Overview of Venture Debt
for Technology and Growth Companies

What is Venture Debt?

The Early Days

There are narrow and broad definitions of venture debt. The term “venture debt” or “venture lending” was originally used in the 1970’s to refer to equipment financing (venture loans and venture leasing) provided to early-stage companies. These startups needed to acquire physical assets, such as computer hardware or life sciences laboratory equipment, but lacked the cash flow for traditional debt financing.

The Emergence of Venture Banks

In the early 1980’s, lenders such as Silicon Valley Bank (SVB) created a new type of venture debt financing. Generally, they did not require physical assets nor cash flow. However, they focused on providing loans to startups backed by well-known venture capital firms. The loans were structured to complement the equity provided by the venture capital firms, and were essentially secured by the enterprise value of the startup and the expectation that the venture capital investors would continue to fund the startup in subsequent equity rounds.

The Proliferation of Lenders

During the low-interest rate environment since the Great Recession of 2007-2009, institutional investors have been aggressively seeking out higher yield lending opportunities. Venture debt caught their attention, which has led to a tremendous increase in the number of lenders and types of loans in the market.

This expansion has been so broad that the term “venture debt” and its common definitions are much too narrow. As a result, some industry participants and observers have begun to use the term “growth debt” instead of “venture debt.”

At Find Venture Debt, we agree that “growth debt” has become a more appropriate term as the market has evolved. However, we continue to use “venture debt” as an umbrella term for a broad range of non-dilutive and minimally-dilutive funding since it’s more commonly recognized.

Types of Venture Debt Financing

The complexity of the landscape reinforces our view that “venture debt” is an umbrella term for many types of debt available to startups and other fast-growing businesses. We have identified more than 20 types of venture loans. These range from working capital revolvers to synthetic royalty loans, with most venture lenders providing more than one type. We have distilled these into 10 types:

Lines of credit

Term debt

Equipment financing

Royalty monetization (primarily life sciences)

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Use Cases for Venture Debt

Determining the type of debt that is the best fit for a startup or other fast-growing business is case specific. The table below provides general guidance for pre-revenue, SaaS, life science, and other businesses that should serve as a starting point for consideration.

In the examples, we refer to “equity sponsor,” which means that the company has institutional shareholders such as a venture capital fund or private equity fund. Sponsored companies generally have access to more debt financing options.

Regardless of profitability or equity sponsorship, companies that have collateral can usually borrow money. Debt that is secured by specific assets will have the lowest cost. Therefore, if a business has accounts receivable or inventory, working capital financing should be considered. If they need to purchase fixed assets (e.g. computer hardware, lab equipment), an equipment loan or equipment leasing should be considered.

Venture Debt Example
Debt Financing Alternatives for Startups and Other Fast-Growing Businesses

Pre-revenue: To obtain debt capital, pre-revenue startups need either collateral or venture capital sponsorship.

SaaS: Lenders like recurring revenue so SaaS companies can easily obtain debt financing. Sponsorship is not required. Profitability helps but is not required.

Life science: Working capital financing will usually be available. If a life sciences company receives recurring revenue from licensed IP or an approved drug or medical device, it can obtain royalty-based financing.

Other industries: In other industries, asset-based loans are always available. If a business has recurring revenue or reasonably predictable topline performance, it is a candidate for revenue-based financing. Other borrowing alternatives depend on profitability or equity sponsorship.

As a company progresses from early-stage to late-stage, and as its profitability improves, more financing options become available. The source for a particular type of financing may also change. For example, the only source of senior term loans for early-stage companies is likely to be traditional venture lending such as Square 1 Bank. As the company matures, debt funding from a broader array of sources becomes available.

The debt alternatives for each case are not mutually exclusive. To optimize the capital structure, it is common to utilize more than one, assuming the company has the financial capacity. The goal is not to maximize the total amount of debt but to minimize the weighted average cost of capital.‍

What are the Benefits of Venture Debt Financing?

