Last editedOct 20202 min read
For emerging growth companies, access to capital is a key concern. Consequently, capital at a cost that makes sense for start-ups is highly valuable. That’s why venture debt, a type of risk capital, has become increasingly popular since its inception in the 1980s. But what is venture debt financing? Find out everything you need to know about venture debt with our comprehensive guide.
What is venture debt financing?
Venture debt (also referred to as venture lending) is a form of debt financing aimed at start-ups and early-stage companies. Unlike traditional forms of financing, venture debt is offered to companies that do not have significant assets or positive cash flow. As such, it can be a viable alternative to equity financing, as it doesn’t require the business to give up any ownership of the company.
There are many reasons why start-ups may pursue venture debt funds. Firstly, it can be used as growth capital between investment rounds. It can also be used to finance the purchase of equipment and make investments in infrastructure. Finally, venture debt loans can be useful for accounts receivable financing for businesses with significant unpaid receivables that need to free up cash.
How does venture debt work?
How does venture debt work? Essentially, in exchange for the principal loan amount, lenders are compensated with warrants on common equity (while the loan amount is repaid, as usual, in the form of interest and principal payments). This is because venture debt loans have a high risk of default. Typically, the total value of the business’s distributed warrants amounts to anywhere between 5% and 20% of the principal loan amount.
Further down the line, these warrants can be converted to common shares (at the per-share price from the last round of financing). In other words, warrants provide lenders with the right to invest in the future. Depending on the terms of the venture debt loan, the lending process may also include covenants (i.e., restrictive terms and conditions to ensure repayments).
Pros and cons of venture debt loans
Venture debt funds can have a dramatic impact, helping to extend your company’s “runway” and provide the capital investment that’s necessary to reach certain milestones. Venture debt also allows you to postpone subsequent rounds of investment financing until the business is in better shape. Furthermore, venture debt loans have many benefits for lenders, providing them with the opportunity to invest in emerging companies that require a capital infusion to maintain their momentum.
Of course, there are certain disadvantages associated with venture debt. Most significantly, it needs to be repaid, which can be difficult if your financial projections come up short. It can also make it more difficult for you to raise money, as investors tend to be wary of putting money into a business that may use it to repay its debt obligations rather than fuel growth. It’s also worth remembering that if you can’t repay the venture debt loan, you could be forced into bankruptcy or liquidation.
Venture capital vs. venture debt
When it comes to securing investment capital, entrepreneurs can get confused about whether they should pursue venture capital or venture debt. Although these forms of start-up business investment cover similar ground, there’s one crucial difference. Essentially, venture capital is a form of private equity investment, which means that you’ll need to give up some of your equity. On the other hand, there’s nothing for your company to repay. With venture debt funds, you’ll need to repay the debt, and while you may need to give up shares in the future, it’s not a definite outcome.
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