What Is Venture Debt Financing? And When to Use It

Ever wondered how to fund your startup without giving up more equity? Venture debt can be an excellent financing option for venture-backed startups, especially those that want to lower their overall cost of capital or avoid further diluting their ownership. 

Here’s what you should know about it, including how it works, where you can find it, and how to get it.

What Is Venture Debt?

Venture debt is a broad term for loans offered to startups that have already secured backing from venture capitalists. It’s not a replacement for venture capital financing but is a relatively affordable way to supplement it while preserving your ownership.

Venture debt is also somewhat flexible, offering terms that are customized to the borrowing startup’s needs and circumstances. However, there are limits to that flexibility. Here are some typical restrictions you can expect:

• Loan amounts: Venture debt loan proceeds are typically limited to between 20% and 40% of a startup’s most recent round of equity funding. Alternatively, it may be capped at roughly 10% of its latest valuation.
• Repayment term: Startups typically must repay venture debt funds within three to four years, but there’s often an initial interest-only period of 6 to 12 months where no principal payments are required.
• Cost of debt: In addition to interest charges, venture lenders typically demand an origination fee and stock purchase warrants, which grant them the right to purchase company shares at a certain price within a given time period.

Startups often take on venture debt to extend their runway and generate working capital between equity investment rounds. 

They can then use the funds for a variety of purposes that accelerate growth or drive innovation, such as research and development, marketing, or hiring a sales team.

Venture Debt vs. Venture Capital

Venture debt and venture capital are fundamentally different forms of financing. Venture debt accounts are a form of installment debt, while venture capital is a form of equity financing that involves selling stock in your company.

Here are the most significant implications of those differences:

• Ownership dilution: Venture capital involves selling a portion of your company to a venture capital firm, which means giving up some amount of control. As a form of debt financing, venture debt doesn’t require you to dilute your ownership.
• Financial burden: As a form of equity, venture capital is more expensive than venture debt, but it generally doesn’t require repayment. In contrast, venture debt comes with fixed principal and interest payments, which can be financially burdensome to your operation.
• Role in development: Venture debt and venture capital play different roles in financing your startup. Venture capital is a long-term play that involves forming a lasting arrangement with an equity investor, while venture debt is more often a short-term bridge loan to the next round of funding.

Keep in mind that venture debt and venture capital aren’t substitutes for each other. They go hand in hand in the startup financing cycle, especially since a venture debt lender will typically only work with a startup after it’s secured venture capital backing.

Venture Debt Pros & Cons

One of the primary benefits of venture debt is that it’s accessible to startups that might not qualify for a traditional bank loan. 

As long as you have venture capital backing, underwriting requirements like business credit, time in business, and strong financial performance matter less.

Another significant advantage to venture debt capital is that, like most forms of debt, it’s cheaper than equity capital. That makes it an excellent option for startup founders who want to raise funds without the high price tag of an equity round.

In a similar vein, venture debt is non-dilutive funding that helps preserve your ownership and control of your company.

Of course, venture debt isn’t without its drawbacks. Unlike equity financing, venture debt must be repaid, which can pose a significant financial burden. 

That’s especially true if you’re so focused on growth that your company is cash-flow negative, which is common among startups.

Notably, venture debt also tends to be more expensive than other forms of debt financing for startups, such as traditional business loans from commercial banks.

How Much Should You Borrow?

Making a venture debt deal can be an excellent way to supplement your venture capital rounds, but there is such a thing as too much of a good thing, especially when it comes to borrowing money.

Like any form of debt financing, venture debt should be used sparingly. Because it involves making regular debt payments, too much can put significant stress on your startup’s cash flows, especially once the interest-only period ends.

Beyond its negative impact on your cash flows, too much venture debt can compromise your ability to raise your company’s next round of venture capitalist funding. 

Not only does it make you a riskier investment, but an investor may also dislike seeing too much of their funds go toward paying off debt.

While it’s difficult to suggest how much you should borrow in a vacuum, one rule of thumb is to keep your debt service below 25% of your net burn. Another healthy goal is to keep your venture debt to 6% to 8% of your latest valuation.

