May 12, 2022

What is Venture Debt? A complete guide to Venture Debt 2022

Nikhil John
Product Marketing Manager

You’re probably here hoping Venture Debt is for you and you’d like to validate that fact with a bit of research. Well, there’s some good news and some bad news depending on who you are and depending on what stage your company is at right now. But before we get down to figuring that out, let’s take a look at what Venture Debt really is? Well, the terms are confusing for sure, take it at face value and you’ve probably assumed something else. 

What is venture debt?

Venture Debt, also known as venture lending, is a form of Debt financing that was created to meet the needs of growing startups and pre-profit companies. To be more specific, for startups and companies that are already backed by Venture Investments. 

So what it means for you is that it isn’t an alternative to venture capital, but is more like a complementary source of funds for venture-backed companies. And unlike Venture Capital investments it does not demand your company’s equity as collateral.

How does venture debt financing work?

Venture debt works differently, unlike conventional loans. It doesn't require any collateral for the loan sanction, but your previous equity round is used to determine the principal amount. The debt is short to medium term, commonly up to three-four years. The principal amount would be typically 30% of the total funds raised in the last equity financing.

Since venture debt lenders provide loans to start-ups that are not yet profitable or do not have any hard assets (like SaaS or technology companies), the risk would be high. Due to this increased risk, venture debt lenders require higher interest rates than banks. In addition, the lenders would receive warrants on the company’s equity as a part of the compensation for the higher default risk.

What are warrants in venture debt?

Warrants are what sets Venture Debt apart from ordinary loans. Warrants are security that gives the holder the right (but not the obligation) to purchase company stock at a specified price within a specific period of time. Warrants are what make venture debt an expensive option for most startups since warrants devalue the company when it comes to raising future rounds. 

Benefits of venture debt for a company 

Venture debt is a smart and critical source for today’s entrepreneurial companies. The start-ups use venture debt as a multipurpose tool in their growth strategy. 

Let’s discuss the 3 primary uses of venture debt:

  1. Helps extend the runway of the company   

    The venture debt can extend the cash runway of the startup to the next valuation driver. In the below example, the company could raise a smaller Series B and then leverage the venture debt to ensure Series C is raised at a higher valuation. So, the management and employees would benefit from less dilution due to small equity raises. Existing investors also benefit from less equity dilution or less cash required to maintain their ownership position.
  1. Helps extend the runway to cash flow positive:

    The venture debt can extend the runway of a company to be cash-flow positive. In  this example, the company can leverage venture debt to completely eliminate its last round of equity financing. This is a great use of debt as it reduces equity dilution for both employees and current investors and propels the company forward during a critical period of growth.
  1. Provides a cushion for what can go wrong:

    The venture debt can serve as a cushion for what can go wrong; what if your first set of customers who were supposed to sign this year slip out to next year? You don't have enough cash to last until then, you still need to raise your Series C financing, but now it won't be at that higher valuation. In addition, because you missed your plan, it will likely be a penalising down round. The venture debt could have helped bridge this gap until the company is back on track.

Difference between venture debt and other financings:

Now that you’re aware of what Venture Debt is, based on the stage your company’s in, it may or may not be the right choice for you. So what are the alternatives? There are your usual business loans that can be taken from banks and other financial institutions. In some cases, it's crucial that you have a good credit score and an appealing market strategy to ensure you can pick up this source of funding. The rest is pretty straightforward in the sense that there's a tenure to pay back your debt and additional interest that’s incurred on the loaned amount.

Another alternative is either raising funds through angel investors or venture capitalists. This is obviously assuming you haven’t done either in the past in which case Venture Debt wouldn’t even be an option for you. Unlike Venture Debt, you’re liable to trade stakes in your company for such an investment. The below table explains the exact difference between Venture debt and venture capital funding.

Factors Venture Debt Venture Capital
Equity The lender/debt issuer does not take much equity in a company. The investors/VC’s will take the equity based on the valuation and the amount invested.
Repayment Debt is repaid with interest over time. VCs will make money by selling the equity.
Returns Average venture debt returns are lower VC returns are slightly higher than the venture debt
Qualifications Only the companies with previous VC funding can be eligible for venture debt. No previous backing is needed.
Companies that can opt for funds High-growth companies Early-stage companies also can be eligible for venture capital funding.
Company Valuation There is no need for a new company valuation. Equity investment requires a company valuation.
Due Delligence Due diligence is usually not as thorough as venture capital funding. There will be a thorough due diligence procedure undertaken.

