Venture debt emerges when startups seek growth without surrendering equity. This risk-oriented financing option has become a valuable complement to venture capital. What should every startup know about venture debt?
Venture debt is a well-known term in the startup world (it is also known as venture lending). First, it was used in the 1970s. Back then, banks like Silicon Valley Bank (SVB) provided venture debt to finance hardware, machines, and office equipment. A lot has happened since then, and venture debt is no longer an option for financing tangible goods.
This article explores how venture debt works, what kind of eligible criteria there are, and how venture debt and venture capital play together.
What is venture debt?
Venture debt is a form of debt financing (risk loan) provided to early-stage, high-growth companies. It serves as a complement to equity financing, often used by startups and companies that have already received venture capital funding and wanted to grow further. Therefore, it is also called growth capital.
While equity financing involves selling shares of the company to raise capital, venture debt allows companies to borrow money with the obligation to repay it over time, usually with interest. This financing tool has gained popularity due to its ability to provide capital without significant dilution of ownership. Venture debt loans are usually provided shortly after or during an equity financing round. This venture loan ensures that startups receive debt financing between their equity rounds.
Institutional investors in the form of venture debt funds, banks, or government funds act as venture debt lenders.
Definition and characteristics
Venture debt is a type of loan specifically designed for venture-backed companies. It is typically provided by specialized venture debt funds or banks and is structured to meet the needs of startups and growing companies. Key characteristics of venture debt include:
- Non-dilutive financing: venture debt does not require companies to give up ownership stakes. This allows founders and early investors to retain more control over the company.
- Subordinated debt: venture debt is often subordinated to other forms of debt, meaning it has lower priority in case of liquidation. This makes it riskier for lenders but also more flexible for borrowers.
- Warrants: lenders may receive warrants, which are rights to purchase equity at a later date, as part of the loan agreement. This provides lenders with potential upside if the company performs well.
- Short to medium-term: venture debt typically has a repayment period ranging from 12 to 48 months, making it a short to medium-term financing option.
How venture debt works
Venture debt is usually structured as a term loan or a revolving line of credit. The process involves the following steps:
- Loan application: companies apply for venture debt, providing financial statements, business plans, and information about existing venture capital investors.
- Due diligence: lenders conduct due diligence to assess the company’s financial health, growth prospects, and the credibility of existing investors.
- Loan agreement: upon approval, a loan agreement is drafted, detailing the terms and conditions, including the interest rate, repayment schedule, and any warrants.
- Funding and repayment: once the agreement is signed, funds are disbursed. The company then makes periodic interest payments and eventually repays the principal amount according to the agreed schedule.
Venture debt is particularly interesting for startups that have made it through the seed phase and need an injection of cash for their further growth. At this stage, they have raised equity, generated revenue, developed a product, and have a product-market fit.
Scaling further growth is very capital-intensive. Since the focus is not on profitability, startups burn money (cash burn) during this phase. Therefore, they continuously need new cash to finance growth measures and to extend their cash runway. However, their cash flow is not sufficient, or even intended for this purpose.
Typically, early-stage companies now have two choices of traditional financing instruments to finance growth.
Which financing instrument is the right one?
The first option is a bank loan.
However, most startups are hardly eligible for a loan. They usually cannot provide any securities or assets that would be of interest to a traditional financial institution.
After all, the business model of a tech startup is not something banks deal with daily – there is a lack of relevant experience and knowledge about it. Traditional banks work with predictable cash flows, cash balances, and profitable companies.
The second option is equity, meaning venture capital.
Business angels, later venture capital funds, and family offices are available at the initial stage. Startups, however, do not want to finance themselves in new equity rounds. There are three main reasons for this:
- Every equity funding involves a dilution of shares.
- Dilution reduces control, because VC investors actively influence the company, are part of the board, and give advice.
- VC rounds are time-consuming for founders and tie-up resources.
Venture debt follows venture capital – but does not replace it
If traditional avenues such as banks and venture capital firms fall through the cracks, venture debt can be an alternative form of financing for startups. By providing debt, startups can scale their business model and finance growth.
The startup does not have to give up too many shares too early (with warrants being an exception). It allows the company to reach further milestones and creates the basis for the next VC funding.
Typical growth measures that a startup finances with venture debt are:
- Purchase of operational equipment such as hardware or machinery
- Capital for acquisitions (M&A)
- Increasing revenue (e. g. marketing campaigns)
- Hiring of new employees
- Preliminary costs of a planned initial public offering (IPO)
Usually, venture debt accompanies existing equity financing. It follows venture capital, but it does not replace it. Venture debt and venture capital go hand in hand.
Thus, a good time for venture debt financing is directly following or during an equity round. Why?
- The startup has strong liquidity and is well-funded for the coming months or years. The costs of venture debt can be repaid with the help of equity.
