Capital is an essential concern of emerging growth companies. They have to secure the proper amount of capital in order to grow efficiently. Besides, the cost is also critical for them. Venture debt is a type of debt obtained by newly established companies or startups.
Companies usually use venture debt usually as a complementary method. Both banks and non-bank lenders can provide venture debt. Venture debt can be a viable option for equity venture financing. Its main benefit is preventing the further dilution of the equity stake.
Breaking Down Venture Debt
Venture debt is different from conventional debt. It does not require any form of collateral. Since startups generally do not own substantial assets, this will be a perfect alternative for them. In another hand, the company’s warrants compensates the lenders.
Venture debts are usually given to startups that have completed several rounds of venture capital fundraising. These companies have a history of operations. Yet, they do not have sufficient positive cash flows. Thus, they are not eligible to obtain conventional loans.
Companies usually uses it to reach anticipated milestones. They also usually aim to acquire capital assets they have expected.
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How does it work?
It is generally different from conventional loans. The debt is naturally short-term (three to four years). The amount raised in the last round of equity financing determines the amount of the debt. The commonly acceptable amount is 30% of the total fund raised previously.
Venture debt’s majority instrument involves interest payments. The payments are based on their prime rate or an interest rate benchmark.
Additionally, lenders receive warrants on the company’s common equity. The compensation for the high default risk is the company’s warrant. The total value of distributed warrants generally represents 5% to 20% of the loan.
In the future, they can convert the warrant into common shares. Moreover, the venture debt process can also include covenants. The number of covenants depends on the loan agreement.
