Venture Debt

What Is Venture Debt?

Venture debt refers to a financing arrangement wherein companies in their start-up, or early phase are backed by venture capital. The banks or financial institutions fund them to meet their working capital requirement or finance their capital expenses. There is a high risk involved in such debts. Thus, the financers acquire the right to purchase equity shares in the company as a security.

After a round of equity has been closed recently, going for a venture debt will be easier for the companies since creditworthiness will be highest. The companies should ensure that they have sound business plans, ensuring that one can repay such loans at the time. These funds can help companies accelerate their growth and performance.

• Venture debt is a high-risk financing option where banks or financial institutions fund start-ups or early-phase companies backed by venture capital, with the right to purchase equity shares as security.
• The company's last round of equity funding usually determines the amount of approved funds, typically 30% of the total amount raised. These funds are utilized for lending to companies as venture debt.
• Venture debt offers equipment financing, accounts receivable financing, and growth capital. Venture debt is a practical solution for cost-cutting and contingency planning for businesses. It is a viable alternative when other financing options have been exhausted.

How Does Venture Debt Work?

Venture debt is a debt provided by the banks or financial institutions to the companies for the short or medium term. The number of sanctioned funds is based on the last round of equity raised by the company. Usually, amounts equivalent to 30% of the funds raised in the previous equity funding are approved for lending to the companies as venture debt funds.

The interest rates attached to the borrowings may either be a prime rate or a benchmark rate, such as the LIBOR rate.

This kind of funding is highly risky due to the lack of significant collateral or potential cash flows, which is warranted upon the company’s equity capital to protect against the risk. Such a warranty may range from nearly 5% to 20% of the amount of the loan sanctioned. These warranties can be later redeemed as company equity shares at the price that prevailed at the last equity round.

Further, based on the type of lender, the financing agreement may contain other specific conditions. For example, banking companies may impose strict requirements, whereas non-banking companies may relax some conditions.

Types

These are available in various forms, exploring which helps understand the venture debt meaning better. Let us check them out below:

1. Equipment Financing: This financing allows a company to finance the equipment necessary for its operations.
2. Accounts Receivables Financing: This financing is provided by the lenders against the accounts receivable, reflected in the financial statements of the borrower company.
3. Growth Capital: Such funds serve as a source for working capital and milestone financing. These are known as growth capital since they help an organization accelerate its growth.

Why Venture Debt?

Venture debt financing is opted for by investors due to their inclination towards higher liquidation. In these types of debt, the amount is likely to be paid back on time or retrieved through the company equity owned as a backup. It is considered more secure than owning common shares of a company.

Such debts can minimize the cost of capital utilized to finance operations. They can also act as insurance against operational issues and capital requirements that may suddenly arise. If the company does not have any capital source left, the only option is venture debt.

Examples

Let us consider the following examples to understand how venture debt funds work:

Example 1

Company A decides to raise funds and finance its capital requirements for its upcoming project. Being in the budding stage, they decide to go for the venture debt option, given the inexpensive repayment involved. They obtain the fund and buy the resources required for the production as they know the finished goods, once sold, would help yield significant returns.

Example 2

Although raising funds through venture debt may sound prudent, a company should keep itself at bay from such debt in the case of the following scenarios.

• Suppose a company does not have a road map or means to repay the debt. Then, if the loan is not repaid on time, the lenders may overtake the company's assets to make good on its loss.
• One should avoid this debt if the amount payable in installments is greater than nearly 20% of the aggregate operating expenses of the company.
• Do not agree if the additional conditions that form an agreement part are too risky.
• If the company does not have any capital source left, the only option is venture debt.

Advantages

• It is easy for start-up companies to raise funds through debt once they have raised venture capital.
• The companies can get funding without diluting their control by issuing equity shares.
• It is a much cheaper way to raise funds than equity.
• Through these, venture debt providers help companies meet their growth objectives.

Disadvantages

• The financing arrangement may contain strict covenants, non-fulfillment of which can lead to penalties.
• The repayments of the amounts, if not made, can enable the borrower to take control of the company's assets and sell them off, leading to significant risks of bankruptcy.

Venture Debt Vs Venture Capital

The key differences between the two are enumerated below:-

• The major difference between venture capital and venture debt is that this debt needs to repay.
• Capital control is diluted in the case of the venture, which is not the case in venture debt since no equity stocks are issued.
• The conditions are harsher in venture debt, and the consequences can be serious when needs are not met.
• It is cheaper compared to venture capital.

Frequently Asked Questions (FAQs)

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