Venture Debt: Meaning, Types, and How it Works

One of the trickiest phases for startups is the period between early-stage funding rounds, when the intense pressure of cash burn feels like a constantly ticking clock on your survival. You’ve raised capital, which is further than most founders get, but it’s quickly eaten up by payroll, office space, marketing campaigns, and all the other components your company needs to scale operations and hit growth milestones. This creates a difficult choice: find more funding and dilute ownership, or risk letting your cash reserves run dry just as you’re gaining momentum.

This is the exact challenge that venture debt was created to solve. However, while it can provide the capital needed to extend your runway without significant dilution, it comes with its own set of risks. To determine if it’s the right strategic tool for your company, it’s important to first understand venture debt’s meaning and how it compares to other financing options. 

What is Venture Debt?

The primary role of venture debt is to act as supplemental funding that extends a company’s cash runway between equity rounds. By providing this capital bridge, it allows founders to reach necessary growth objectives before raising their next, more dilutive round of financing. This is one of the several differences that distinguish venture debt from traditional business loans.

How is a Venture Debt Loan Different from a Traditional Business Loan?

Many banks offer traditional commercial loans for the purpose of growing a business, but these lenders typically look at past performance as an indicator of the business’s ability to repay the debt. For start-ups, this isn’t a fair metric, because you may not yet be profitable or cash flow positive. To understand the specific distinctions between the two, it’s helpful to compare venture debt directly with a traditional bank loan.

Venture Debt vs. Traditional Bank Loan

Different Types of Venture Debt and Financing Options

While the term loan is the most traditional form of venture debt, startups often evaluate it alongside other alternative financing methods like revenue-based financing and factoring. Each serves a distinct purpose, has its own set of advantages and disadvantages, and carries a different level of risk.

1. Term Loans (Risk Level: Moderate to High)

The most familiar and traditional type of venture debt is the term loan. Like many other loans, these provide a company with a lump sum of capital upfront that they must repay over a set period. You’ll find these offered by banks and specialized debt lending funds. 

Term Loans Offered by Banks 

Banks usually the more risk-averse of the two and will often require start-ups to have a highly reputable and credit-worthy VC backing them to qualify. A variety of institutions offer these loans, including Silicon Valley Bank (now a division of First Citizens Bank), Bridge Bank, and Comerica. 

Even when banks have a specialized debt lending department, qualifying can still present challenges. These loans often come with various covenants attached that restrict how the money can be used, which is less than ideal for a cash-strapped startup. Businesses that do qualify, however, typically have access to funds at a relatively lower rate and can gain access to a line of credit along with their term loan. 

Term Loans Offered by Specialized Funds

The other way to get a term loan is through specialized funds. These lending organizations exist for the sole purpose of funding high-risk investments like venture debt. They’re more aggressive and more willing to play ball when traditional bankers are not. Some of the most active debt funds in this space include Western Technology Investment, Hercules, and Trinity Capital. 

The tradeoff is that their money often comes with higher costs (interest rates, warrant coverage, etc.) than you might find at a bank. However, these funds can also lend alongside a bank’s term loan as a second-lien or junior tranche of debt. This gives startups the additional liquidity they need to make it through a market downturn or other rough economic conditions.

2. Revenue-Based Financing (Risk Level: High)

Revenue-based financing (RBF) is a form of funding where a company receives capital upfront and repays it with a small, fixed percentage of its future monthly revenue, creating a flexible repayment plan that is directly tied to your company’s performance. RBF is generally offered in two main structures: short-term and long-term. 

Short-Term Loans

Short-term revenue-based loans can be utilized for a quick source of capital, but at a significant cost. For example, a loan with an 8% fee paid back over five months will cost closer to 20% interest when annualized. If used judiciously, this type of funding can supercharge your growth without any dilution to your equity, which is the most expensive source of financing. Firms like Clearco, Gourmet Growth, and Flow Cap all specialize in these short-term revenue-based funding programs. 

However, borrowers should be aware that this type of short-term debt shouldn’t be funneled into working capital or long-term needs like product research and development costs. Too many startups have been sunk by trying to use short-term loans to extend their runway. This type of short-term debt should only be used when it will help you drive revenue growth, preferably with a 50% higher gross margin or greater than 3 times return on ad-spend. Anything less, and you risk revenue growth crushing cash flow, leaving your business broke. 

Long-Term Loans

If an early-stage company has actively growing revenue and a long-term growth runway, it may qualify for long-term revenue-based loans. This structure gives lenders the ability to secure larger dollar amounts with extended repayment terms, but is still considered a high-risk loan for early-stage companies. Speciality lenders like Decathlon offer long-term funding using a hybrid model that includes a term loan and revenue-based financing.

3. Factoring (Risk Level: High)

Factoring is not a loan in a traditional sense but a financial transaction where a company sells its unpaid invoices (accounts receivable) to a third party, known as a “factor”, at a discount, providing the company with immediate cash. When your customer pays the invoice, the factor collects the full amount, profiting from the difference. 

While factoring offers a quick way to free up cash, like other short-term financing options, it comes with significant risk. The main danger is becoming so reliant on selling invoices for quick cash that your company never builds up its own reserves. This can cause startups to become stuck in a cycle of constantly trading future revenue to cover present expenses, which is difficult to escape. 

