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Venture Debt: How Does it Work?
Venture debt is a financial formula used in many countries, and many new businesswomen and men have achieved their growing financial goals with this. Today in Codedesign, we'll help you understand more easily what venture debt is about, how it works and its benefits and risks.
Venture debt is a form of financing commonly used by early-stage companies and startups to help fund their growth and expansion. It can be obtained from specialized venture lending banks and non-bank lenders and is often used in conjunction with equity financing.
SaaS companies that are experiencing rapid growth often seek a combination of venture debt and equity financing for two main reasons. By using venture debt in addition to equity financing, these companies can maintain a greater level of ownership in their business and avoid diluting their equity too heavily. Additionally, investors can benefit from the higher interest rates associated with venture debt, providing them with a cash flow while they hold their equity stake in the company.
What is Venture Debt?
Venture Debt is a financing model that can help startups and new businesses gain capital for early company process.
Suppose you're a new startup founder or business owner and still don't have a credit story or a way to prove your revenue capabilities. In that case, Venture Debt is a financing model that can help you with this business growth goals. With this process, you find a lender person or entity that will give you the funds in exchange for potentially higher returns. In this case, the lender doesn't have complete control over your company, you still have, but the lender expects excellent results from your alliances to keep with this financing process.
And as we mentioned startups, it's good to point out that this financing option is suitable for technology-based companies as it can scale its business globally. However, it needs some years to start perceiving the benefits of it.
Venture debt is usually provided as a loan, and you can use it for purposes like:
- Acquiring equipment
- Expand your business operations
- Research and development purposes.
How does Venture Debt work?
Venture Debt consists of getting a venture debt firm or institution willing to grant your startup or company a loan or line of credit. For this, the venture debt lender will have access to your financial history, growth potential and future business plans to assess your potential and the amount of money they will be willing to invest. On certain occasions, lenders can guide you on the steps you should follow to make the business feasible for both parties.
You must pay the Venture debt lenders first, as they are the senior secured lenders in a company's stack. If you have a bank loan, this entity will be the first one you must pay.
Among the most typical terms we find in a Venture Debt contract, we find:
The loan term length varies from 24 months to 48 months, with an industry average of 36 months.
Companies usually receive a venture debt between 25 - 50% of the amount previously raised through a Venture Capital company.
As venture debt means more risk, the price of financing venture debt is higher than a loan. You have to pay the principal and interest payments, but there is no standard for interest rates.
In this case, you can sometimes negotiate a balloon loan structure with your lender. In this situation, you pay interest only or nothing until the loan matures, at which point you pay the remaining balance all at once.
This type of loan can be helpful if your company has high expenses but you're still confident you can get higher revenue.
Hypothetical Example: A SaaS Startup's Journey to Combining Equity and Debt Financing
Imagine a hypothetical scenario where we consider a SaaS startup named CreativeWeb that helps users create 3D interactive websites as easily as WordPress. In this example, CreativeWeb is a fast-growing SaaS company with a 20% month-over-month (MoM) growth rate and annual revenue of $5 million. To continue scaling the business, the company's management team seeks additional funding through a combination of venture debt and equity financing.
Let's say that CreativeWeb aims to raise $4 million at a pre-money valuation of $30 million. Because the startup is cash flow positive and has a projected growth rate and annual revenue, it is in a good position to pursue a combination of equity and debt financing. Suppose a venture capital (VC) firm, EquityVentures, agrees to invest $3 million in CreativeWeb as part of equity financing and suggests that the company consider obtaining venture debt financing to complement the equity investment.
If everything goes well, CreativeWeb will raise $3 million in equity financing and an additional $1 million in debt financing with a 12% interest rate, which must be repaid in 3 years.
Pre-money valuation: $30 million
Post-money valuation: $34 million
Equity that Equity Ventures get -
(3 million dollars/34 million dollars)*100
= 8.82%(round off figure)
Obviously, there could be many differences in real-time, but you got an idea.
Why use venture debt?
Venture debt is a much more achievable financing model than a loan.
In principle, the first obstacle that new businesses or startups face is that they need a credit history extensive enough to be able to apply for a bank loan. Since these businesses are in the early stages of development, they most likely it doesn't have it on hand. Even as a relatively good business, you can have reliable proof of how profitable your venture is, but it's still challenging to obtain the loan you want. That is why venture debt becomes one of the most feasible options for them since it can even boost you in its growth or construction phases.
