Founder's Guide to Venture Debt

What is Venture Debt?

Venture debt is a form of debt financing for venture capital-backed companies to fund growth.

Venture debt is a fixed-term loan with monthly interest payments and is most commonly recognized in tech for pre-profit or recently-profitable emerging companies. This form of financing is typically provided by banks or dedicated venture debt funds and is used as either a replacement or complement to equity financing. 

Advantages

Fuel Growth

Growth is not limited to venture capital. Venture debt provides the crucial capital needed for companies to achieve their next milestone. Instead of focusing on hyper-growth at all costs (as seen with venture capital), companies can focus on growing their companies at their pace in a sustainable way. 

Extend Cash Runway

Businesses may opt for venture debt when wanting to extend their cash runway or to act as a bridge from one funding round to another. This capital provides the necessary means to achieve the next milestone. 

No Equity Dilution

Venture debt does not involve exchanging equity for capital. Instead, the loan requires monthly payments and entrepreneurs are able to minimize the dilution of equity at any stage. Revenue-based financing also offers this as an another alternative to debt and equity financing. 

Flow’s Founder Tip: Revenue-based financing also offers no equity dilution. You can use this as another alternative to debt and equity financing. Check out the full ‘Founder’s Guide to Revenue-Based Financing.’

Increase Valuation

Acting much like a bridge round, venture debt offers entrepreneurs the opportunity to receive capital in order to reach growth milestones and get to the next round of financing at a higher valuation. 

Enhance Liquidity

The capital provided in a venture debt loan helps to strengthen balance sheets and enhance a company’s liquidity. When used as a replacement or complement to equity financing, businesses will achieve a more balanced and less costly capital structure. 

Due Diligence Process Less Exhaustive

As opposed to the due diligence process of venture capital which would take months, venture debt requires a less exhaustive due diligence process. Entrepreneurs get funded more quickly, allowing them to achieve the next milestone sooner. 

 

Disadvantages

Possible Dangerous Financial Covenants

The main disadvantage of venture debt is the possibility of dangerous financial covenants. If a company does not meet certain metrics set forth in the loan terms such as net income losses, this can lead to a default. When a company is in default, the loan is due and payable at that time. For some startups, this could shut down doors. 

Quarterly Cash Advances

Although venture debt helps high-growth businesses retain equity while extending cash runway, this does mean it creates quarterly cash expenses for the company. Unlike equity financing, this needs to be repaid at some point in the future. If venture debt is used correctly, it can be a helpful financing tool that can boost success for companies who use it in conjunction with equity financing. However, if not negotiated properly, it can become very costly. 

Growth is Not Limited to Venture Debt

Types of Debt

Line of Credit

A line of credit is a flexible financing product that lets you withdraw funds up to a predetermined amount.  

This allows you to withdraw funds as you need it, as opposed to receiving the full sum of the loan all at once. Lines of credit are generally a less expensive form of working capital financing.  

This type of financing is typically used for short-term working capital needs, such as company payroll, inventory purchases, or future project costs.  

Businesses can apply for credit lines at banks or alternative online lenders. While banks have high minimum qualifications and often require specific collateral, online providers are more flexible and often have quicker and easier application processes and requirements.  

In order to obtain a business line of credit, you will need to supply personal or business financial information. Your business’s annual revenue, credit rating, history, and other factors will all help in determining the maximum amount of funding available, duration of the credit line, and repayment terms.  

The interest rate of the loan will vary as the market changes.

MRR Line of Credit

An MRR line of credit is a loan facility in which the amount available for borrowing is tied directly to the borrower’s monthly recurring revenue.  

Software-as-a-service (SaaS) companies have minimal accounts receivables because customers pay upfront, but no inventory because they sell a service rather than a product. 

MRR is one of the most important metrics for SaaS and subscription-based businesses. With an MRR line of credit, your business can obtain financing based on revenue instead of assets or profits. The credit line has a revolving structure, where you can use the funds again and again as you pay down what you owe.  

