What Is Venture Debt Financing?
Venture debt or venture lending is only available only to venture-backed businesses as working capital. This type of financing is low-priced than equity financing and is generally structured as traditional medium-term loans, with three- to five-year repayment periods. A company’s assets or equipment secures it. This financing is offered based on different factors that lenders take into account with investors such as growth rate, business plan, and track record.
Securing capital for growth is the paramount disquiet of emerging growth startups and due to the enormous business startup costs; startups are always worried about financing their ventures. Securing traditional financing is challenging and hard especially for a startup, so instead many turn to equity investors. Most founders are reluctant to give up more ownership, however, which is when venture debt financing can be a fundamental instrument. Regardless of the growth of the venture debt industry, yet it remains an unfamiliar form of financing for many.
It is a type of business loan where a company assumes the debt, instead of taking investors’ money in exchange for equity. However, venture debt financing is dissimilar from traditional business loans. Here is an overview of venture debt financing, the eligibility criteria to secure it, and some alternative business loan types to consider.
How Venture Debt Financing Works?
In venture debt financing, the funds are not provided by the venture capital firms, but instead particular venture debt lenders, such as private equity firms, traditional banks, hedge funds, business development companies (BDCs), and a few others in form of debt, and not equity. This allows founders to keep the ownership of their ventures—being a distinct benefit of venture capital loans. Occasionally, such loans are the issue as business lines of credit or equipment financing.
How Venture Debt Financing Assist Startups?
Venture debt financing is a new improved way to secure financing as well as a key to growth. Most business owners keep debt and equity separate while running a business. Many successful startups like Airbnb, Genentech, and Uber confirmed the potential of venture debt financing by propelling their apparent irresistible growth paths, instead of raising more funding.
With traditional venture capital, the business owner has to give away some ownership in the company. And, if you’re unwilling to give up your slice of equity any further, acquiring funding via venture capital loan is your way to go.
Benefits and Drawbacks
There are pros and cons of raising money via venture debt financing. Besides raising equity, raising venture capital funding also requires a lot of time and solid effort. As a founder, you’ll be restricted to how much you can spend on fundraising. In addition, even after you raise funding, investors require you to meet certain requirements before approving you more money.
Venture capital loans are remarkably supportive when you need to:
- Extend cash runway to accomplish the next landmark
- Finance a marketing project
- Finance an equipment or inventory purchase
- Invest in a particular prospect to expedite growth
- Provide growth capital with little equity reduction
- Attains a balanced and reasonable capital structure
- Strengthens accounts and improves cash flow
While venture debt financing is economical than equity financing, there are some drawbacks to it as well:
- It’s risky for startups that are in the growing phase
- Being a “senior debt”, it precedence over other unsettled debts in case you default.
- Venture debt is only available for companies that have already raised venture capital.
How it Differ from Regular Business Financing?
Partially, venture debt and business loans are similar—and both categorized as debt financing options. However, there are some fundamental differences between the two in regards to underwriting, security, warrants, terms, and access.
While applying for a business loan, the lender examines the borrower’s business and personal credit score, before making a decision. In addition, they thoroughly review the business cash flow, revenue, and debt-service coverage ratio to conclude the financial health in order to understand whether you’ll be able to repay the loan or not.
Unluckily, Startups don’t have such credentials for lenders to underwrite. Lenders use different values to judge startups for venture debt financing qualification and to determine their repayment terms. And, this is where their investors come in.
The lenders underwrite a loan depending on the investors’ track records, their commitment in preceding financing rounds, along with how much funding the company has raised generally, with additional factors like the company’s business plan, technology value, workforce, and capital strategy as well.
For a regular business loan, collateral comes in the form of real estate, savings, equipment or a blanket lien. For venture debt financing, lenders also place blanket liens on companies. Sometimes, an absolute pledge to the company’s trademark serves as collateral, especially when the lender considers it as likely very risky.
Stock warrants is another feature of venture capital loans—enabling holders to buy the stock at a price indicated by the strike price on the warrant, till a certain expiration mentioned period. These warrants serve as a financial incentive for the venture capital lender. These warrants serve as an incentive to lenders in exchange for their money.
