What Is Venture Debt? Complete Guide

Most entrepreneurs think their only financing alternative is equity. Fortunately startups can raise debt as well (“venture debt”, as venture capital is for equity).

There are clear advantages for raising debt vs. equity. If you aren’t clear on what venture debt is and when you should use it. Let’s dive in!

What is venture debt?

Venture debt, also referred to as “venture financing” or “venture lending” is a form a debt financing provided by specialised lenders to early stage businesses. Unlike traditional bank lending, venture debt is designed for companies that do not have sufficient positive cash flows and/or assets for collateral. Instead, lenders ask for other guarantees such as warrants or options to purchase equity to compensate for the risk of default.

Venture debt financing is often used along with equity: the debt provides for extended cash runway for the next funding round, whilst minimising the risk of dilution for existing investors. As such, venture debt enhances liquidity by providing cash for growth until you raise your next equity round. Therefore, if used correctly, venture lending can increase your company’s valuation and make sure you get the best terms out of future fundraisings.

There are 2 main types of venture debt instruments, they are:

Working capital financing: the debt is provided to finance the purchase of inventory or even marketing-related customer acquisition costs. Revenue-based financing and ecommerce financing are both working capital financing instruments. Working capital financing can either be provided as a standard loan facility or a revolving credit facility
Growth capital: the debt is typically provided as a term loan facility. The debt is either repaid over time (amortisation) or paid in fine (bullet repayment). This form of debt is often used to bridge the gap between 2 different equity rounds or to fund acquisitions

Pros and cons

Venture debt, like any form of debt, presents strong advantages vs. equity. It also comes with some limitations. For a refresher on the key 3 differences between debt vs. equity, read our article here.

When structured and used appropriately, venture lending can be a very attractive source of financing for the following reasons:

It prevents any equity dilution for existing investors (unlike equity)
It is readily available because of a less intense due diligence (indeed debt investors are taking less risks vs. equity)
Venture financing does not require to set a valuation for the business, which can be a source of negotiations and back-and-forth

Keep in mind debt comes with one main drawback: your company will need to generate sufficient positive cash flows so you can repay the debt in its entirety (plus interest). If you fail to do so, you will likely have to sell at a significant discount equity in your company and maybe even lose majority ownership of your startup.

Still, whilst you should be aware of the risks, don’t worry too much about repayment either. Venture debt investors are experienced lenders and will make sure their investment is protected from any downside. They will ask you for guarantees (warrants, options as discussed above) to compensate for their risk of course. Yet if they are willing to finance your business, it’s probably because they’re confident you will be able to repay the debt anyway.

When to raise venture debt

There are a number of situations where raising venture debt is an appropriate financing option for entrepreneurs and their investors:

To bridge the gap between 2 funding rounds. The debt can extend the cash runway of a startup so it can achieve the next milestone prior to their next equity raise. Think of a startup which needs a few more months to meet their Series A funding targets they promise to Seed investors: by raising debt instead of their Series A today, they get the cash required to grow and meet these targets. That way, the next equity round results in a higher valuation, whilst minimising dilution.
To extend cash runway until profitability. If you are a few months away from profitability, you should raise debt instead of a small equity round. For the same reasons explained above, equity will take time to raise (due diligence and legal paperwork) and cost you some dilution. Debt in comparison is within reach: you will be profitable soon hence you may be able to repay the debt.
To fund large capital expenditures. For companies that need to purchase (or lease) large assets (e.g. hardware equipment) debt is a great option at the condition that these assets will allow the startup to generate revenue (and therefore help repay the debt). These assets can be intangible as well (think patents for instance).
To minimise dilution when used along with an equity round. Sometimes, instead of raising say $5M equity, it’s better to raise $4M equity and $1M of debt. Indeed, the fresh equity round gives debt investors more confidence regarding debt repayment (equity funds growth thereby generating cashflow). Also, it reinforces the valuation of the company, and therefore, the collateral that debt investors take to reduce their risk.

Do you want to raise venture debt for your business? You will need to provide investors with your financial plan for their due diligence.

For more information on startup revenues projections and financial modelling, see our articles below: