When it comes to financing SaaS startups, there are several avenues to explore. Bootstrapping, venture capital, and venture debt all provide viable options for funding.
The latter, in particular, has been a popular financing method in the U.S. for many years and is becoming increasingly prevalent in Germany, with debt funds such as Kreos, Columbia Lake and Claret Capital offering venture debt services.
But what is venture debt, and how does it differ from re:cap financing? Knowing the advantages and disadvantages of venture debt is essential in order to make an informed decision and develop a successful financing strategy.
Venture Debt: what Startups should know
Venture debt is a type of external capital offered to startups by venture debt funds and is generally similar to a traditional bank loan. This makes things interesting: usually, startups cannot receive bank loans as they need to demonstrate a viable break-even point. Since their priority lies in growth rather than profitability, the break-even point is usually only targeted in the medium to long term.
Furthermore, banks often require sufficient assets to be offered up as collateral in the case of insolvency, something that young software companies – which possess rather intangible assets – rarely have.
Venture Debt doesn't fit all Startups
On the other side, venture debt is also not suitable for all 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, and with a longer repayment period of three to four years, plus an interest-only period.
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.
Watch out for warrants and covenants
The contract design is often intricate and may include covenants, which are additional agreements that restrict a company. It is therefore imperative for startups to seek experienced advice and explore different offers from various venture debt providers. Interest rates for venture debt are normally higher than traditional loans, ranging typically from 8 to 15% – sometimes even higher.
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.
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.
This is exactly the type of debt financing that re:cap offers: With re:cap, SaaS companies convert up to 60% of their ARR directly into funding.
Exploring the benefits of Modern Debt Funding over Venture Debt
Unlike equity financing, which is considered standard for early-stage startups, both venture debt and re:cap financing 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.
Plus, financing with re:cap allows companies to get capital quickly, without the lengthy and complex conditions of financing with venture debt.