Closing an equity financing deal with a venture capital investor is a major milestone for many startups. But like everything, equity financing comes with a cost.
With each priced round, startup leaders are effectively selling pieces of their company. In an economic downturn, startups risk raising money on a “down round” – meaning they’re forced to give up more equity for the same amount of capital when compared to more favorable markets.
Looking for a way to raise capital and extend runway without selling more equity? Venture debt is one source of non-dilutive financing for startup leaders to explore.
Recently Brendan Syron, Director at Triple Point Capital, and Ruslan Sergeyev, Senior Vice President of Venture Debt at Pacific Western Bank (PacWest) – two venture debt lenders – joined us to explain venture debt vs. venture capital and share insights for startup leaders to consider.
Venture debt is a way for startups to increase cash flow without eating up equity. We’ll explain the basics of this form of financing, and then follow with four expert tips.
What is venture debt financing?
Venture debt is capital that is loaned to equity–backed companies – and paid back to the lender with interest – as a supplement to equity financing. Venture debt allows companies to take on loans that follow their equity model while enabling founders and early investors to avoid immediate dilution. Many venture debt deals will give the lendor an option to buy equity at a discounted rate in the future.
Loans are typically administered by venture banks and specialized debt funds focused on the venture ecosystem. Venture debt is normally used by early-stage, high-growth companies. It makes up roughly 10% of the venture market.
Venture debt vs. venture capital
In the venture debt vs. venture capital debate, there’s one key difference: venture debt issuers take little to no equity in the company, while venture capital firms tend to take a sizable equity stake in exchange for capital.
Venture debt issuers profit off the interest that’s paid back on their loan – and may take advantage of their right to discounted equity in a future round. The downside comes in the stricter terms that often accompany venture debt deals.
4 things to know about venture debt financing
Now that you understand the foundational elements of venture debt, let’s hear from the experts. Here are four insights, outlined by webinar guests and venture debt lenders Brendan Syron and Ruslan Sergeyev
1. Venture debt helps startup leaders avoid equity dilution
Companies searching for more capital may be quick to call up their VC contacts for another round of financing, further diluting leaders’ ownership of the company. Alternatively, capital that wasn’t part of the initial equity plan can be acquired through venture debt.
“A lot of founders do get laser-focused on their equity financing strategy,” said Syron, Director at Triple Point Capital . “The cost of that capital can sometimes be opaque because you're not giving up that dilution until there's the exit…That dilution can actually be a lot more expensive in the long-term versus the venture debt interest that you're paying over time.”
Most companies raise venture debt just after, or in lockstep with, a round of Series A, B, or C funding. This is when companies have the most cash on their balance sheet, which often provides them more flexibility on terms with their lenders.
2. Strict loan covenants bring risk to venture debt deals
No capital is truly free, so it’s important to understand some of the risk associated with taking on venture debt. If your company takes on venture debt and things don’t go according to plan, investors may stop putting in new capital. Additionally, venture loans often come with covenants that can restrict a company’s behavior.
However, a venture debt agreement doesn’t have to be an adversarial relationship. Sergeyev points out that all parties involved — company, lender and previous investors — are in it together. Being punitive or “not playing nice in the sandbox” doesn’t help anyone.
“We're really not in this business to do anything other than lend into and support these emerging companies,” said Sergeyev, Senior Vice President of Venture Debt at PacWest. “It's kind of up to us and the company to really think through a way to work through any issues and get to the next inflection point.”
3. Not every venture debt partner is equal
One way to mitigate risk is to foster positive relationships with venture debt partners. Once a company shows its interest in venture debt, firms like Triple Point Capital and PacWest will schedule a kickoff meeting. That’s when they understand a company’s goals, and come back about a week later with a structure for the deal.
The whole process of taking out a venture debt loan might only take 4-6 weeks, with most of that time reserved for due diligence checks from each side’s legal counsel. Sergeyev says to watch out for any lenders that are moving too quickly to provide loans, as they likely aren’t doing their due diligence. This can lead to hassles and bank switches down the line.
“As quick as these fast-acting firms enter the market, we see time and time again, they leave the market just as quickly,” Sergeyev said
4. Venture debt can extend runway and fund new launches/hires
A typical venture debt loan represents about 30% of the value of the company’s most recent equity raise, according to the panelists. Traditionally, companies that are drawn to venture debt are part of more capital-intensive industries such as frontier tech, e-commerce and biotech.
Potential uses for extra capital include R&D, sales and marketing, funding a new business line, or just having the insurance to extend their runway. This can keep your company on track for sustainable scaling.
“Venture debt can play an important role in helping scale up your company and increase your growth rate,” Syron said.