- Venture debt lenders follow the results of the most recent equity round: They use the startup's valuation in terms of goals, performance, and enterprise value to allocate venture debt.
Who issues venture debt?
In Germany, "Kreditanstalt für Wiederaufbau (KfW)" with its "Venture Tech Growth Financing" acts as investors in venture debt. In Europe, it is the European Investment Bank (EIB).
While it is not required for the EIB to cooperate with a private venture debt fund, KfW finances exclusively in cooperation with private funds. Venture debt investors with a government background tend to work with early-stage companies over a longer period. According to the EIB, five to seven years.
Private vs. government providers
In the case of venture debt from the private sector (banks and funds), there are now multiple providers (a list is at the end of this article). One of the most active was the Silicon Valley Bank until its dissolution in 2023.
They usually lend debt capital for one to three years. From the lender's point of view, repayment evolves from the revenues a company generates from the previous VC financing round. In addition, the venture capital itself may still be available as an option for repayment.
Venture debt is a popular method of financing startups, especially in the US, China, and Israel. In 2022, around $45 billion was invested in young companies via venture debt in these three countries. In Europe, the financing volume with venture debt amounted to around $28.1 billion in 2022. Among the most active investors in debt funding rounds are the European Investment Bank, Bpifrance, BNP Paribas, Deutsche Bank, and HSBC.
How startups can secure venture debt
There are various requirements and processes for startups when using venture debt, depending on the investor.
Venture debt with a government background
For venture debt from the public sector, there is usually a distinct set of requirements for startups.
The german Kreditanstalt für Wiederaufbau (KfW) has been supporting young and innovative technology companies looking to finance their future growth with its venture debt program since 2019.
Startups must meet the following criteria:
- Startup must have raised venture capital
- No banks, insurance companies, or comparable financial institutions have a stake of more than 25% in the company
- The investment is made exclusively in combination with private venture debt providers, whereby the goal is a risk distribution of 50:50.
The European Investment Bank also has several requirements:
- That have received at least one round of equity financing from venture capital
- Where the EIB provides a maximum of 50% of the planned investment
- Which are strategically crucial to the European Union, e. g. AI, Industry 4.0, or circular economy technologies.
Venture debt financing from private companies
Similar to government players, equity financing is essential to venture debt funds. Usually, a startup must have secured at least one VC financing beforehand.
Other criteria for securing venture debt:
- Sustainable business model that has proven to be robust in the market
- Stable revenues and corresponding growth
- Reliable customer base
- A market that offers sufficient growth potential
- A team that has experience in scaling a startup and taking it to the next stage of growth
Of course, the requirements of venture debt funds are less transparent than government providers. Nevertheless, their offer is for startups that have passed the seed phase and are on the way to Series A or further equity financing.
Typically, startups must submit a detailed description of their investment expenditures and financial planning.
Venture debt firms review the submitted documents in light of their financial viability and economic profitability. In addition to due diligence and personal interviews, social, environmental, and climate aspects also play a role in the decision.
Venture Debt has its price
As with any form of financing, venture debt offers advantages and disadvantages. Startups should evaluate these carefully before making a decision.
The advantages of venture debt
- Startups gain access to debt capital.
- Venture debt can ensure that there is less dilution.
- Venture debt ensures that startups can continue to finance their growth.
- With the help of venture debt, startups can overcome financial bottlenecks (extend their runway) and use this extra time to reach important milestones and further develop their business.
- Venture debt can help startups to achieve a better valuation for the next equity round.
- Venture debt has repayment terms of up to several years.
- The disbursement of the debt capital can be structured as a credit line in two phases: In the first phase, interest is paid (interest-only), and in the second, interest and principal are paid. This structure relieves the cash flow of a startup.
The downsides of venture debt
- Venture debt providers cover their risks well. It means higher costs for startups. The costs are driven by three components:
- Upfront payments after the closing of the venture debt deal.
- Interest rates are higher than conventional loans and range from 8% to 15%, sometimes even more than 20%.
- Warrants give venture debt investors the right to buy shares in the company at a certain price.
- Warrants mean that there is a dilution of shares. Investors get co-determination rights and can actively influence the company. It limits the control of founders.
- Some venture debt agreements come with an equity kicker. It's a provision that allows the venture debt lender to convert some or all of their loan into equity at a predetermined price. This gives the lender an additional stake in the company's success.
- As with a VC investment, venture debt can take a long time. In the European Investment Bank's own words, up to nine months. That can be a problem for startups with an urgent need for capital.
- Regardless of how a startup develops: It needs to pay interest on its venture loan. Startups may find themselves in a position where they cannot repay the loan within the agreed-upon timeframe.
- If interest or repayment installments cannot be paid, venture debt lenders can impose surcharges or, in the most extreme case, cancel the contract.
