Start-up Entrepreneurs' Blog

Can’t Afford That Start-Up Expense? Venture Debt In A Nutshell

August 9, 2011

Venture debt or venture lending is a type of debt financing provided to venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses. Back when Google was a start-up, they initially raised $10 million to build their server farm. A generation later, Facebook build a similar server farm for $500,000.  Today’s definition is far more general, it’s any form of debt financing provided to a company that is still dependent on investors to fund its operations.

Unlike traditional bank lending, venture debt is available to startups and growth companies that do not have positive cash flows. Venture debt providers combine their loans with warrants or rights to purchase equity.

So why do venture debt companies take such a risk on these start-ups? No matter what the collateral, if the start-up shuts down, the lender loses. The answer lies in the worthiness of the investors. The lender is betting the investors will fund the company beyond the term of the loan, which is likely if the start-up is backed by investors with deep pockets.

Venture Debt is available to start-ups that have secured at least one round of venture capital financing. Developed startups that are credit worthy with significant assets or cash flow may also tap into venture debt.

Venture debt lenders expect returns of 12–25% on their capital but achieve this through a combination of loan interest and equity returns.

Rates can be as high as prime plus 5%. Draw periods can be within 12 months with repayment in 24 months to 36 months, and even longer for certain types of start-ups.  A lender is also likely to take liens on all of a company’s assets. In the event of a default, the lender can legally take the whole company.

The venture debt deal will also include a warrant, which is a right to buy company’s shares at a fixed price. The concession is negotiable and is often 5% to 20% of the loan amount.

The lender may also seek to obtain some rights to invest in follow on equity rounds under the same terms, conditions and pricing offered to its investors in those rounds.

Equipment can be funded at 100% of the cost of the capital expenditure. Receivables financing is typically capped at 80–85% of the accounts receivable balance. Venture debt can be used for numerous purposes such as bridge financing or just general corporate uses.

The downside to venture debt financing is not only is it pricey, but the lender may add clauses and covenants that restrict a company’s actions such as incurring more debt or issuing additional stock. Events such as a founder leaving the start-up or losing a major customer can trigger some of the undesirable clauses.

Filed under: Start Up Funding

Tags: venture debt financing