The terms and costs of regular business financing options vary from venture capital loans. The U.S. Small Business Administration (SBA) loans are perhaps the most sought-after business financing option that is backed by the federal government. The SBA loans offer the lowest interest rates and longer repayment terms in comparison to other loan options. But, they are only available to qualified borrowers with high credit scores and solid business financials. The maximum rate of interest is 2.75% + Prime Rate for SBA 7(a) loan and 5% to 6% interest rate for SBA 504/CDC loan. For venture capital loans from banks, the costs are Prime Rate + 0% to 4%, and from hedge funds, the costs are Prime Rate + 5% to 9%.
Venture debt financing is not issued by the capitalists and venture firms—instead venture debt lenders, like a bank or a hedge fund, issues it. Most startups aren’t venture-capital-backed, therefore they don’t have access to venture lenders—and also don’t have the needed underwriting credentials for venture capital lenders.
Best Financing Alternatives to Venture Capital Loans
Venture capital loans are not viable financing options for most startups. There are some alternatives to venture capital financing, which are listed below:
SBA Loans – For Revenue-Generating Startups
The U.S. Small Business Administration (SBA) offers loans by guaranteeing up to 85%, eliminating risk for their partner lenders. This also allows lenders to offer lower rates, higher loan amounts, and longer repayment terms. However, qualify for SBA loans is hard—they’re only available to borrowers with great credit histories and solid business financials. SBA also offers a microloan program to help finance startups, with loan amounts up to $50,000. This loan program is specially designed to help business owners who are much like in the venture capital ecosystem (minorities, people of color, and veterans).
Business Lines of Credit – For Early-Stage Startups
Startups don’t have the needed credentials like a time-in-business, revenues, and a business credit score to prove their creditworthiness for a business loan. That’s the reason most lenders will not willing to work with early-stage startups on business loan products.
Nonetheless, all you have is a personal credit score, business bank statements, and basic documentation—and for some lenders, that’s adequate to approve you for a business line of credit. A credit line is a great financing option, especially for early-stage startups. It works similarly to a business credit card, where you’re provided with a pre-approved amount of funds to draw as and when required. And the best part: you only pay interest on the funds that you use.
Asset-Based Loans – For Specific Purchases
If you need funding for specific purchases like new equipment, inventory, or supplement cash flow, asset-based loans can help. Asset-based loans are easily accessible for early-stage startups since they’re self-secured. The asset you purchase from the loan will actually serve as collateral. With that said, if you default on an equipment loan, the lender will seize the equipment and liquidate it to recoup its loss. Equipment financing and Invoice Financing are the most pertinent types of asset-based loans.
Though these loans are accessible easily, lenders still review your credit score and business financials. Due to the built-in collateral, the risk is much lower for the lender, so you don’t have to have a solid credit or financials in order to get approved.
Personal Loans – For Pre-Revenue Startups
Putting personal money into the business makes sense for most startups. In fact, many founders across all industries that are pre-revenue and spending cash, consider putting their own money into their business with a personal loan. The only thing worth considering is to build a separate business credit history and business bank account while your personal loan is unsettled. Make sure to repay your bills on time and in full via a credit card to establish business credit.
0% Introductory APR Business Credit Cards – For Planning Stage Startups
First things first, apply for a business credit card in order to build business credit, in order to get eligible for business loan products. Applying for a 0% introductory APR business credit card is the most suitable option for early-stage startups. Having these cards mean you carry a balance for a predetermined period without any interest until the period is over—making it an interest-free loan. There is no minimum time in business requirement as long as your personal credit score is solid enough to qualify.
When Venture Debt Isn’t A Viable Option?
Financing a startup is challenging, and requires a lot of preparation and planning. With so many business loan options available—especially when venture debt financing isn’t accessible—there is a comfort that you can still finance your startup.
The above-mentioned alternatives are great financing options for startups and some are structured alike venture capital loans, nonetheless. This goes without saying, the best things grow little by little over time.