Venture debt: what startups should know

Venture debt is a risk loan offered to startups by venture debt funds. It is used to finance further growth without without diluting ownership as much as traditional equity financing would. Venture debt follows venture capital. Meaning, that a venture debt is a financing instrument that is used between equity financing rounds. It helps a startup to keep its liquidity and invest in further growth. That's why venture debt is sometimes called "growth loan" or "growth capital".

A venture debt loan is generally similar to a traditional bank loan. A startup receives debt capital and has to pay it back over a specific period of time, including interest. And this is were things get interesting.

Startups access a loan

Usually, startups cannot receive (bank) loans as they need to demonstrate a viable break-even point and a proved business model. Since their priority lies in growth rather than profitability, the break-even point is usually only targeted in the medium to long term.

Furthermore, financial institutions often require sufficient tangible assets to be offered up as collateral in the case of insolvency, something that young companies – which possess rather intangible assets – rarely have.

That's why a typical loan isn't easy to access for startups. But venture debt is essentially a loan provided to startups, typically by specialized lenders, including venture debt funds, banks, or other financial institutions.

Why venture debt for startups?

Preservation of equity

‍Unlike equity financing, which requires startups to trade ownership for capital, venture debt allows founders to secure funding while maintaining a larger ownership stake in their company. This is particularly crucial for entrepreneurs who want to retain control and value in the long run. Although there are other restrictions who might affect a startup's business.

Extended runway

‍Startups often face the challenge of managing their cash flow and extending their runway until they achieve profitability or reach the next funding round. Venture debt provides a financial cushion, allowing startups to extend their operational runway and navigate the uncertainties inherent in scaling a business.

Flexible use of funds

Usually venture debt is used to fuel further growth but it has a broad range of applications. It can be used for various purposes, such as product development, marketing initiatives, working capital, or even to bridge the gap between funding rounds. Its versatility makes it an attractive option for startups with diverse capital needs.

Venture debt doesn't fit all startups

But venture debt is not suitable for every startups: this financing method is typically only available to companies that have gone through one or more equity rounds and is best used in combination with or shortly after an equity round. Moreover, companies that use venture debt should be profit-oriented and have a focus on growth. 

Like a bank loan, venture debt is paid back in monthly installments, typically over a period of three to four years. The terms and conditions include several different elements, such as interest payments, closing fees, maturity fees and prepayments fees.

Venture debt also usually comes with covenants that vary from case to case. It is usually awarded based on the fulfillment of various financial ratios. Additionally, warrants for the venture debt provider may also be included in the contract.

The pros and cons of venture debt

The upside of Venture Debt

Venture debt can be a great choice for SaaS startups looking to extend their runway and use the extra time to reach important milestones and gain a better company valuation for their next funding round.

It's also worth noting that venture debt can provide larger volumes of capital than recurring revenue financing or revenue-based financing, and with a longer repayment period of three to four years, plus an interest-only period.

Venture debt often complements equity financing, providing startups with a hybrid funding approach. This allows companies to leverage the strengths of both debt and equity financing to optimize their capital structure.

The downside of Venture Debt

It's often said that venture debt is a form of debt capital where startups don't have to give up any shares. However, this isn't always the case, as many venture debt funds may require warrants as part of the contract, which could lead to eventual dilution.

Similarly, some venture debt providers may also ask for a board seat, further reducing the control a startup has over their company. In this respect, the statement "no dilution and full control" applies only to a very limited extent in the case of venture debt. 

Venture debt financing may come with some additional downsides. Much like the case of equity financing, the process of obtaining venture debt can take a few months. This can be a problem for startups seeking quick access to capital for activities such as acquiring another company.

Venture debt comes with regular interest payments that are normally higher than traditional loans, ranging typically from 8 to 15% – sometimes even higher. It can add financial pressure, especially for early-stage startups that may not yet be generating substantial revenue. Managing cash flow becomes crucial to avoid liquidity challenges.

Watch out for warrants and covenants

Venture debt agreements often come with covenants, which are financial performance metrics that the startup must maintain. Breaching these covenants can have serious consequences, including acceleration of the debt and increased financial pressure. It is therefore imperative for startups to seek experienced advice and explore different offers from various venture debt providers.

Furthermore, the actual costs go beyond mere interest, taking into account warrants, fees, and legal costs to implement the agreements.

How financing with re:cap works

Raising capital doesn't have to be limited to venture debt or equity financing. There are other debt alternatives for SaaS business models.

For instance, re:cap offers a financing line within which companies can draw multiple fundings. To do so, re:cap creates financing scenarios that help companies get money when they actually need it – without risking unnecessary capital costs due to overfunding.

Wit re:cap, startups can:

• access up to €5m of funding initially and increase the amount over time.
• set up payback horizons of up to 5 years.
• customize a company’s grace period to extend its runway.
• get funding that matches the current business needs and adjust if things change.

As in the case of venture debt, re:cap financing can be used to improve the starting position for a future funding round by investing in growth initiatives or generally generating higher revenues due to a deferred equity round.

Venture debt or alternative debt funding for startups?

Unlike equity financing, which is considered standard for early-stage startups, both venture debt and re:cap funding are most suitable for companies that are already generating fixed revenues.

However, when it comes to increasing growth through investments in marketing and sales activities or obtaining capital as quickly as possible, for example to acquire another company, financing with re:cap offers several advantages. While re:cap financing generally does not dilute company shares, this only applies to a limited extent to venture debt.