When should you look for venture debt?

It isn’t so much when but if you should look at Venture Debt as a source of funding. You know by now that it only makes sense if you’ve raised equity in the past. So with that out of the way, there are a couple of reasons one would choose debt financing.

  1. To extend your cash runway:  One good reason to opt for Venture Debt is if your burn rate is high and you're looking at extending the period before your business runs out of it. It’s ideal for fast-growing tech companies that are always on the lookout for cash. Since they burn a lot of cash and are always on the lookout for funding. It's quick and flexible and keeps the company focused on growing the business.
  2. As a supplement to equity: Another reason to pick up Venture Debt is you’re using it as a supplement to equity. If your company’s at a stage where it isn’t generating enough revenue yet, it may not be applicable for you to pick up a 100% debt-based round. A mix of debt and equity however ensures that you pick up the funding you need minus the dilution you would incur on a 100% equity round.
  3. For a higher valuation:  If you were to leverage venture debt strategically you could delay your last round of funding. How this helps is when you dilute your shares for a price X, with the help of venture debt, to last you another year or two, your company’s shares stand the chance of reaching 2x within that period. Thus by delaying your last round of equity by a year or two, you’ll have a much bigger valuation and higher share of the profits.
  4. Expanding into new markets: Venture debt also helps fast-growing companies that want to sell in other markets. Venture debt in recent years has paved the way for a new market of cross-border facilities, offered along with equity-sponsored financing. Having an international debt fund is great because they know the market, they can even lend in the same currency offering a strategic advantage without taking over your company.

The top 3 things to consider while choosing venture debt

While there isn’t a fool-proof method for choosing the best lender for your business, there are a few tips to help you wade through the process and ensure you don’t land yourself in trouble.

  1. Talk to multiple lenders
    It's best to reach out to multiple lenders to discuss your pricing and agreement terms. While lenders may not have a say in your business they can still prove to be a valuable asset for your business. A Little research on the reputation of the lender and the experience and reputation they have with similar lenders should give you a good idea of whom to place your bets on.
  2. Sum total of the loan Vs Lender’s fee
    Pay close attention to the sum total of the loan amount and the lender's fees before you make your decisions. Experts recommend accepting an amount that extends the runway by 6 months to be a good estimate to go by. This should be a good ballpark to finance daily operations, onboard staff, or accelerate growth for a larger financing round. 
  3. Legal fee for undertaking a venture debt
    Another thing to keep in mind is that companies will have to incur legal fees for undertaking a venture debt that is above the loan amount provided. Being aware of the downsides of venture debt should go a long way in making the right decision.

Disadvantages of venture debt

  • The possibility of a dangerous financial covenant or in simpler words the downsides of not achieving the target you set out to.
  • The risk of defaulting on repayment. Usually, the loan agreements include set criteria for the business to follow. Not meeting these could be a killer for startups
  • Not applicable for companies that have picked up angel investments

The current landscape of Venture Debt Financing in India (2022)

In 2021, Indian companies raised over Rs 4,500 crore ($600 million) in venture debt, which was almost double the amount raised in 2020 (Rs 2,100 crore ($300 million))

Over 100 companies raised venture debt last year, including Urban company, Licious, Mensa Brands, and Zetwerk, with ticket sizes ranging from $2 to $25 Million.

Alternative to Venture Debt

There are a few alternatives to Venture Debt in the market today - especially for startups. Subscription-based Financing is one of them. SBF allows you to access the annual value of your periodic receivables. 

Revenue-based financing is another option that gives you a term loan and allows you to pay it back based on a percentage of your monthly revenues.

Frequently asked questions:

Is venture debt a good idea?

Venture debt can be a good complement to equity because it allows businesses to extend their cash runway and reach their next goal. Existing shareholders may see less dilution as a result of venture debt, which does not require a new business valuation.

How long does it take to raise venture debt?

Venture debt can be raised a lot quicker than the other conventional fundraising methods. While the duration of the due diligence procedure influences the timeline, the full process normally takes 4 to 8 weeks.

How is venture debt repaid?

Initially, venture lenders may offer a period during which the borrower just has to pay interest. Following the "interest-only" phase, the company continues to repay the principal in instalments (a process known as amortisation) until the final maturity date.

What is the difference between venture capital and venture debt?

Although venture capital is the most common kind of startup finance, venture debt — which allows VC-backed companies to borrow money to raise funds — can be enticing to founders looking for a quick infusion of cash without giving up much equity.