How can startups raise Venture Debt?
To apply for Venture Debt, startup founders and business owners can use financing options from bank and non-bank lenders. You can even find venture debt lenders for your specific niche.
Usually, the best way to find venture debt is through a referral, as many VC firms have access to their venture debt lenders. Since these people typically do business together, they trust each other and will be more willing to listen to your business pitch, help you with some guidance, and give you that venture debt if they like it enough.
Venture Debt VS Traditional Loans
Venture debt is a financing often used by startups and small businesses to fund their operations and support their growth. It is typically provided by specialized lending firms or banks and is designed to supplement a company's equity financing.
One of the key features of venture debt is that it has a shorter term than traditional loans. While traditional loans may have repayment periods of several years or more, venture debt typically has repayment periods of one to three years. This makes it a good option for companies that need a short-term source of capital.
Another feature of venture debt is that the loan amount is typically smaller than a traditional loan. Venture debt lenders may consider a loan of up to 30% of the company's last equity financing round, which means that the loan amount is typically smaller than that of a traditional loan.
How should founders approach Venture Debt?
How must founders approach Venture Debt?
Founders need to familiarize themselves with the terminology of venture debt and understand their contractual obligations. Founders should evaluate multiple lenders to create competition once they understand the basics. While a more familiar lender may be beneficial in difficult situations, it is important not to prolong the process, as the business needs to be the main focus.
When entering a venture debt relationship, founders need to involve legal counsel. The terms and conditions of venture debt financing may be even more important than those of equity financing, as lenders may aggressively assert their rights and use assertive tactics to recover their investments.
What are the factors that lenders consider before making an investment?
Before investing, lenders evaluate the business's liquidity position and ability to manage liquidity efficiently, showing financial responsibility and the capacity to take on debt. The protocols established by the company to maintain data integrity could also be a factor, as trust and transparency are vital in any financing relationship.
The skills and qualities of the founders and key management team, including their expertise in their field, vision for the future, and ability to assemble a strong team, are important factors for lenders to consider. The backing of existing investors is also a positive indication for lenders, as it demonstrates faith in the business. At the same time, a revenue model with strong margins demonstrates the business's ability to take on debt and utilize it to scale.
What do you need to apply for Venture Debt?
When you apply for venture debt, you use practically the exact financials you show to venture capitalist firms. For this reason, it's a good option to apply for both at the same time.
Also, before going into this process, look for venture debt funds when you have raised enough capital to show financial entities how well your startup has performed at its best moments. If you have less money in the bank, you may not secure enough debt to accomplish the following process.
Among the requirements you'll need to apply for venture debt are the following:
- A summary: Showing what your startup it's about and what makes it unique.
- Market fit: What problem does your product or service solve, and what makes it unique?
- Business model: What is your business plan and marketing and sales strategy?
- Team profile: Who is your management team, and who will fulfil the work? What are their experience, achievement and academic goals?
- Financials: How are your finances, and what are the growing projections? Make sure to outline revenue and profit.
- Capital needs: How much money do you need, and how do you plan to use it? In this part, it's a great option to include any milestone you want to achieve with the capital they provide.
- Repaying the debt: What's your business plan o repay the debt, and even what could happen if you don't?
If you want more guidance or help with this process, Codedesign can provide a team of professionals to take your startup to the right place. Contact us now
What are venture debt lenders looking for?
In short, venture debt lenders want a profitable business that will make their money work for them.
Because of this, venture debt lenders often prefer a venture-backed business as these companies tend to be the ones that are better capitalized.
These lenders will also want to know who your investors or venture capitalists are, including how much they recommend your company and what metrics your investors use to gauge its progress.
Startups must always have a good team behind their project as most lenders want to know their abilities and ability to manage your business and achieve each plan.
Finally, you need to prove that you are money-making and have a proven revenue model and strong product fit in a large market. They need to know that you can scale your business into high-margin profits.
Finally, in the operational area, you must show how you can manage the corporate interests of investors, managers and staff to provide clear communication.
When to use Venture Debt?
When does it make sense to use Venture Debt? Throughout this article, we've mentioned that the best uses for venture debt involve helping your company grow in the early stages of getting the supplements you need to go bigger within your business niche. Nevertheless, there are some other case scenarios where you could use it, like:
- Create a credit record quicker: In case you don't have a notable credit history, venture debt can help you be eligible for future bank loans. This aspect is also an excellent option for companies with low assets and revenue, making your business look less risky for bank loans.
