- Venture debt differs from other forms of credit and equity, and understanding the differences and how to leverage both is important.
- By leveraging equity raised by a startup, venture debt can reduce the cost of capital needed to fund operations and can be used as insurance against operational hiccups and unforeseen capital needs.
- Understanding how to use venture debt, when is the right or wrong time to raise venture debt, and how venture debt is priced are just some of the important considerations evaluating how to fund a fast-growing company.
Venture debt is widely discussed in startup circles, but often misunderstood. At Silicon Valley Bank, we work with more than half of the U.S. venture capital-backed companies and a growing clientele in global innovation hubs outside the U.S. SVB has provided banking services and credit to thousands of startup companies and venture debt has been a core part of our lending practice for decades. We compiled this list of commonly asked questions about venture debt to help explain the fundamentals.
Answers to important questions
How does venture debt work?
What makes venture debt different from other forms of credit?
Why does venture debt make sense for startups and fast-growth companies?
The cost of equity fluctuates significantly in innovation economy business cycles but one thing stays true: debt is cheaper than equity. Thus, the primary benefit of venture debt is that it leverages the equity raised by a startup and reduces the average cost of the capital required to fund operations when a company is “burning” more cash than it generates. A secondary benefit is flexibility, since venture debt can be used as insurance against operational glitches, hiccups in fundraising and unforeseen capital needs, such as performance bond requirements.
Here’s how it works: If a Series A round of $10 million provides the new investor with 20 percent ownership (on a fully diluted basis), then the stake held by the existing shareholders is valued at $50 million. Let’s assume the company has a monthly cash burn of $1 million, meaning the Series A proceeds provide a 10-month runway. A venture debt loan of $3 million in this scenario might require warrants with dilution equivalent to 25-50 basis points (fully diluted). In this example, the venture debt would extend the operating runway by another three months. The venture debt loan, provides roughly 30 percent additional runway but carries only 1/40th the dilution, even with a 50 bps warrant in the pricing.
Is venture debt available to seed-stage and pre-revenue companies?
When is the right time (or wrong time) to raise venture debt?
When you are working on an equity term sheet, you should consider initiating a conversation with a lender about venture debt. Typically, venture debt is synced up to close a few months after a fresh round of equity. Raising debt when the company is flush with cash may seem counterintuitive, but in many cases the debt can be structured with an extended “draw period” so that the loan need not be funded right away. Regardless of when you want to actually fund the loan, your creditworthiness and bargaining leverage are highest immediately after closing on new equity.
Conversely, soliciting venture debt when liquidity is diminished and the operating runway is minimal will inevitably prove more arduous and more expensive. It helps to recall that the venture industry is highly cyclical and venture debt availability is highly correlated to industry valuation trends. The availability of venture debt and the variety of loan structure options will expand and contract in response to venture capital trends, the direction of valuations in your particular sector and the business cycle across the broader economy. Think of yourself as the proverbial “umbrella shopper.” The best time to test the market is when there isn’t a cloud in the sky, and the worst time is when the storm is already lashing at your windows.
What criteria do venture debt lenders use to underwrite?
How do venture capital firms evaluate venture debt?
How is venture debt priced?
What are most common deal terms for venture debt?
Do loan terms differ based on company stage?
Why do venture debt lenders include warrants in the pricing?
Do venture debt lenders typically take warrants on common or preferred stock?
Is venture debt considered senior debt in terms of the lender’s security interest?
Who offers venture debt?
What is a venture debt fund?
What are key considerations when selecting a venture debt lender?
What is the biggest mistake entrepreneurs make when taking on venture debt?