it, as it could affect the future of their business. Overall, convertible debt can be a beneficial financing option for both investors and startups, but it’s important to weigh the pros and cons carefully.
FAQs
It's often secured at the same time or soon after an equity raise. Venture debt can help reduce the cost of capital needed to fund operations and could be used as insurance against operational hiccups and unforeseen capital needs.
What is the exit fee for venture debt? ›
Venture debt deals involve various fees, including a closing fee (also known as an origination fee or upfront fee), a final exit fee (often termed a “success” fee) and a prepayment fee. The vast majority of loans have closing fees of 1-2 percent and exit fees that average 6 percent.
What do venture debt lenders look for? ›
Venture debt relies on a company's access to venture capital as the primary repayment source for the loan (PSOR). Instead of focusing on historical cash flow or working capital assets, venture debt emphasizes the borrower's ability to raise additional equity to fund the company's growth and repay the debt.
What is venture debt for dummies? ›
Venture debt is a form of non-dilutive funding for early stage companies. Many venture debt deals include warrants which may be exercised to purchase common stock in the borrowing entity. As a debt instrument, venture debt has a higher liquidation priority than equity.
What are the problems with venture debt? ›
Venture debt products usually have higher interest rates and quicker turnaround times than other traditional debt products. This means that it is very much a “break glass in case of emergency” financing tool, as it can put immediate pressure on a company's cash flow.
Why is venture debt bad? ›
One of the main drawbacks of venture debt is that it can be very expensive. The interest rates on venture debt are usually much higher than traditional bank loans. This means that you will need to make sure you can afford the monthly payments. Another drawback of venture debt is that it can be difficult to obtain.
How do you pay back venture debt? ›
Venture debt is paid back in monthly instalments, whereas venture capital equity is only paid back by selling your company's shares. You prefer to have experienced advisors to help you grow. Equity investors will sometimes get a seat on your company's board and can become great advisors to startups.
What is an example of venture debt? ›
Company A is in its Market & Sales Development stage and is looking to raise $20 million. Instead of raising the full $20 million through a Series B, the company decides to only raise $15 million through venture capital investors and raise the remaining $5 million in venture debt.
What is the draw period for venture debt? ›
Draw periods can be as long as 18 months but the venture debt draw period is usually structured as a six- to 12-month period, followed by 30 to 36 months of amortization. Amortization refers to the length of time it takes a company to pay off a loan.
How to structure venture debt? ›
Typical structure of venture debt deals
The principal amount is determined based on the startup's valuation, financial health, and perceived risk associated with the loan. Startups need to repay this amount over the agreed loan term, which typically ranges from one to four years.
Unlike conventional loans that focus primarily on cash flow, venture debt takes into account the equity already raised by the company, prioritising the borrower's ability to secure additional capital in the future. Typically, commercial borrowers are assessed for credit and debt based on their cash flow generation.
Does venture debt have collateral? ›
Traditionally, banks only loan money to companies that have collateral (i.e. assets, cash flow, profits); venture debt is different in that venture debt lenders will offer debt financing to promising companies that are not cash flow positive, without existing collateral, provided that these emerging companies have ...
What are the key terms of venture debt? ›
Key Terms in Venture Debt Term Sheets
- Principal Amount. The principal amount refers to the sum of money the investor provides to the startup. ...
- Interest Rate. ...
- Maturity Date. ...
- Repayment Schedule. ...
- Equity Incentives. ...
- Warrants. ...
- Covenants. ...
- Financial Reporting Requirements.
Venture debt is a loan designed for fast-growing investor-backed startups. It most often is secured at the same time or soon after an equity round—and is typically used to extend runway to the next round.
What are standard terms venture debt? ›
Venture debt is a term loan typically structured over a four-to-five-year amortization period, usually with a period of time to draw the loan down, such as 9-12 months. Interest-only periods of 3-12 months are common.
What is the downside of VC funding? ›
Disadvantages of Venture Capital For Startups
This means that they will have to share decision-making authority with the venture capitalists and may have to consult with them on major strategic decisions. This loss of control can be challenging for founders who are accustomed to having complete autonomy.
When to use venture debt? ›
To fund large capital expenses, an acquisition, or interim cash needs. Venture debt can be used as a cheaper alternative to equity to fund acquisitions or purchases of equipment. It can also fund new growth initiatives that require an amount of capital too small for an equity round.
What are the disadvantages of venture capital? ›
Disadvantages
- Approaching a venture capitalist can be tedious.
- Venture capitalists usually take a long time to make a decision.
- Finding investors can distract a business owner from their business.
- The founder's ownership stake is reduced.
- Extensive due diligence is required.
- The company is expected to grow rapidly.
Venture capital is a high-risk, high-reward type of investment, and there is no guarantee of success. While VC firms aim to identify the best opportunities and minimize risk, investing in startups and early-stage companies is inherently risky, and there is always the potential for loss of capital.
