Venture Debt: What it is and How it Works [with Examples]

Early-stage companies take a lot of funding. The early days of most startups are expense-heavy. They’re filled with product development and market research rather than actual revenue-generating activities.

The money that these cash-burning businesses need to make payroll and pay rent on office space, along with many other things, comes from a variety of sources–including venture capital and more recently, an increased use of venture debt.

With the trend turning towards venture debt to fill funding gaps, let’s take a closer look at this often misunderstood funding source.

What is Venture Debt?

Venture debt is a short-term funding option for early-stage companies. It’s typically structured as a loan with a payback period between 18 months and three years. These loans are made by banks or special funds that specialize in venture debt. 

Venture debt is most often used as supplemental funding in between equity rounds. And as such, venture debt lenders typically expect repayment with the next round of funding–hence the short repayment terms. 

How is Venture Debt Different from a Traditional Business Loan?

There are plenty of banks that offer traditional commercial loans for the purpose of growing a business. However, traditional lenders look at past performance as an indicator of the business’s ability to repay the debt–meaning that you need to be profitable or cash flow positive. 

Types of Venture Debt

There are three ways that start-ups can access venture debt: term loans, revenue-based financing, and factoring. 

Traditional Venture Debt: Term Loan

The most familiar type of venture debt funding is a term loan. These loans are offered by banks and debt funds that specialize in venture debt lending. Between the two, banks are the most risk-averse bunch. 

They will look at the strength, track record, and reputation of the VC backing the startup to determine creditworthiness. This means that non-VC-backed startups are often not qualified to borrow from a bank. 

Even when a bank has a department specializing in venture debt lending–like Silicon Valley Bank (SVB), qualifying can still be challenging. The funds often come with various covenants attached that restrict how the money can be used–which is less than ideal for a cash-strapped startup. 

On the upside, businesses that do qualify can typically access funds at a relatively lower interest rate and often gain access to a line of credit along with the term loan. 

Banks that offer traditional venture debt loans:

• Silicon Valley Bank
• Bridge Bank
• Comerica
• Signature Bank

Alternatively, there are also several debt funds–specialized lending organizations that exist for the sole purpose of funding high-risk investments like venture debt. Debt funds are typically structured so that they can take on more risk. 

They’re more aggressive–which means they’re willing to play ball when traditional bankers are not. But it also means that their money comes with higher costs (interest rates, warrant coverage, etc.)  than you might find at a bank.

There are many debt funds that offer traditional venture debt loans. Some of the well-known firms include:

• Western Technology Investment
• Hercules
• Trinity Capital

Another benefit to direct lending debt funds is that they can lend alongside a Bank’s term loan as a second-lien or junior tranche of debt. This provides the company additional liquidity especially in challenging market conditions.

Revenue-Based Financing

No two startups are exactly the same–and that’s true from concept to product development to financial health. Some startups are just starting to see revenue; others haven’t even figured out what their revenue streams are. 

For early-stage companies with a track record of revenue-generating performance, there are a few more venture debt loan options designed for either short-term or long-term use. These loans take an upfront fee and structure payback based on a percentage of revenue.

Short-Term Revenue-based  Loans

Short-term revenue-based financing options can be utilized for a quick source of capital, but it comes 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 your most expensive source of financing.

Borrowers should be aware that this type of short-term venture debt financing shouldn’t be funneled into long-term needs like product research and development costs or working capital.

Too many startups have sunk their ships by trying to use these types of short-term loans to extend their runway.

So, when does a short-term venture debt loan make sense? 

If the funds will drive revenue growth with a 50% or higher gross margin or higher than 3 times the return on ad spend–it’s a financing option you might consider. Anything less than a 50% margin and there is a risk that revenue growth will crush cash flow–leaving the business broke.

Firms like Clearco, Gourmet Growth, and Flow Cap all specialize in short-term revenue-based funding programs.

Long-Term Revenue-based Loans

Early-stage companies that are actively growing revenue and who have a long-term growth runway have a little more leverage in revenue-based lending models. It’s still venture debt  because most commercial lenders are averse to the risk of lending to early-stage companies. But the long-term structure enables these companies to secure larger dollar amounts with extended (multi-year) repayment terms.

Specialty lenders like Decathlon offer long-term funding using a hybrid model that includes a term loan and revenue-based financing.

Factoring

The third type of debt available to cash-burning startups involves borrowing against accounts receivables to free up cash. The company that finances the AR, buys your accounts receivables at a discount. When the payment comes in (typically on a 30-day cycle), they collect the full amount making the spread between their discounted purchase price and the full amount of the AR.

Factoring can be another short-term solution to free up cash. But it comes with the risk of getting stuck in a perpetual cycle of handing over every dollar that comes into a factoring company so that the company never really gets ahead.

When this type of venture debt is put in the mix, it typically funds between 70-95% of the accounts receivables–depending on the industry and the counterparties involved. If factoring seems like it might be the best option–proceed with caution.

The true cost of factoring is often much higher than it appears on paper. Tiered fee structures, variable volume, and different risk levels all add up to very different final costs. 

Instead of focusing on the funding percentage or the rate, or even the fee structure–simplify your comparison by looking at the cost-per-dollar. 

Let’s look at an example. If the factoring is offered at a rate of 3% with a 70% advance, the formula looks like this: .03/.70 x 100 = .04 per dollar.

Similar to short-term revenue-based loans, because the AR cycle is typically 30 to 60 days, the annualized cost of such financing can add up quickly. 

The Bottom Line on Venture Debt

Venture debt is a funding source that can help early-stage companies grow revenue, cover capital expenses, or get their products to market. Every company is at a different stage–with different needs and unique prospects. While there are a handful of options for venture debt (along with many other types of financing), not every option is a good fit for every circumstance. 

Taking on venture debt is a strategic move that requires careful diligence and a strong plan to execute. There’s a lot that can go wrong when an early-stage company is borrowing debt. If your company is considering venture debt for financing, make sure to consult an advisor that is independent of any bank or venture debt company that you might be considering.

How Can Embarc Advisors Help? 

Timing is everything. Making the decision about when, why, and if venture debt is the right choice for your startup is complex. At Embarc Advisors, we offer capital raise advisory for startups and middle-market businesses to help them navigate these big decisions.

Our team can:

• Help identify and engage the right venture debt lender.
• Provide detailed pro forma financial modeling to ensure the debt is sustainable.
• Facilitate in structuring and negotiating the debt terms.
• Provide due diligence support.
• Assist in managing the business post-funding to ensure the business is financially healthy.

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