Venture debt is a type of financing for startup companies and young businesses. It comes with the highest interest rates and features flexible repayment terms, but can make it difficult to manage cash flow when you’re still building your company’s profitability.
Venture debt is a type of financing that allows companies to raise funds by issuing securities. Brex offers a range of venture debt products for both public and private companies.
As a startup or a high-growth company scales and encounters new milestones and barriers, the issue of how to fund and prepare for that development will arise.
Fortunately for entrepreneurs, there are a variety of methods to fund your company, depending on your business model, preferences, objectives, and timeframe, among other factors. There are a variety of financing methods available, but venture debt is one of the most popular.
If you have liquidity or previous financial support from a well-known investor, venture debt is a highly cost-effective approach to get funding from a large financial institution. Banks will lend to companies that have institutional investors, such as a well-known venture capital company, or that are producing a particular level of income that will ensure their investment is safe.
What are the disadvantages of venture debt? Even if the interest rate is modest, there is a lot of monthly reporting to the banks that goes into the arrangement. You’re effectively giving up your “financial kimono” to a new organization, which many developing firms may see as a disadvantage (think monthly income statements, balance sheets and compliance certificates, annual tax returns, collateral audits, and more). There are also a lot of legal expenses involved in getting the sale done.
Here’s the lowdown on what obtaining venture financing entails for businesses, when they should consider it, and how to negotiate the best conditions.
Who is the provider of venture debt?
There are a large number of banks and financial organizations that specialize in this form of lending. SVB, Square 1, and others are examples.
What makes venture debt so appealing?
If you have money or support from an institutional investor, venture debt is a no-brainer. Venture debt capital has a very low cost of capital. If you make a lot of money, you may acquire loans with very cheap interest rates. It’s practically unrestricted cash.
Wait, wait, wait—this isn’t free money, is it?
No, it isn’t. However, in terms of interest rates, it is a less expensive option to get funding.
Why are banks lending money to businesses that have a history of failure?
Banks don’t lend money to startups because they’re excellent at it or because they have a strong business concept. Banks are lending to businesses that have access to institutional investors’ funds, such as well-known venture capital firms.
Banks are investing in businesses with investors who are likely to continue with them beyond the loan’s duration. They also know that most VC companies would offer a business a set amount of money up front, with a reserve in case the company needs more later. Essentially, banks are banking on venture capitalists to bail out a firm if necessary.
So it’s not open to just any old startup?
Unfortunately, no. And that is a key point we want to convey here: before you start the process of obtaining venture finance, learn what the banks are searching for so you don’t waste your time.
So, what kinds of businesses are eligible for venture debt?
Because banks demand a seed or A round of VC or institutional financing, it’s a good time to explore venture debt after you’ve gotten a seed or A round of VC or institutional investment. As previously said, banks want to know if your firm is backed by a well-known investor.
Unfortunately for many early-stage companies, banks will not provide venture loans if the company is supported by unknown or angel investors. Even if you’ve collected $2 million from friends and family and have a lot of cash to work with, you won’t be able to secure the bank’s commitment until you have a stable reserve from institutional investors.
Another important stipulation? Revenue. It’s difficult to get venture finance until you have income, and banks will want to know whether you’re profitable or not. As part of the venture debt, banks may investigate to see if they can issue you an asset-backed loan. As a result, they may offer you a loan based on your revenue—a factor of MRR or a factor of receivables, for example. Instead of your capacity to create cash, asset-based borrowings are restricted by the collateral base, which is determined by the liquidation value of accounts receivable, inventories, and fixed assets.
Finally, banks, like traditional investors, will assess the team and product to see whether they are a good match.
Are there any disadvantages to taking out venture debt?
While the interest rates may be modest, you must repay the loan. You’re also exposing your company to a significant, external cash source that isn’t a standard VC or institutional investment. Maintaining the bank’s satisfaction requires a significant amount of additional reporting. Most banks need you to provide regular updates, including monthly income statements, balance sheets, and compliance certifications, yearly tax reports, collateral audits, and so on.
When it comes to collateral, lenders may place a lien on your assets, giving them the right to hold them until you repay them. This can even include your intellectual property assets, albeit this is negotiable and should be included into your selection on which lender to engage with.
Finally, although the amount varies depending on the lender, you will be responsible for paying the legal expenses involved with obtaining the loan. This is important to remember since legal expenses may add up to tens of thousands of dollars to your debt.
What are some of the most common terms from a lender?
Terms might be confusing, but Wikipedia does a good job of deciphering them and explaining how they differ from traditional bank loans:
- Repayment terms range from 12 to 48 months. For a time, it may be interest-only, then interest + principle, or a balloon payment (with rolled-up interest) at the conclusion of the term.
- The rate of interest changes depending on the yield curve in the market where the loan is being sold. Interest rates for equipment financing in the United States are as low as prime plus one or two percent. Prime + three percent for accounts receivable and growth capital loans.
- Warrant coverage: The lender will ask for warrants covering equity in the range of 5% to 20% of the loan’s value. At the per-share price of the previous (or contemporaneous) venture funding round, a part of the loan’s face value may be converted into equity. When the firm is purchased or goes public, the warrants are frequently exercised, giving the lender a “equity kicker” return.
- Rights to invest: The lender may want certain rights to participate in the borrower’s following equity round on the same terms, conditions, and price as its previous equity round investors.
- With venture financing, borrowers are subject to less operating constraints or covenants. Minimum profitability or cash flow constraints are common in accounts receivable loans.
For the most part, a startup’s interest rate should not exceed four or five percent. Most banks will impose an origination fee, but this should be compared amongst providers—if they want to charge you more than $25,000, that’s definitely too much.
Furthermore, banks may insert into the conditions that if you do not leverage all of the money, they can charge you around 1.5 percent per year on any unused cash. In general, there is opportunity for bargaining, so don’t agree to conditions that you aren’t happy with.
Do you have any other venture debt questions? Send us a message on Facebook or Twitter, and we’ll try our best to respond.
Frequently Asked Questions
How do venture debt funds work?
A: Venture debt funds are privately managed investment vehicles for high-risk capital. They exist due to the desire by investors to take on risk in order generate higher returns than traditional investments like stocks and bonds with lower volatility. Venture debt instruments can be used as a source of finance, but they also make it easier for entrepreneurs who may not qualify or want to go through an IPO process that exposes their companys confidential business information before the public market is ready.
What is venture debt used for?
A: Venture debt is a type of loan that companies can use to fund their businesses. Its often used by startups or small business owners who are looking for funds at high interest rates.
What are the four types of debt financing?
A: There are four types of debt financing. These include loans, bonds, mortgages, and derivatives.
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