What is venture debt?

Early-stage companies in the technology and life sciences sectors often have trouble borrowing money from traditional banks and lenders due to a lack of revenue/profitability and established track record. A few decades ago, several smaller banks began tailoring their loan offerings and other financial products to specifically target venture-backed companies. “Venture debt” typically refers to non-dilutive term loans or revolving lines of credit that start-ups use to fund company expansion or acquisitions, or to extend runway until the company’s next equity round.

Start-ups are usually able to take advantage of venture debt offerings only after successfully raising venture capital. Venture lenders use venture capital investments in their underwriting process to validate a company’s ability to grow and repay its debts.

Venture debt should not be confused with convertible debt, which is issued to investors with the expectation that the debt will eventually convert to equity rather than be repaid. Venture lenders, on the other hand, expect their loans to be repaid in full, either out of company revenue or out of the proceeds of a company sale or IPO. However, venture debt can still be slightly dilutive, as lenders often receive stock warrants as a condition of making the loans.

Common features of venture debt include:

• Securitization: Loans might be secured by some or all of the assets of the company. If a start-up is unable to meet its debt obligations, it may face default, which can lead to a loss of assets, damage to the company’s reputation, and potential legal action from lenders.
• Subordination: Any existing or future debt or liens may need to be subordinated to the venture debt.
• Restrictive Covenants: Venture lender consent may be required before the company is permitted to issue additional debt or equity, enter into a merger or acquisition, license or sell its intellectual property, or undertake other significant actions.
• Flexible Repayment Terms: Term loans are often amortized over several years, with a period of up to a year to draw down the loan. Lenders may offer initial interest-only periods of 3-to-12 months.
• A Thorough Diligence and Underwriting Period: Companies should expect the approval and closing process to take one-to-three months.
• Increased Financial Burden: Venture debt increases a start-up’s financial obligations, as companies must service the debt through regular interest payments and eventually repay the principal. This can put pressure on cash flow, particularly for businesses with fluctuating or uncertain revenue streams.

Venture debt can be a valuable financing tool for start-ups that have successfully raised venture capital and are looking to minimize dilution while funding their growth. However, companies and their founders should carefully consult with their legal counsel, accountants, and other advisors to weigh the benefits and risks before pursuing this financing option.

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