Venture debt is a useful tool for startups and growing companies who are still in the cash burn phase (negative cash flows) or lack the collateral required to access traditional debt. This means venture debt is available earlier than traditional debt in your capital structure, usually whilst your business is younger and in the steepest part of its growth.
Venture debt is available when a firm reaches a certain level of maturity. For a startup, this is a milestone governed by its customers. Your business is no longer defined by the products it is going to build — it is now defined by the products it has already built and the revenue that this generates. Venture debt providers are interested in your existing revenue, its sustainability and its ability to grow. There are other factors, but these are usually the main considerations.
The $1M ARR stage, is where things start to get interesting. This is the sort of scale you would typically associate with a Series A round and it’s here where you gain access to a far bigger pool of potential investors, in both equity and debt. The key thing to note here is that VC equity investors will generally be looking for firms with growth of around 300% whereas you can potentially source debt even if your growth is as low as 20%.
There are many different structures, but the main two categories are:
Relationship venture debt — This is debt provided to a firm supported by a tier-1 VC. Usually the underwriting of the debt falls on the VC rather than the firm on a standalone basis. This tends to occur alongside an equity round which is the primary source of funding. The addition of the debt aims to add a layer of security to the funding risk of the company. Banks typically provide the debt funding at around 9–11% (in Europe) with a small equity warrant and a requirement of up to 75% in cash posted as collateral. It is important to calculate the cost of debt relative to how much cash you can actually deploy versus how much you are required to keep as collateral.
Fund venture debt — This is debt provided to a firm that is underwritten by a venture debt fund. It tends to be more expensive at around 12–15% often with a small equity warrant but usually no requirement to post cash as collateral. It will likely also include covenants based on the performance of the firm and it is important to monitor compliance with these very carefully. This is often the cheapest source of capital available before the stage when a firm has access to traditional debt or the bond market.
Ideal factors for your current business model include the ability to quantify recurring revenue streams, the potential for strong revenue growth and a cash burn rate that is under control. You should also be able to show that your products have a good level of stickiness with your current customer base.
You should have a very well-defined strategy regarding how much cash you need to raise and how you intend to use it. Be able to show clearly how each unit of capital deployed will add a multiple of value to your business.
Venture debt is useful for companies in early series equity rounds. It is also useful for companies growing in a bootstrapped manner and it has particular value as a source of funding to businesses that don’t want any further equity dilution. It does have its complexities though and you should ensure that your business model can support and track debt repayments whilst modelling how those repayments could change depending on any debt covenants that may exist. If you are considering taking debt, it is worth taking detailed advice where available to evaluate whether venture debt is the right tool for your business.