  • Accelerate growth: Provides growth capital while avoiding or minimizing equity dilution.
  • Extend cash runway: Provides a bridge between equity financing rounds, allowing a company to achieve key milestones and a higher valuation in the next equity round. Can also extend the cash runway until profitability, allowing them to avoid raising additional equity or reach the point at which less expensive capital is available.
  • Prepare for Series A round: A startup that has not completed a Series A equity round may benefit from first raising venture debt. A partnership with an experienced debt investor can accelerate growth while helping management refine strategy and improve operations. These actions should enhance the appeal to venture capital investors and maximize valuation in the subsequent Series A equity round.
  • Easier to obtain than bank debt: Does not require positive cash flow or significant assets to use as collateral.
  • Alternative to raising equity from VC firm: Can be a great alternative when a business needs growth capital but is not growing fast enough to attract a venture capital firm or is not satisfied with the terms offered.
  • Alternative to selling to PE firm: For late-stage companies, can be a great alternative when a business needs growth capital but does not want to sell a controlling interest or is not large or profitable enough to attract a private equity firm.
  • Flexible terms: Less restrictive than banks with regard to amount borrowed, term, amortization, covenants, and personal guarantees.
  • No loss of control: Generally, lenders will not require board seats or other direct involvement in the governance or operations.
  • Quick process: Can be as short as 30 days versus 3-6 months for equity, primarily due to a simpler and faster due diligence process.
  • Does not require sponsorship by PE or VC firm: Although some lenders require that borrowers have VC or PE investors, it is not a universal rule. There are many who will consider both sponsored and non-sponsored companies.

What are the Drawbacks?

  • Debt must be repaid: The borrower must make scheduled principal and interest payments.
  • Equity participation: Depending on the type of debt, the lender may require equity participation.
  • Difficult to estimate the cost of capital: Due to amortization, equity participation, and other features, it can be difficult to estimate the cost of capital.

Frequently Asked Questions

When is venture debt not appropriate?

A company should not raise venture debt if management or the board does not believe the debt can be repaid. Seriously, venture debt is debt; the lender expects to be repaid. Venture debt should not be used when a business is on a downward trajectory, nor should it be used as a last resort source of capital. Debt provides leverage; it makes the upside better for equity holders but makes the downside worse. A company should also avoid venture capital loans if the terms offered by the lender(s) are not attractive; not doing a deal is usually better than doing a deal that is too expensive or restrictive.

How do you select a lender?

It is beneficial to talk with several lenders, so you can compare pricing and terms. In addition, you have to consider whether the lender will be a good partner. Although a lender may not be as involved with your company as a venture capitalist, the good ones can be a great source of advice and introductions. Although it may not seem relevant when you are raising capital, it is very important to determine whether the lender has a good reputation for working with borrowers when a restructuring is necessary. Talking with companies and venture capitalists who have previous experience with the lender can provide valuable insights.

In some cases, capital can be obtained from two sources. Banks usually provide the least expensive capital, but their loan size is constrained due to regulatory requirements. Specialty finance firms and venture debt funds are less constrained but more expensive. Combining the two maximizes the amount raised while minimizing the weighted average cost of capital.

What happens if the debt cannot be repaid?

If a borrower cannot repay the debt using cash on its balance sheet or the proceeds from an equity financing, there are two alternatives:

  • Refinancing – find another lender to replace the existing lender.
  • Restructuring – negotiate an alternative payment plan with the existing lender.

If the business is on an upward trajectory, it can usually repay the loan using through an equity raise or a refinancing.

If the business is on a downward trajectory, restructuring may be the only alternative. Most, but not all lenders, will try to restructure the debt. One of the most important criteria in choosing a lender is whether they have a good reputation for working with borrowers when a restructuring is necessary. Of course, it is also important for the borrower to maintain open and frequent communication with the lender when times are good. This helps establish a relationship of trust and avoid negative surprises from the perspective of both the borrower and lender.

What do venture lenders look for in potential borrowers?