- Extend the time to meet objectives: Since specific achievements need more time, the Venture Debt can give you up to 48 months to meet them.
Who benefits the most from venture debt?
SaaS is one of the most profitable industries for venture debt as these companies don't require too many assets and generate constant revenue from their monthly or annual subscriptions. We've seen examples of this in companies like Netflix or Hubspot.
This business model has made SaaS one of the most lucrative industries to invest in, and that's why venture debt lenders and firms see too much potential from these, while banks could see it as riskier. This benefit goes the same for any technology company that doesn't rely too much on assets.
Now, for non-technological companies, it's safe to say that you aren't out of opting for venture debt as a financing option, as you need to prove to these financial entities that your business idea is innovative and profitable. This way of thinking is practiced within the European Investment Bank, which pays more attention to those companies with something new to offer. In its article about venture debt, the institution says:
At the European Investment Bank, we want innovative companies backed by good equity investors, managed by capable teams, and addressing market failures or showing good prospects.
After carefully considering your venture debt, they only need to ensure that you have the business capabilities to return that money to them, with interests included.
It's important to point out that as Venture Debt requires a much higher risk than a bank loan, the price for this type of financing tends to be higher. However, regardless of this, it's still more beneficial than equity financing, as the first will benefit the original investors. In contrast, the equity model usually sells part of the business and all its future earnings and benefits.
In any case, when studying your subject, the European Investment Bank will check on aspects like:
- Venture capitalists look at your team
- Success history
- Knowledge as a company
- Your market and what resources you have to face any challenge like demand or scalability
What are the pros & cons of Venture Debt?
At this point, you may be considering venture debt as the best option for your startup, but before making any hasty decision, let's look at the benefits and risks of this financing option.
- Less Dilution: The most notable advantage of venture debt among traditional fundraising is that this option gives you additional cash while maintaining control over your business. As a founder, you can choose funding sources without diluting your ownership. Instead, lenders care more about warrants or preferred stock, but whatever the equity portion is, it will be less than traditional options.
- Favorable Terms: Some partners can negotiate lower interest rates than the amount of risk they are taking and consider a small equity component. Ultimately, this makes venture debt a much cheaper option than traditional equity fundraises.
Why is venture debt a viable option for certain startups?
Venture debt could be used by startups to extend its runway and continue operating while it works to generate revenue or secure additional funding. At the same time, it could fund a variety of other business needs, including acquisitions, capital expenses, and inventory. It also serves the purpose of helping a company bridge the gap between rounds of equity financing, allowing it to continue growing and developing its products or services until it is able to secure additional equity funding
- Future funding: When contacting new investors, having a debt with other entities could make your company look problematic since it could see your investment as a way to pay this debt. Although the risk of affecting future funds is relatively small, it is good to be aware of this factor.
- Financial Covenants: Once you get a venture debt approved, it's expected that you'll have to meet specific financial performance metrics while keeping your lenders informed on all the activities you're doing with their money. In case of non-compliance, you can get the lender charging higher interest rates on outstanding balances, requiring you to pay back the entire balance immediately, or even forcing you into renegotiation or, in the worst case scenario, bankruptcy.
- Operational Covenants: Your lenders may restrict the type of operations you carry out with other businesses to maintain all of your financial accounts in one central location. Ultimately, this can take away some of your freedom when making moves according to what is happening in your market.
- Extra legal advice: Since the venture debt is a legal agreement, it's recommended that you seek legal advice to read all the documents before the contract. You will also need an administrator who can keep track of all the operations within your business.
- Repayment Requirements: For any debt, you'll be obligated to repay this plus any other interest. Paying these monthly quotes can be challenging or stressful for your business. Also, you must consider any different challenge you could face, like unpredictable cash flow, raising the risk of a default due to an unexpected downturn.
The founders of startups, SaaS and any other type of business often need a push to get their business moving forward. To face all these business challenges, the best thing you can do is fill yourself with information to make the best decisions for your venture.
At Codedesign, we offer you a helping hand to advise you on digital marketing and any other negotiation you have for your company so that you can unleash the full potential of your startup to the world. For further guidance, keep up to date with our blog content and, above all, contact us for advice on your specific business. Contact us now!