Increasingly, founders have opted to skip venture capital funding in order to avoid down rounds that would dilute their ownership and have instead turned to venture debt. Venture debt refers to loans made to early-stage, high-growth companies that have venture capital backing. For founders, there are many benefits to using venture debt versus equity, including: 1) the potential to gain more time between equity rounds in order to build the business and achieve critical milestones, creating the potential for higher valuation; 2) the ability to achieve milestones more quickly, allowing the borrower to reach a liquidity event like an initial public offering (IPO) or merger and acquisition (M&A) sooner; and 3) the retention of a larger ownership stake in the company prior to an IPO or other liquidity event.
While venture lenders often require a first lien on assets such as intellectual property or the company itself (the value of which may be lower than the loan value if the lender is forced to take possession), they usually assess startups based more on their near-term viability and ability to raise future equity rounds. Some of the factors considered by lenders include: company life stage, strength of management team, product market fit, market share, cash-burn rate, investor quality, recent equity rounds and ability of the startups to attract additional equity capital from new investors.
Venture lenders primarily make money through interest payments, fees and warrants. Venture debt is typically floating rate and short term in nature, with the term averaging three years and accompanied by the expectation that most borrowers will service the full interest and fee payments — as well as repay the full principal — well within that period.
The principal amount is usually determined using the amount raised in the last equity financing round, and can vary between 25% and 50% of that round. Fees can include up-front fees (1%-2%), back-end fees (3%-5%) and pre-payment penalties. The lender also has the opportunity to participate in equity upside through the issuance of warrants, which typically represent 10%-15% of the loan amount. Given the rising-interest-rate environment (relative to the floating-rate nature of the loans) and the improving quality of pledged collateral, lending to venture-backed companies has recently become more attractive.
Most commercial banks do not offer venture debt. Instead, the majority of venture debt financing is provided by specialized banks or non-traditional lenders such as Silicon Valley Bank, Western Technology Investment, Trinity Capital and TriplePoint Capital. Other sources of venture debt include hedge funds, private equity firms and business development companies.
The downside of venture debt for some startups include: 1) future investors may view debt on a company’s balance sheet as an issue since they could interpret their investment as going toward repaying the company’s debt, 2) unpredictable cash flow might make it difficult for a young company to repay its debt and 3) failure to meet the financial requirements of the lending agreement can result in severe penalties. These penalties might include incurring higher interest rates on remaining balances, being required to pay back the entire balance or even being forced into bankruptcy so the lender can recoup its investment.
Key Takeaway
Venture debt is likely to continue growing as an attractive financing option for the right young venture-backed companies. While it does have disadvantages, these are far outweighed by the advantages for high-growth startups that: 1) are close to reaching profitability, 2) need a non-dilutive funding source between equity rounds and 3) want to have cash on hand in case they need more time to reach their next milestone.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
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