An MRR line allows a business to move forward some of its revenue from future periods in order to invest in growth opportunities. Companies can take capital as needed as opposed to an all-at-once or for a single event. Uses of this capital are typically used to support sales, marketing, and product development efforts.  

Pros:  

  • Access to more capital than a traditional bank line 
  • Access to capital when you need it 
  • Borrowing limit grows with your company 
  • Low-cost capital 
  • No loss of control 

Cons:  

  • Requires a recurring revenue business model 
  • Requires annual revenue of at least $3 million 
  • Requires low churn rate 
  • Usually requires equity participation 

MRR lines of credit are available from two types of lenders: venture banks or non-bank lenders that focus on the technology industry. Banks have a strong preference for borrowers that are backed by a venture capital firm. 

Term Debt

A term debt is a loan with a set payment schedule over several months or years. These types of loans typically have a fixed interest rate with set payments.  

Term debt is best used for long term investments in your business, such as buying equipment, funding operations, or making an acquisition. Given these expenses can be quite large, a term loan allows you to pay off the investment over several years, so your payments will be more manageable.  

Companies that wish to delay principal payments should look for longer-term maturities.  

Founder’s Tip: It is smart to combine debt and equity when you are confident you can pay the debt back. 

Uses of Debt

Extending Cash Runway

Startups receive funding in stages (Seed, Series C, Series B, Series A), benefiting both the VCs and the entrepreneur. VCs reduce their risk by introducing multiple yes/no and valuation checkpoints while the entrepreneur reduces dilution by raising successive rounds at higher valuations.  

Each funding round is designed to get the business to its next funding round, allowing the company to achieve tangible milestones of development. Funding rounds are typically designed to fund 12 to 24 months of operations. To help extend the cash runway of a business, venture debt can provide companies an extra 3 to 6 months of cushion in case of delays without increasing dilution.

Preventing a Bridge Round

A good use case for venture debt is for borrowing between rounds to fund new growth projects.  

The road to success for a startup is never a straight path. Opportunities can present themselves outside of the equity funding cycle. For example, a fast-growing company may find traction in a new market and wants to build-out development and marketing quickly. In order to do this, they will need extra cash, but not enough that requires a full equity raise.  

Two options may include allocating capital from other parts of the business or taking an inside round or an investor bridge. However, allocating capital from another area of the business would slow down operations elsewhere. Likewise, raising a bridge round from your existing investors can be expensive and would send a bad signal to prospective investors.  

A venture loan would offer a quick solution to bringing capital in for new projects. The company can borrow between rounds and prevent setting a valuation until the next equity round.

The Insurance Policy

A venture loan may provide an extra cushion in the event that a company needs more time to get to its next milestone.  

As mentioned in our previous article about cash runway, each funding round is designed to get the company to its next funding round. When funding each round, the VCs look at how much cash the company is forecast to use (burn) to reach the next milestone. This amount is spread over the cash runway, and the rate at which the money is spent is called burn rate.  

Taking a venture loan at the time of an equity round may provide the company comfort that it will have enough operating cash to reach its next milestone.

To Avoid Setting a Valuation

Venture debt is a way to finance your business without having to set a valuation.  

There are times when a business may be underperforming or market conditions change. This may cause concern that the next round of capital would result in a down round. Venture debt is a way to finance your business without having to set a valuation.

Funding Large Capital Expenses

Venture debt can be used as a less expensive alternative to equity when funding purchases of equipment or acquisitions.  

There are many times where new growth initiatives require an amount of capital too small for an equity round, which is when venture debt would be a fitting option.

Founder’s Tip: To make the venture loan economically sound, try delaying the drawdown period (the time when you actually get the funds) as much as possible. Delaying when you begin paying interest and principal extends your runway and reduces the actual cost of the debt. If you are unable to delay the draw period, try pushing for a 6 to 12-month interest-only period.

Who Can Get Venture Debt?

Venture debt is best suited for companies that are revenue-generating.  