When To Raise Venture Debt

Venture debt funding is for early-stage startups that have just secured venture capital backing. Typically, these startups raise their venture debt within a few months of the round closing when they already have 9 to 12 months of cash runway.

However, just because you’ve recently closed a round of equity funding, doesn’t mean it’s a good idea to pursue venture debt. Instead, it’s best to save the resource for when you really need it. For example, that might be to:

• Fund a strategic investment in your growth
• Extend your cash runway in order to reach the next round
• Increase your enterprise value so your next round is raised at a higher valuation

If you’re using venture debt to invest in your company’s growth, make sure it’s for something specific. Be able to clearly explain to your VC investors how you’ll make the venture debt work toward your long-term goals.

In that scenario, think of venture debt as an accelerant. It’s something to use when you have a clear roadmap ahead. If you take on venture debt when you’re still figuring out the way forward, you could just be propelling yourself off a cliff.

Lastly, before you take on venture debt, consider whether you have other borrowing options on the table. If your startup has the qualifications necessary to secure traditional debt from a bank, that will likely offer more favorable terms.

Where To Find Venture Debt Providers

Venture debt isn’t a common offering among commercial banks or traditional lending institutions. It’s a fairly unique type of financing, and you’ll typically get it from a venture debt fund that specializes in it.

Here are some options to consider:

• Western Technology Investment (WTI): WTI has issued more than $7B in venture debt to more than 1,400 companies since 1980, including Gusto, Bloomenergy, and Toast.
• Correlation Ventures (CV): CV has built a portfolio of more than 190 companies, including Upstart, Personal Capital, and Casper.
• Hercules Capital (HC): HC has committed more than $20B to over 650 companies since 2003, including Carbon Health, Phathom Pharmaceuticals, and uniQure.
• Trinity Capital (TC): TC has provided over $3.2B in funding to more than 330 companies since its founding in 2008.
• Battery Ventures (BV): BV has invested in more than 450 companies over the last 40 years, including companies in the software, consumer financial services, and life science sectors, such as Coinbase and Glassdoor.

The easiest way to find a venture debt provider is to research them online, but you can also leverage your network. Your venture capital investors will very likely have a venture lender they can recommend.

What Are the Requirements for Venture Debt?

The underwriting for venture lending varies significantly from that of a traditional loan. Instead of focusing on factors like creditworthiness and historical cash flow, venture debt lenders tend to care more about your startup’s VC funding.

More specifically, venture debt lenders tend to focus primarily on the following, especially earlier-stage startups:

• Investors: Startups typically repay their venture debt using subsequent venture capital rounds, so lenders place a significant emphasis on the likelihood that the existing investors will be able to provide or help secure them.
• Equity rounds: The strength of your previous equity rounds also impacts your ability to qualify for venture debt financing. For example, lenders may want to see that you raised at least $5M in your last funding round.
• Projected cash burn: Your startup’s projected burn rate is one of the few meaningful lenses lenders have into its financial health at its earliest stages of growth, so it can carry a lot of weight in their decisions.

Venture capital backing is just as important in underwriting for more established startups with a longer operating history. However, your previous financial performance may play a more significant role than your projected cash burn.

Automate Your Finances to Get More Financing

Bookkeeping is the foundation of your financial statements and reports, and those documents are critical to convincing venture capital investors and venture debt lenders that your startup is a worthwhile partner.

Unfortunately, as important as your startup’s financial records are, they can often take a backseat while you focus on growing your operation. That’s understandable, but it can be a significant roadblock when you want to raise financing.

Fortunately, that doesn’t have to be the case. With Zeni’s comprehensive AI bookkeeping product, you can harness the power of artificial intelligence and machine learning to automate your finances.

Not only can Zeni automatically categorize your transactions, but it can also learn from the adjustments you make, increasing the software’s accuracy over time. 

In addition, Zeni’s AI services includes fractional CFO services, bill pay, employee reimbursement, and a business checking account that currently earns 4.05% APY.

Schedule a demo today to see how Zeni can organize your startup’s finances and help streamline your access to financing.

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