One of the highest priorities of a startup owner is to ensure that the company never runs out of cash. Most entrepreneurs understand the concept of venture capital, but many are unfamiliar with its loan-based option, venture debt. Over the years, the popularity of venture debt has skyrocketed. For some companies, venture debt can be a fantastic way to extend their VC round while minimizing damage to their remaining stock.
What is venture debt?
As the name suggests, venture debt is a type of loan financing that is exclusively available to startups and growing businesses with venture capital backing. It is given out by tech banks and special venture debt funds, usually in the form of a three- or four-year term loan that is generally interest-only for the first year and fully compounding for the remaining two years.
It is protected by a company’s assets, such as its intellectual property or machinery. In other words, it’s about taking out a loan to get a lump sum of money upfront, and in return for that money, the loan will need to be repaid or refinanced. Over the term of the loan, this repayment is often made in a series of monthly payments with interest rates between 10% and 15%.
Types of Venture Debt
Venture debt includes a wide range of loans, including synthetic royalty loans and capital revolvers.
1. A line of credit
A line of credit facilitates a company’s investment in short-term assets, such as equipment or accounts receivable. The money is flexible enough to sustain the day-to-day activities in line with overhead and payroll, which is necessary for the early stages of growth.
2. Term debt
Term debt is a loan with a fixed repayment period over a number of years and often fixed interest installments. Venture debt is quite foreseeable for both borrowers and lenders, whether used as a senior-term loan or a second-lien-term loan.
3. Equipment Financing
The primary purpose of equipment financing is to purchase expensive capital goods. The expected life expectancy of the equipment is most often matched with the repayment period.
4. Royalty monetization
Royalty monetization is built on the borrower’s estimated revenue stream. The loan installments vary in accordance with a preset percentage of the original loan as the borrower’s revenue performance changes. Furthermore, the financing is non-dilutive and has no minimum interest payments; therefore, the borrower is not required to be capital-backed. However, to convince royalty-based financing lenders, the borrower must have generated income and strong gross margins.
When a business is “burning” more money than it generates, venture debt can help a lot. It increases the value of their equity and decreases the average cost of capital. The second advantage is that it can pay for technical challenges, fundraising, and unforeseen capital shortages. It increases profitability, money runway, and capital while accelerating business growth. With flexible benefits, it serves as an alternative to equity financing. The debt ensures easy approval without requiring sponsorship.