Venture debt refers to a specific type of loan tailored to cater to the distinctive requirements of innovative businesses that are backed by venture capital.
This financing method is appealing to entrepreneurs as it offers the opportunity to prolong their operational timeline, minimise their capital costs, and foster continuous innovation.
In this article we’ll explain what venture debt is, the differences between it, venture capital, and traditional loans, and finally the pros and cons of obtaining a venture loan.
Like all finance types, it’s a good idea to seek independent advice to ensure a particular type of finance is right for you and your business.
What is venture debt?
Venture debt refers to the process of lending funds to early-stage, high-growth companies that are already supported by venture capital.
This form of funding serves as an additional source of liquidity for start-up and scale-up businesses during the intervals between equity financing rounds.
It is typically an additional source of funds, supplementing venture capital rather than replacing it.
Start-ups and rapidly growing businesses, even those lacking substantial assets, can apply for venture debt.
A key advantage of this financing option is that it doesn't necessitate surrendering an additional stake in the company, thereby reducing the risk of equity dilution.
You could think of venture debt as a kind of ‘student loan’ extended to a young business.
Despite the absence of tangible assets, these companies are anticipated to generate future earnings and returns, making them suitable candidates for such loans.
What is the difference between venture capital and venture debt?
Venture capital is a form of investment which provides funds to a business in return for an equity stake and often, a seat on the company's board.
Venture capital investors are typically seasoned industry professionals who can offer start-up founders valuable connections and guidance.
On the other hand, venture debt serves as a supplement to venture capital, with its primary function being to provide early-stage companies additional capital during the period between equity funding rounds.
Unlike venture capitalists, providers of venture debt do not demand a board seat.
However, in certain instances, they may also offer advice to the business.
Learn more about venture capital.
What is the difference between venture debt and other loans?
Venture debt is significantly different from other loans, particularly in its underwriting process.
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.
Traditional bank loans are often granted against assets like inventory, property, or machinery, which serve as collateral until they are converted into cash.
This asset-based lending approach primarily relies on the collateral for repayment, rather than cash flow.
However, this approach is not suitable for start-ups that are either pre-product or have just started generating revenue as they are likely to lack these assets.
Moreover, the cash flow approach is not ideal for companies that deliberately choose to prioritise growth over profitability.
In such cases, instead of focusing on historical cash flow or working capital assets for repayment, venture debt looks at the borrower's capacity to raise additional capital to fuel growth and repay the debt.
Learn more about business loans.
Why do businesses use venture debt?
There are a number of possible reasons for a business to want to access venture debt, but the classic one is known as extending the cash runway of a business.
By way of example, consider a new life sciences company that requires approximately £20 million in funding to transition from an initial concept to a profitable and self-sustaining business.
This funding will not be sourced from a single venture capitalist (VC) nor provided in one lump sum.
Instead, the $20 million is usually accumulated across multiple funding rounds.
This staged approach offers mutual benefits - VCs get to mitigate their risk through various decision and valuation checkpoints, while the entrepreneur can limit the dilution of their equity by raising successive rounds at progressively higher valuations.
Each funding round is strategically structured to enable the company to reach its next round.
It ensures the necessary capital for the company to achieve a significant milestone in its developmental journey.
Such milestones are pivotal, offering both existing and potential investors tangible proof of the company's progress, reduced risk compared to the previous round, and justification for an elevated valuation.
When deciding on each round's funding, VCs consider the company's projected cash burn rate to achieve the next milestone.
A cash burn rate is the rate of negative cash flow, or in simple terms, how quickly a business spends its money through its operations such as developing a prototype or expanding into a new market.
Typically, a round is designed to finance 12 to 24 months of operations.
For instance, if a company is expected to burn through £0.5m each month for 12 months to reach its next milestone, the funding round will likely be set at £6m.
This 12-month period of funding is known as the cash runway.
However, whether 12 months of runway is sufficient is debatable.
The company might need 15 or even 18 months to reach the milestone.
In such cases, a venture loan can be extremely beneficial.
Incorporating a loan of £2-3m into the funding round can extend the company's runway by an additional three to six months.
If there are developmental delays, for instance, the venture loan could provide the company with up to six extra months to achieve the milestone.
This is a more cost-effective solution than adding an equivalent amount of equity to the round.
What criteria do venture debt lenders use when deciding to offer a loan?
For early-stage companies with a limited operational history, the primary focus is on their investors, recent equity rounds, and estimated cash burn rate.
The size of the venture loan typically correlates with the scale of the equity round and the company's current and forecasted cash burn rate.
Companies with high burn rates are viewed as riskier borrowers due to their increased reliance on external capital to sustain their operations.
Lenders will also evaluate the track record and the amount of committed capital that each existing investor has earmarked for subsequent funding rounds.
When evaluating more mature companies, a venture debt lender will examine a business’s capacity to secure non-dilutive capital from new investors to help determine loan pricing and terms.
A proven track record of meeting product development and financial milestones is also taken into consideration.
How much money can I borrow using venture debt?
Although limits vary between venture debt providers and their requirements, a business can sometimes obtain a venture debt loan of up to £10m.
Advantages of venture debt
As with all finance types, there are a number of advantages to using this type of finance:
Additional capital
Venture debt can provide much needed capital to a business that might otherwise find it difficult through more traditional means such as bank loans, due to having a lack of assets, profit, or even revenue.
In this way, venture debt often extends the so-called runway for businesses between various funding stages, meaning that their founders can focus on growing the business before looking to seek additional equity finance.
Reduces need to sell further equity
Given that venture debt does not require the founder of the business to give up any equity above and beyond what they have already given, it allows both founders and employees to maintain their existing shareholding in their business as it expands.
Doesn’t require additional board members
Equity investments often require the business owner to give up additional seats on the board which can have an influence on decision making.
Due to its status as a debt product rather than an equity one, business founders don’t need to give a seat to the venture debt provider.
Learn more about non-executive directors.
Can support further equity agreements
Taking on venture debt, in addition to venture capital, could make you a more attractive proposition for future equity investment if your business is successful and continues to grow.
Learn about the different types of equity investment.
Disadvantages of venture debt
In addition to the benefits, there are a few disadvantages to using venture debt to finance your business:
High interest rates
Venture debt can come with high interest rates relative to traditional business loans which can make repaying a challenge if your business encounters financial difficulties or fails.
Difficult to obtain
Since, in order to be eligible for a venture debt product, a business must already have secured venture capital investment, it can often be difficult for businesses to obtain venture debt.
This is mainly due to the difficulty of attracting a venture capital investor in the first place.
Learn how to attract an investor with our guide.
Reference to any organisation, business and event on this page does not constitute an endorsem*nt or recommendation from the British Business Bank or the UK Government. Whilst we make reasonable efforts to keep the information on this page up to date, we do not guarantee or warrant (implied or otherwise) that it is current, accurate or complete. The information is intended for general information purposes only and does not take into account your personal situation, nor does it constitute legal, financial, tax or other professional advice. You should always consider whether the information is applicable to your particular circ*mstances and, where appropriate, seek professional or specialist advice or support.
