For startups and high-growth businesses, as you scale and encounter new milestones and obstacles, you will be faced with the question of how to finance and plan for that growth.
Luckily for founders, the ways in which you can finance your startup are varied based on your business model, your preference, your goals, and timeline, and so on. There are a wide range of options for finance, but one of the more common choices is venture debt.
Venture debt provides a very cost-effective way to receive capital from a big financial institution if you have liquidity or existing financial backing from a well-known investor. Banks will loan to startups that have access to the pockets of institutional investors, like a well-known VC firm, or that are generating a certain amount of revenue that will foolproof their investment.
The downsides of venture debt? While the interest rate is low, there is a lot of reporting to the banks that goes into the deal on a monthly basis. You’re essentially opening up your “financial kimono” to a new entity, which might be viewed as a negative to many growing businesses (think monthly income statements, balance sheets and compliance certificates, annual tax returns, collateral audits, and more). There are also a good amount of legal fees that go into procuring the deal.
Here’s the scoop on what raising venture debt means for startups, what and when they need to consider it, how to negotiate the best terms, and more.
Who provides venture debt?
Why is venture debt desirable?
Venture debt is a no-brainer if you have liquidity or backing from an institutional investor. The cost of venture debt capital is very, very low. If you’re generating a lot of revenue, you can get incredibly low-interest rates. It’s essentially free money.
Wait, wait, wait—it’s not actually free money, right?
No, it’s not. But, it’s a cheaper way to get financing from an interest rate perspective.
Why are banks giving money to startups, which are known for failing?
Banks aren’t loaning money to startups because they’re good for it or because the bank is confident in their business model. Banks are loaning to startups that have access to the pockets of institutional investors, like well-known VC firms.
Banks are investing in startups with investors that will likely stick with their investment past the terms of the loan. They also know that most VC firms will give a startup a certain amount of capital, but include a reserve, should the startup need more down the road. Basically, banks are betting on VCs bailing out a startup if needed.
So, it’s not available to any old startup?
Sadly, no. And that’s an important message we want to get across here—before you get into the process of trying to obtain venture debt, understand what the banks are looking for so you don’t waste your time.
Okay, what type of startups qualify for venture debt?
A great time to consider venture debt is after you’ve received a seed or A round of VC or institutional funding, as this is a pretty big requirement for banks. As mentioned, banks want to know that your startup has a well-known investor backing the business.
Unfortunately for many early startups, banks won’t grant venture debt if you’re backed by unknown investors or angel investors. For example, even if you’ve raised $2 million from friends and family and have a lot of capital to work with, you don’t have the reliable reserve from institutional investors that then ensures the bank’s investment.
Another big qualification? Revenue. It’s very hard to raise venture debt pre-revenue, and banks will look to see if you’re breaking even or profitable. Banks might also look to see if they can grant you an asset-backed loan as part of the venture debt. So, they might loan against your revenue—a factor of MRR or a factor of receivables. Asset-based borrowings are limited by the collateral base, measured by liquidation value of accounts receivable, inventory, and fixed assets, instead of your ability to generate cash.
Finally, like traditional investors, banks will also evaluate the team and the product to determine if they see a fit.
Are there any downsides to venture debt?
While the interest rates can be quite low, you do have to pay it back. Additionally, you’re opening your business up to another large, external financial source that’s not your traditional VC or institutional investor. There’s a good deal of extra reporting that goes into keeping the bank happy. Most banks have you sending updates on a monthly basis—items such as monthly income statements, balance sheets and compliance certificates, annual tax returns, collateral audits, and more.
Speaking of collateral, lenders can take a lien against your assets—basically, a right to keep assets until you pay them back. This sometimes even includes your IP assets, though this is negotiable and should be part of your decision on the lender you choose to work with.
Finally, while the amount can vary based on the lender, you will have to cover the legal fees associated with securing the financing. This is something to keep in mind, as legal fees can be tens of thousands of dollars on top of your debt.
What are typical terms from a lender?
Terms can vary—Wikipedia does a solid job of breaking them down and discussing how they differ from typical bank loans:
- Repayment: ranging from 12 months to 48 months. Can be interest-only for a period, followed by interest plus principal, or a balloon payment (with rolled-up interest) at the end of the term.
- Interest rate: varies based on the yield curve prevalent in the market where the debt is being offered. In the U.S., interest for equipment financing as low as prime rate plus one or two percent. For accounts receivable and growth capital financing, prime plus three percent.
- Warrant coverage: the lender will request warrants over equity in the range of five percent to 20 percent of the value of the loan. A percentage of the loan’s face value can be converted into equity at the per-share price of the last (or concurrent) venture financing round. The warrants are usually exercised when the company is acquired or goes public, yielding an “equity kicker” return to the lender.
- Rights to invest: On occasion, the lender may also seek to obtain some rights to invest in the borrower’s subsequent equity round on the same terms, conditions, and pricing offered to its investors in those rounds.
- Covenants: borrowers face fewer operational restrictions or covenants with venture debt. Accounts receivable loans will typically include some minimum profitability or cash flow covenants.
For the most part, startups shouldn’t have an interest rate higher than four or five percent. Most banks will charge an origination fee, but this should be compared amongst providers—if they’re trying to charge you upward of $25,000, that’s probably too high.
Further, banks can also write into the terms that they can charge you approximately 1.5 percent on unused funds per year should you not leverage all the money. Generally speaking, there is room for negotiation, so don’t settle on terms you aren’t comfortable with.