Lenders look at some of the same factors as equity investors: quality of management team, product-market fit, repeatable sales process. The primary difference is that lenders are far more focused on protecting their downside than hitting a home run. Therefore, market size and high growth potential are less relevant. Although other criteria vary widely by loan type and lender, below are a few guidelines.

  • Size: In certain cases, pre-revenue startups are able to borrow. However, for most loan products, venture debt firms require minimum annual revenue of at least $200,000 to $1 million. There is no practical maximum; many late-stage "unicorns" utilize venture debt financing.
  • Recurring revenue: Recurring or predictable revenue is preferred.
  • Growth: Positive historical and projected growth, but can be much lower than the high growth required by equity investors.
  • Gross margins: High gross margins are preferred since operating costs can be reduced, if necessary, to make interest and principal payments.
  • EBITDA: Business should be cash flow positive or close to it.
  • Total debt obligations: For an unprofitable business, debt capacity is difficult to estimate. A rule of thumb for SaaS and subscription based companies is 3x to 6x MRR (monthly recurring revenue). For profitable businesses, 3x to 4x annual EBITDA is a good rule of thumb.
  • Industry: Can be technology or non-technology sector.
  • Ownership: Do not have to be sponsored by a venture capital or private equity firm.

What are the key provisions of a venture debt term sheet?

  • Structure: Can be structured as senior or subordinated. Since venture lending is more risky than traditional senior debt, the lender often receives an “equity kicker” in the form of warrants to purchase common stock.
  • Amount of loan: Depends on the borrower’s size, profit margins, existing financial leverage, and other factors. The minimum is typically $50,000. The maximum can exceed $100 million.
  • Term: Usually 2 to 5 years.
  • Amortization: Often includes an interest-only period followed by scheduled amortization. Some loans may be interest only with 100% of principal due at final maturity (also called a “bullet loan”).
  • Interest rate: 5% to 14% annually.
  • Equity participation: The lender will usually require warrants or other equity participation. The ownership percentage will vary depending on the lender’s required rate of return, the borrower’s expected growth, and other factors.
  • Collateral requirements: Varies, may be secured or unsecured obligation of the borrower.
  • Restrictive covenants: Banks tend to have the strictest covenants. Non-banks tend to have minimal financial maintenance covenants such as coverage ratios. However, all lenders will likely require affirmative covenants and negative covenants. Affirmative covenants require the borrower to take certain actions such as paying required taxes, maintaining financial records, maintaining adequate insurance, etc. Negative covenants limit actions that the borrower can take without the lender’s permission such as borrowing additional money, paying dividends to shareholders, selling significant assets, or other actions that may affect the ability to repay the loan.
  • Governance: Venture banks and most venture debt funds do not require board seats or other direct involvement in governance.
  • Personal guarantee: Usually not required.
  • Access and audit rights: A normal requirement is access to financial statements and bank account data to monitor the borrower’s financial performance and verify compliance with loan agreement.

If the borrower has multiple lenders, an intercreditor agreement is usually required. This is an agreement between the senior and subordinated lenders, which specifies how their relative rights and obligations are enforced in a distress or bankruptcy situation.

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What companies provide venture debt financing?

There are a half-dozen commercial banks with venture lending arms that are the best known providers. The venture banks include:

Banks are subject to significant regulatory constraints, which limit the amount they can lend to each company and subject the borrower to restrictive covenants. There are 15-25 non-bank lenders that specialize in traditional venture lending and venture leasing. They have a higher cost of funds but provide larger loan amounts and more flexible terms.

During the past ten years, new providers of venture debt have emerged which focus on a specific industry (e.g. SaaS, life sciences), loan product (e.g. MRR line, revenue-based financing), stage of development, or geographic region. In addition, many debt funds focused on the middle market have become more interested in expansion-stage and late-stage lending. Companies with recurring revenue business models have been the largest beneficiaries of this trend.

Resources and Related Blog Posts:

Bessemer Venture Partners' Ten Questions Every Founder Should Ask before Raising Venture Debt

Venture Debt Is Not What it Used To Be...and That's Good News for Potential Borrowers!

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