Companies that are ideal candidates for venture debt include those with subscription-based or recurring revenue models or those with an enterprise customer base that is bought in for the long-term. While venture debt can play a supporting role in early-stage companies who have recently raised an equity round, this form of financing is easier to secure for more established startups that are creditworthy through significant assets or cash flow. Typically, venture debt financing is available to companies that have secured at least one round of venture capital financing.

Explore Venture Debt with Flow Capital

Flow's venture debt financing structure offers entrepreneurs a lower-cost but more restrictive alternative to a revenue royalty.

When to Raise Venture Debt

Alongside an Equity Raise

The best time to raise venture debt is alongside or immediately following an equity raise when momentum is strong and cash is in the bank. A venture debt loan can grant you an extra boost of cash without the extra equity dilution.  

Between Equity Rounds

Startup companies can use venture debt to extend their cash runway to reach the next milestone to their next equity raise. This will result in a higher valuation and less equity dilution.

An Insurance Policy

Entrepreneurs may not know what’s lurking around the corner. To minimize the impacts of emergencies, venture debt can serve as an insurance policy to protect the company from potential delays and eliminate the need for an emergency bridge round. This allows the company to raise its next equity round as planned.

Fund Large Capital Expenditures

For companies that require large capital expenditures, venture debt can help finance these without depleting the company’s cash balance. Companies can receive “just in time” financing to purchase these assets as they are needed. 

Fund to Profitability

During a company’s critical period of growth, venture debt can bridge a company to profitability. This can eliminate the need for a final round of equity, allowing founders and shareholders to retain their existing equity. 

When is Venture Debt a Bad Idea?

If you don’t think you can repay it.

If your company is performing poorly, lacks momentum, has a high burn rate, has a highly variable revenue stream, and has less than 6 months of cash and is considering debt as a last resort for financing, you should avoid venture debt. You should only raise venture debt if you believe your existing or future investors will invest more equity in the future to repay the loan.

When the loan amortizes immediately. 

If you have raised a lot of capital from equity, you will want to delay when you begin paying off the loan. If the loan amortizes immediately, you will end up paying a significant portion of the loan before you even begin using the money.

When the terms or covenants are too heavy.

Before agreeing to a venture debt loan, you should have someone on your team take the time to model the cost of the debt and understand the impact of any covenants on the company.

When your investors are not supportive.

Although VCs are generally okay with venture debt, you should avoid it if investors are not supportive. Venture lenders will think your investors will be tough to work with.

What Can I Negotiate?

Your ability to negotiate will depend on your company’s performance and the relative competitiveness amongst debt providers.

Type of Loan

As discussed earlier, there are two primary types of venture loans: term loan and revolving line of credit (I.e. accounts receivables financing). A term loan consists of receiving a lump sum in one or two instalments and repaying the principal plus interest over a fixed period of time.  

A revolving line of credit is more common for companies that have recurring revenues but needs greater cash liquidity.

Loan Amount

Sometimes loans are needed to solve immediate cash needs while other times the capital provides a support cushion. Before agreeing to a loan amount, be sure to take into careful consideration how much money you need, when you need the money, and how much you will need at a time.  

In a revolving line of credit, the maximum loan amount fluctuates as the business goes up or down because the amount is tied to the company’s receivables.

Payment Schedule

A term loan is paid back over a fixed period of time. This is split into two parts: an initial limited period of interest only and a longer period of principal plus interest.  

Based on the agreed lengths of each period, the lender will adjust the interest rate accordingly.

Cost of Capital

Lenders will tack on additional fees and expenses onto the loan that the Company is expected to pay. This may include a commitment fee (incurred for the right to receive credit), a final payment fee (paid when the loan is fully repaid) or a pre-payment fee (incurred when you decide to pay the loan off early). These are typically calculated as a percentage of the loan amount and are almost always negotiable.

