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Venture debt financing, also referred to as venture lending, is a type of small-business financing for startups with high growth potential. Typically used between equity rounds, it’s a way for businesses to access more capital without further diluting their ownership by issuing more shares. Unlike traditional small-business loans, this type of financing is only available to businesses that have already raised venture capital.
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What is venture debt financing and how does it work?
Venture debt financing is a type of short-term debt financing available to early-growth-stage, venture-backed startup businesses. It differs from equity financing, where businesses trade partial ownership (or equity) for capital, and is often used to increase cash flow between equity rounds. Venture capital loans can be easier to qualify for than other startup business loans, but they are only available to venture-backed startups and typically come with higher interest rates and shorter terms.
In general, the venture debt financing process can be broken down into four main parts:
Finding venture lenders and applying
Venture loans may come from banks or nonbank lenders that specialize in venture lending. Through the application process, things like your history of investors, how much capital they have invested in your business already and how much total capital your business has raised will factor into a venture lender’s approval decision and the amount you get approved for.
Using the funds
Venture debt financing is one of the most flexible types of business debt financing. Once you’re approved, you may use the funds for product development, expansion, marketing, working capital and more.
Repaying the loan
Venture loan terms are typically shorter than traditional loans — they may be as short as 18 months. Generally, venture lenders want to be repaid before your next round of business funding, whether that’s through more equity or additional debt.
Venture loans often have periods of interest-only payments in order to maximize the amount of liquidity you’ll have, but that means that your initial monthly payments won’t be contributing to the principal amount. At the end of the interest-only period, you may be expected to pay the remaining balance entirely, restructure the debt with the lender or refinance the remaining balance with a new loan.
Exercising equity warrants
Equity warrants, or stock warrants, allow a lender to purchase a certain amount of stock in your company at a future date for a predetermined price, and are sometimes included in venture capital loan terms as an added risk mitigant. If the value of your company goes up, a lender with warrants could buy in and dilute your ownership for a lower price than what the share is currently worth. If equity warrants were a part of your loan agreement, it’s important to understand how much they’re potentially worth and how long they last.
Venture debt financing pros and cons
Pros of venture debt financing
- Limits ownership dilution. Venture debt does not require you to trade ownership shares in your company for funding, which can ultimately make it a much cheaper form of financing than equity financing. However, if warrants are a part of the loan agreement, be aware that a lender may exercise them at some point in the future to purchase shares in your company, which will dilute your ownership.
- Designed to fill cash flow gaps. Venture debt financing can be secured quickly and usually has an interest-only repayment period, which maximizes the amount of cash you have on hand while your company is in a key growth phase.
- Faster than equity financing and other types of debt. Compared to equity financing and certain types of small-business loans, venture debt financing can offer a much faster process, which can be key during a growth stage of your business.
Cons of venture debt financing
- High interest rates and short terms. Because they fund early-stage and sometimes pre-revenue startups, venture capital loans are considered a risky kind of debt. That means that interest rates are usually higher than traditional debt financing, and terms are usually shorter.
- Senior debt. Venture debt is generally what’s called “senior debt,” which means it takes precedence over other outstanding obligations if you default on your loan. In traditional business loan terms, the venture debt lender would have first lien position, meaning they'd collect before any other lender. In the event of a default, venture capital lenders can seize control of the company or its assets, or force it to liquidate.
- Only available for venture-backed businesses. Venture debt financing is only accessible for startup businesses that have already secured venture capital investments. If that’s not the case for your business, you’ll have to look into other loans for startups.
Venture debt financing vs. traditional debt financing
Venture debt financing | Traditional debt financing | |
|---|---|---|
Qualifications | Based on investors' track record, how much they have committed to the company in the past and how much financing the business has raised overall. Business plan, quality of technology and team and capital strategy also factor in. | Typically based on business and personal credit histories, time in business, cash flow, revenue and debt service coverage ratio (DSCR). |
Collateral | In addition to typical collateral like assets or accounts payable, may also be secured by a first-position lien or intellectual property. Stock warrants may also be sued to mitigate a venture lender's risk. | Typically secured by property, savings or a blanket lien. |
Terms | Typically one to three years. | Typically between two to 10 years, but can be up to 25 years for certain SBA loans or commercial real estate loans. |
Availability | Only accessible to venture-backed startups. | Accessible for non venture-backed businesses. |
Alternatives to venture debt financing
If venture debt financing isn’t for your business, there are several alternatives you can consider.
- Small-business loans include traditional term loans, lines of credit and SBA loans, and typically come from banks or online lenders. The best fit will depend on you and your business. SBA loans and bank loans come with good rates and terms, but you usually need to be generating revenue to qualify, while online lenders may have more flexible qualification requirements but often at a higher cost.
- Asset-based financing uses assets like vehicles, property or large equipment as collateral to secure a business loan. Having collateral can help you get approved for financing, and potentially improve your terms and rates. It’s a great option if you have acquired strong assets during your time in operation. Invoice financing, whereby you use unpaid customer invoices to secure a business loan, is a form of asset-based financing.
- Personal loans can be a viable option if you don’t need a lot of funding, especially if your business is not generating revenue yet. If you have good personal credit and assets, you may be able to get better terms than you would for a business loan; however, your personal finances are more at risk if your business fails.
Meredith Turits, a freelance writer, contributed to this article.
This article originally appeared on Fundera, a subsidiary of NerdWallet.