- Venture debt is given priority over equity investors, e. g. in the event of insolvency, the lender's claims are settled first.
Types of venture debt financing
As an alternative financing instrument, venture debt is available to startups in various forms.
Growth capital
As mentioned, startups use venture debt to finance their growth and the measures associated with it. Startups thus create a better position for the next equity round. For lenders, the allocation of growth capital is associated with significantly higher risks.
Equipment financing
If you want to grow, sometimes it is necessary to purchase specific goods. It can be new computers, office equipment, or servers. But it can also be machinery or raw materials for production.
In this case, startups can use venture debt, which works as working capital. For lenders, this means less risk. If the startup cannot meet its payments, the venture debt firm can sell the goods or equipment. It thus serves as collateral for the lender.
Factoring
Startups can also use venture debt in the form of factoring or accounts receivable financing.
Factoring involves the startup selling its outstanding receivables from customer invoices to the venture debt lender. In return, it receives part of the invoice amount directly as capital from the lender. The lender charges a fee and then collects the invoice amount from the customer.
The startup is immediately liquid and does not have to wait several weeks or months for money. It is particularly advantageous in the case of long payment terms. At the same time, the lender takes over receivables management, including dunning and collection procedures. Startups also save time and resources.
Bridge loans
Bridge loans are short-term loans intended to bridge the gap between funding rounds or significant business milestones. They provide temporary financing to cover operational expenses, payroll, and other urgent needs until the next equity round is secured. Bridge loans are often used by companies anticipating a near-term liquidity event.
The role of venture debt and venture capital
To better understand venture debt, it helps to have a look at venture capital.
In general, venture debt follows venture capital – and that has consequences. The motives of the respective providers of debt and equity are often contradictory.
Who pursues which interests?
Venture debt investors carry the risk that the startup will neither make it to the next financing round nor be able to repay the loan. Therefore, they cannot afford a high default rate. Lenders hedge their risk with correspondingly high interest rates, subscription rights, or other collateral.
It is a different ball game with equity capital.
In the case of venture capital, failure rates are part of the business model. VCs compensate them with a portfolio that is as diverse as possible, where one successful investment can make up for several failed investments.
Venture debt: high interest, high risks?
Venture debtors do not carry the same risk as VCs. However, they also do not participate in the success of the startup.
If a startup can no longer service its loan with venture debt and, in the worst case, has to file for insolvency, this has consequences for all shareholders. They rank after the venture debt lender. Accordingly, they are subordinated as investors in equity and receive money only after the claims of the venture debt lender have been serviced.
Focus on cost of capital
VCs will pay attention to their startups' cost of capital. If interest rates burden cash flow and restrict the scope for action regarding investments, the growth rate can be lower. It impacts a potential exit, and a VCs profit when selling the shares.
Venture debt and venture capital are closely related. For startups, it is therefore advisable not only to deal with the terms of venture debt financing in advance. They must also consider the impact of venture debt funding on existing investors.
A list of venture debt providers
Venture debt has established itself as a popular alternative to equity-based financing. In addition to those already mentioned, these are among the most active venture debt firms for startups:
- Kreos
- Columbia Lake Partners
- Blackrock
- Claret Capital
- Atalaya Capital
- Bootstrap Europe
- Flashpoint
- Orbit Capital
- Viola Credit
- TriplePoint Capital
- Hercules Capital
- Pacific Western Bank
- Comerica Bank
- Western Technology Investment
- Horizon Technology Finance
- Wellington Financial
- BlueCrest Capital Finance
- NXT Capital
- First Midwest Bank
- Canadian Imperial Bank of Commerce
Conclusion: take a closer look into venture debt
Debt financing has increased in recent years. Startups have recognized that debt capital optimizes their capital stack and cost of capital. Generally, they still rely on VC financing, especially in their early stages. However, alternative options play an increasingly important role in further planning.
Venture debt benefits from this development. It helps startups to master the capital-intensive growth phase and to scale their business model.
Venture debt complements equity-based financing in the financing mix of tech startups. It enables them to finance their activities between two equity rounds – without unnecessarily diluting their shares. However, it is not the only form of financing to secure debt capital.
Be aware of the repayment burden
However, venture debt also means taking on debt. And unlike equity, startups must repay debt. Therefore, they should avoid taking on too much debt at all costs. The consequences are carried not only by companies but also by the venture debt providers and equity shareholders.
Startups should carefully evaluate a decision for or against venture debt. They should ask themselves whether venture debt funding is the right financial instrument and if the lender understands how the startup's business model works.
Choose a venture debt provider that understands your business
After all, it must be clear to the lender what strategy the startup is pursuing, the possible risks of the market and business plan, and what KPIs define success. Why? It is because rapid company growth can lead to turbulence. Venture capital providers should deal with this professionally and pragmatically.