Warrant Coverage

For venture debt loans, lenders typically do not take an equity interest. However, there is a desire for lenders to benefit from the upside of a successful company and reward their risk. The value of the warrant is typically calculated as a percentage of the loan amount and entitles the lender to purchase equity and share in a small piece of the profits in a distribution event. 

Covenants

Covenants are a list of do’s and don’ts lenders give while you owe them money.  

Do’s: List of compliance requirements (e.g. delivery of financial information, maintenance of insurance coverage).  

Don’ts: List similar in scope to the veto rights demanded by equity investors.

Default Events

‘Default’ status may be declared based on a list of events constituting a ‘default.’ These will almost always include failure to make payments on time. However, the exact circumstances of each event are subject to negotiation.

Reporting Requirements

Part of the covenants includes ongoing reporting to the lender, specifically the delivery of financial information. This allows the lender to assess the financial health of the company and its assets. Other reporting requirements may include keeping the lender informed on the location of the Company’s assets, the addition of new assets, the existence of legal proceedings, and other significant developments in the business.

Summary

The flexibility your company has in negotiating the loan terms will come down to the risk profile of your company based on its internal review. The lower the risk you are perceived to have, the more flexibility the lender will show in their proposed terms. It is highly recommended to seek advice while negotiating terms of venture debt financing as it can often lead to significant savings in the long run.

What Happens If I Can’t Repay the Loan?

Once it is time to repay the loan, you have three options:

Repayment

Pay back the loan using the cash on your balance sheet or equity from investors.

Refinancing

Find another lender who is willing to refinance the loan. This involves giving you a new loan to repay the existing loan.

Restructuring

Try negotiating a more favorable repayment plan with the lender.  

If you are unable to raise equity or refinance, your company will be at risk of default. Although venture lenders do have the right to foreclose and sell off your company’s assets, they will try avoiding this by working with you and your investors to restructure the loan to provide more flexibility. It is in times like these where choosing the right lender is key. You will want to choose a lender who is able to work with founders in a constructive way during tough times.

How Do I Decide Which Venture Lender to Work With?

Banks are typically cheaper but are limited in loan size. Venture debt funds accommodate larger loan sizes at a higher cost. In either situation, it is wise to research how a lender has behaved in the past in difficult situations. You should contact VCs and companies they have worked with for reference.

Positive References

Prior to selecting a venture lender, companies should reach out to current and past companies of the lender to understand how each lender acts during the good, the bad, and the ugly.

Competitive Terms

Companies should get the best terms they can from the best partner.

Timely & Dependable Funding

Entrepreneurs should be focused on growing their business and adapting to customer needs. Taking the time to select a lender who has a strong reputation of funding on time and per the agreed-upon terms can relieve unnecessary distraction from your business’s development.

Partner Mentality

Commitment doesn’t end when the term sheet is signed and the transaction is closed. It is important to select a lender that will be a good financial partner over the duration of the loan.

Venture Debt Terms Glossary

  • Balloon Payment: Pay the loan amount in full when the term expires.
  • Covenants: Financial or non-financial behaviors that could trigger a loan default.
  • Equity Kicker: The equity component to the deal to get the returns.
  • Loan Price: The fees and interest you must pay the lender 
  • Loan Size: Determined by the amount of capital required and amount of debt desired by the business. 
  • Timing of Amortization: When do you have to start paying back the loan?
  • Warrants: The right to purchase company stock at a fixed price for a period of time, usually five or ten years. This is typically calculated as a percentage of the loan amount.

About Flow Capital

Flow offers emerging and high-growth businesses the opportunity to grow their businesses in a smart and sustainable way.

Our project is to feed the growth of the world’s most cutting-edge, innovative companies emerging in the markets today through fair funding that meets the needs of each business.

Our promise is to offer you a welcoming and inclusive community, to anticipate needs before they are voiced, and to treat every business owner with thoughtfulness and respect.

Our goal is to make financing your business as simple as possible while securing long-term sustainable growth.

Interested in Applying?

If you’re ready to grow your business while maintaining control and ownership of your company, apply for financing today.

Funding usually occurs within four weeks.

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