DEBT FINANCING
Venture Debt vs. Venture Capital
Venture debt and venture capital funding are two of the most common methods of raising money for startups.
Building a startup requires a lot of things — time, dedication, passion, and not least of all money. It is quite rare for a startup founder or team of founders to build a startup entirely with bootstrapped funds (money contributed out of the founders’ own pockets). It’s far more common for founders to rely on some kind of external financial support. Sooner or later, almost every startup takes on debt, accepts investments from venture capitalists or angel investors, or pursues some other avenue of outside financing.
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It’s very important for startup founders to understand their options when it comes to raising money to fund their companies.
Venture debt and venture capital funding are two of the most common methods of raising money for startups. These two terms are sometimes confused or conflated due to their similar names. However, they represent two separate ways of securing funding for a startup, each with its own pros, cons, and ideal uses. So, how does venture debt work and how is it different from venture capital?
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Venture Capital Definition
Venture capital is a type of equity financing. In an equity financing deal, a company exchanges a percentage of ownership (equity) for an agreed-upon amount of money. In this way, investors (usually venture capital firms) can basically buy slices of startups they believe will go up in value by supplying the money to help them grow. Venture capital financing is a popular method of funding startups, but raising too much venture capital can heavily dilute a founder’s ownership of their company.
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Alternative form of financing
Venture Debt Definition
Venture debt is an alternative form of financing that works more like a conventional loan from a bank or other lender. However, unlike a traditional loan, venture debt financing relies on previous rounds of equity for collateral — not the business’s current assets. Typically, venture debt lenders will consider loans amounting up to a certain percentage of the previous round of venture capital the startup raised.
Some startups choose to use venture debt during the early stages of growth before they have the assets to secure a traditional loan. Often, startups time venture debt in between planned rounds of equity to help avoid diluting ownership of the business any further than necessary and because venture debt is only available to previously venture-backed startups anyway.
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Venture Debt vs Venture Capital
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Top Venture Debt Firms
Venture capital lenders are usually venture capital firms, though not always. Venture capital firms are investment groups that invest pools of money on behalf of the individual investors in the group. On the other hand the top venture debt firms are not venture capitalist firms, but rather banks or other specialized venture debt brokers. Not all banks are in the habit of supplying venture debt financing, but some do. For example, Silicon Valley Bank is one of the most well known top venture debt banks.
There are other types of venture debt lenders as well besides banks. For example, Golden Section can provide venture-backed startups with lines of credit between $1 and $5 million to enable growth without diluting equity the same way a venture capital investment would.
Golden Section’s venture debt financing options are available to young startups that do not have the assets to support a traditional, revenue-based loan.
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Venture Debt vs. Bank Loan
Venture debt financing is a unique method of raising money for a startup (but not one that should be overlooked). When most people think of venture debt, the first thing that comes to mind is probably a traditional bank loan. However, venture debt works very differently from a typical bank loan. Just like there is a significant difference between venture debt vs. venture capital, there is also a very important distinction to make between venture debt and bank loans.
So what is venture debt and what makes it different from a regular bank loan? A bank loan is a typical loan supplied by a bank that must be repaid with interest. Banks often use a business’s current assets, such as its current annual revenue, to determine how much of a loan the business qualifies for. Venture lending is different because the lender does not consider the business’s current assets when determining the loan amount but rather the business’s existing amount of venture capital backing. In addition, other specialized organizations, besides banks, sometimes provide venture debt financing.
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Venture Debt For Startups
Some startup founders never even consider venture debt in favor of sticking with only equity financing, but venture debt financing can actually be the smarter option in many scenarios. However, it’s also important to fully understand the pros and cons of venture debt vs. venture capital, because each financing method has its place.
First of all, it’s important to understand that venture debt can only be taken on by already venture-backed startups. This is because venture lenders use the amount of venture capital a startup has secured instead of the amount of revenue it is currently generating to determine the amount of loan money it qualifies for.
Venture-based lending is a great alternative to revenue-based lending for startups that need the means to grow before they’ve actually reached the point where they can start generating a significant amount of revenue — however, it does require that venture capital has been invested in the business already.
Here are a few examples of scenarios in which venture debt for startups can be uniquely beneficial:
- Startups often use venture debt to extend their capital in between rounds of equity financing, not as a means of replacing equity financing.
- Venture debt is a good option in situations when a founder does not want to further dilute the company with equity financing.
- When a startup is performing very well, additional venture debt funding can provide the means to capitalize on the success.
Venture debt examples like these show just a few of the ways venture debt financing can be a smart source of funding for many startups.
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Venture Debt Terms
Venture debt works quite a bit differently from equity financing or other types of lending. Venture debt terms are often favorable for young, venture-backed startups. Here are a few examples of the ways the terms between startups and venture debt firms are different than the terms between startups and venture capital firms:
- It’s fairly common for venture capital deals to give a certain number of board seats to investors, which further reduces the founders’ control of the company. Venture debt lenders usually do not ask for board seats as part of their financing deal.
- One of the primary benefits of venture debt financing is that it results in much less dilution than equity financing. Venture capital investments can sometimes dilute a company by as much as 20%, while a typical venture debt example will usually only dilute a company by 1% to 5% in the form of a warrant.
- Unlike venture capital investments, which are based around a company’s valuation at an exit, venture debt financing is bound by a predetermined interest rate that is decided when the deal is closed.
- Venture debt financing requires repayment, just like any loan comes with contractual repayment terms. Venture capital is not paid back like a loan — instead, venture capital firms receive their payment in the form of equity, which can be recouped when the company is sold or eventually goes public.
Venture debt
How Is Venture Debt Structured
Venture debt vs. venture capital are also structured very differently. Typically, venture capital investments are made with the expectation that the investor will recoup the value of the initial investment plus additional value gained due to growth at the time an exit of some kind occurs, like a sale or IPO (initial public offering). However, this doesn’t always happen (since startups don’t always succeed) and venture capital firms know their investments represent a great deal of risk.
So how is venture debt structured differently? As we mentioned before, venture lenders do not take equity that is later cashed in but rather provide a loan with the expectation of repayment plus interest. Venture debt interest rates are typically set at the time the deal is closed. Most of the time, founders can expect venture debt interest rates to be somewhere between roughly 12% and 20%. Keeping careful records of venture debt reports can help startups ensure they take on an appropriate amount of debt and manage repayment effectively.
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Venture Debt Funds
Startups that choose to use venture debt have a few options regarding how to get venture debt funds. Listing every possible means of finding a lender to provide venture debt financing would be very difficult, but the following are a few of the best options:
- One of the most common methods is to use a bank that offers venture lending services, like Silicon Valley Bank. Not every bank is willing to provide venture debt financing.
- Venture debt can also be secured through organizations that use venture debt funds or funds that have been pooled for the purpose of venture lending. For example, Golden Section can offer venture lending for startups.
The distinction between venture debt vs. venture capital is very important for startup founders to understand. By thoroughly answering the question: “what is venture debt?” you can empower yourself to make better strategic decisions regarding startup funding.
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