One of the biggest challenges startups and entrepreneurs face is to finance their ventures without breaking the bank. Standard business loans are an option but they are not easy to get since startups work differently than traditional SMEs.
This had led to startups seeking equity financing (selling business shares in return for capital) instead. However, investors may ask for more ownership than what the founders are comfortable with, which can lead to them losing control of the business.
Hence, startups are seeking viable alternatives to equity financing where they don’t have to dilute too many shares to grow their business—look no further than venture debt.
Venture debt first started making the rounds in Silicon Valley as a way for startups to raise capital without the support of VCs.
Today, it is used all over the world including Australia. NAB recently announced a $2 billion venture debt fund for startups with a host of smaller firms following suit with their own offerings.
What is venture debt financing?
Venture debt financing allows startups to take on debt to fund their company rather than giving away equity in exchange for capital. While they are considered as loans, there are key differences to note between venture debt financing and standard business loans.
This type of funding is offered by fintech banks and dedicated venture debt funds. Agreements are usually bound with three to five-year repayment periods although there are other financing options like equipment leasing or business line of credit (LOC).
Typically, no traditional security collateral is required, as most startups don’t own assets that can be used as a guarantee. Instead, the company provides the lender with share warrants (the right to buy a company’s shares at a specific price within a specific time period- which is usually longer than the loan term) to be used as the lender’s additional risk uplift and collateral.
How does it work?
The funding depends on the amount raised by the company in its previous equity financing round. 30-50% of this amount is loaned which is then calculated to determine the total to be repaid each month including interest.
As mentioned earlier, the lender receives warrants as remuneration for the high default risk. They can opt to cash in on the warrants at the price of the last equity financing round in addition to earning interest.
Banks may also include covenants as part of the agreement to further discourage borrowers from defaulting. Venture debt firms are less strict in this aspect as they are flexible in negotiations and are more open to making risky investments.
The pros of venture debt financing
Venture debt is ideal when you want to finance a large purchase or project where equity financing doesn’t make sense. For example, you can use debt financing to buy new machines without having to raise capital and relinquish your shares.
Another reason why startups might use this mode of finance is to sustain the business in between investment rounds. This would allow them to manage operating costs without the distraction of trying to raise small funding rounds to bridge the gap between more significant fundraising or an exit event.
The biggest advantage of venture debt financing is that founders don’t have to worry about significantly diluting their ownership to raise capital. Since the share warrants are for a much lower percentage of equity than issued during a fundraising round, the dilution is minimal in comparison and is likely to be delayed until an exit event, such as a sale of the company or an IPO.
Debt financing is only granted to startups that have already gone through fundraising rounds, so it is not suitable for bootstrapped companies or pre-seed startups.
It can also be risky if the startup does not grow aggressively enough. If the company defaults, all of its assets (including the company itself) will be sold to cover the debt. Startups can renegotiate the loan but this results in higher interest fees and repayments which worsens the situation if the company does not improve.
Before you apply for financing, make sure you understand your company’s financial situation, so you know which option works best in the long run.
Get in touch with us to find out how we can help you choose the right financing option for your startup and business.
At Law Squared, we partner with passionate entrepreneurs and businesses who need our technical help and expertise in many areas. We’d love to have a chat with you, so feel free to drop us an email at firstname.lastname@example.org.
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