Everybody knows what venture capital is, but many entrepreneurs are fuzzier about its loan-based cousin, venture debt.
Venture debt has exploded in popularity in the last few years. For some startups, venture debt can be a solid option to boost cash flow and supplement a VC round with very little dilution to their remaining equity.
But like anything, there are trade-offs, and it's important to educate yourself on the basics to minimize your risks and avoid bad deals.
What Is Venture Debt?
Venture debt is, as the name implies, a debt funding mechanism available only to venture-backed, early- and growth-stage startups. 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.
How Does Venture Debt Work?
Venture debt is secured by a company’s assets, including IP or equipment. That means borrowing a lump sum of cash up front, and in exchange for the cash, the loan is repaid or refinanced. This repayment usually happens in monthly payments over the course of the loan, historically at interest rates in the 10 to 15 percent range.
Of course, lending to early-stage startups is far riskier than what the interest rates reflect. In venture lending, stock warrantsin either common or preferred stock offset that risk while allowing for lower interest rates. So, if your startup has an exit, investors 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 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.
The definition of venture debt is evolving, though. Today, many people use "venture debt" to describe any debt financing instrument that helps a startup fund growth, including non-dilutive financing that doesn't require equity or warrants.
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How is it different from a convertible note?
Convertible notes are also debt instruments but they don't work like venture debt. Instead of paying back the loan right away, this type of debt can be converted to equity shares for investors at a specific date in the future. Usually, that conversion occurs with your next round of funding, but convertible debt has a maturity date — if you don’t raise before that date, you will have to repay the loan, which is a lump sum payment of principle and interest.
Convertibles can be appealing for early-stage startups. 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 debt 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 startup investors who get ROI from both higher interest rates and warrants.
The Pros and Cons of Venture Debt
So, other than cash appeal, why would startups sign on for venture debt?
Advantages
First, it’s an easy add-on after raising a venture capital round and can significantly help you extend your startup's runway from a previous raise without sacrificing too much 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.
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 give you debt at better terms compared to 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.
Disadvantages
Venture debt comes with a few big potential downsides. The most concerning is the possibility of restrictive debt covenants.
For example, if you don’t grow as fast as you anticipated, then you 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 enter into default, your loan becomes due and payable (all of it including accrued interest), immediately. This could be a showstopper 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 accept venture debt funding, make sure you read the fine print and that you’re comfortable with every aspect of the deal.
Typical venture debt terms and requirements
| Venture Debt Terms |
Historical Revenue | Not Required |
Equity Sponsor | Usually Required |
Funding Amount | $3 - $100M |
Amortization | Fixed Payments |
Financial Covenants | Required |
Warrants | Often Required |
Term Length | 1 - 4 Years |
Learn more about debt financing for startups
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