How to Evaluate a Factoring Offer

A factor will typically advance 70-95% of the value of the invoices, depending on the industry and your customers’ creditworthiness. However, the actual cost of factoring is often hidden behind tiered fee structures and variable rates. To understand what you’re actually paying, you’ll need to calculate the effective cost per dollar borrowed. 

For example, if you are offered a 3% rate on a 70% advance, the real cost is not 3 cents on the dollar, but closer to 4.3 cents per dollar. Because this fee is paid over a very short cycle, the annualized cost of this financing can be surprisingly high. 

Getting Expert Help With Venture Debt

Deciding on the right financing is a high-stakes process for any startup, especially riskier approaches like venture debt. From the hidden costs of factoring to restrictive bank covenants or unnecessary equity dilution from warrants, one misstep can cause founders to shorten their runway or surrender more equity than necessary. 

To avoid these consequences, many founders partner with a professional financial advisory firm. The right advisor acts as a strategic partner, offering benefits that include:

• Helping identify the right venture debt lender
• Providing detailed pro forma financial modeling to ensure debt sustainability
• Facilitating debt term structuring and negotiation
• Providing comprehensive due diligence support 
• Assisting with post-funding management to maintain ongoing financial health 

While venture debt may be hazardous for the unfamiliar, an advisor can determine whether it’s right for you. If it is, they can manage the capital raise process to structure a deal that maximizes the strategic advantage for your company.

Takeaway

Venture debt is a funding option for early-stage companies that can help satisfy cash burn between equity rounds. Offered by banks and special funds, venture debt loans typically have shorter repayment periods and higher interest rates, and equity warrants. Unlike a traditional loan that requires past profits and often a personal guarantee, venture debt is designed for startups and offsets its risks with higher interest rates and equity warrants instead, focusing on a company’s growth potential rather than its history. When evaluating their options, founders will often assess venture debt term loans alongside other alternative financing structures. 

• Term Loans: A venture debt term loan provides a lump sum of capital that is repaid in fixed installments. Getting one involves a trade-off between cheaper rates from restrictive banks or more expensive, flexible capital from specialized funds. 

• Revenue-Based Financing: This type of loan allows you to borrow against future sales and repay via a percentage of your monthly revenue, which avoids equity dilution but comes at a high annualized cost and is risky if not used for immediate growth. 
• Factoring: Factoring provides immediate cash by letting you sell unpaid invoices at a discount. It’s a fast but often expensive short-term solution that carries the risk of creating a difficult cycle where you’re constantly selling off revenue to stay afloat. 

The stakes are high for startups, and the wrong type of debt can sink a company before it starts. To avoid these risks, many founders partner with financial advisors to handle venture debt and the overall capital raise process. These experts can model financial outcomes, negotiate favorable terms, and make certain that any debt you take on becomes a tool for growth instead of a future burden.

Without professional guidance, venture debt can turn from a powerful tool into an expensive mistake. Get the help you need and start growing now with Embarc Advisors. 

Venture Debt Frequently Asked Questions (FAQs)

What is the Difference Between Venture Debt and Normal Debt? 

The primary difference between venture debt and normal (or traditional) debt lies in the type of company they are designed for and how the loan is underwritten. Normal debt, such as a traditional bank loan, is typically provided to established businesses that can demonstrate a history of positive and consistent cash flow. Lenders also usually require tangible assets (like property or equipment) to serve as collateral, which reduces the lender’s risk. 

Venture debt, on the other hand, is specifically structured for early-stage startups. These companies are often not yet profitable and may not have significant physical assets to offer as collateral. To compensate for this higher risk, venture debt lenders may charge higher interest rates and include unique terms. This type of debt works best for high-growth potential businesses that don’t yet qualify for traditional lending. 

How is Venture Debt Paid Back? 

How venture debt and other types of financing are paid back will vary depending on the specific determined repayment structure:  

• Repayment for Term Loans: Term loans, which provide a lump sum of capital upfront, are paid back in regular, scheduled installments that include both principal and interest. 

• Repayment for Revenue-Based Financing: Revenue-based financing, in which funding is provided in exchange for a percentage of future sales, repayment is not a fixed amount. Instead, the company pays back a pre-agreed percentage of its incoming monthly revenue. 
• Repayment for Factoring: This method involves selling unpaid invoices (accounts receivable) to a lender at a discount. The lender provides immediate cash to the startup and is then paid back directly by the startup’s customer when the invoice is settled. 

What is the Difference Between Growth Debt and Venture Debt?

While venture debt and growth debt are both forms of private debt financing for companies, they cater to businesses and different stages of development and serve distinct purposes. Venture debt is designed for early-stage, high-growth companies that are still burning cash. It acts as a supplement to venture capital equity rounds and helps to extend a company’s cash runway until they can reach the next funding round. 

Growth debt is intended for more mature, mid-to-late-stage companies with substantial revenue. Unlike venture debt, growth debt can serve as a substitute for an equity round, providing larger amounts of capital to fuel acquisitions, consolidate existing debt, or make the push towards profitability.

We specialize in delivering enterprise-level talent to support the growth of startups and middle-market businesses.

If you’re looking for support as you make big decisions regarding the growth of your company, contact Embarc Advisors today.

Learn more about term sheet negotiations in our blog: Understanding Term Sheet Negotiation