Debt Funding Guide for Startups

by Adarsh Raj Bhatt in August 11th, 2021

Key Takeaways

  • Recognizing the distinctions between venture debt and other kinds of credit and equity, as well as how to leverage both options, is critical.
  • Venture debt can lower the cost of the funding required to support operations by utilizing a startup's equity. 
  • It can also be used as security against operational snags and unanticipated cash demands.
  • Venture debt is used to accelerate expansion until less expensive funding becomes available to the startup. The most obvious benefit is that debt is always less expensive than equity. While equity shifts with the value of the startup, venture debt is generally issued with more advantageous terms for the borrower.
  • Top venture debt firms include Silicon Valley Bank, SaaS Capital, Espresso Capital, Flow Capital, and Wells Fargo. 
  • Knowing about using venture debt, when is the best time to address venture debt, as well as how venture debt is valued, are just a few of the essential factors to consider when deciding how to finance a fast-growing startup.

What is a Venture Debt Fund?

The term "venture debt" refers to loans specifically suited to the demands and risks of investor-backed startups in the technology, medical science, and the innovative economy. These loans are intended for businesses that have received financing from venture capital firms or other institutionalized entities rather than from “friends and family”. 

Deposits are used by banks to finance their loans. There is extensive oversight of banks as to the sorts of loans and the level of risk they can assume in return for access to this fairly affordable source of funding. Debt funds, like VCFs, fund lending activities with equity invested by their stockholders or limited partners. This form of financing is less regulated but it comes at a considerably greater cost. As a consequence, many debt funds are able to take risks that blur the line between debt and equity, although their loan costs are also significantly higher.

Benefits of venture debt

During innovation economy market cycles, the value of equity changes dramatically, although one thing remains constant: debt is less expensive than equity. The main advantage of venture debt is that it harnesses a startup's equity and lowers the overall cost of capital needed to support operations when a business is "burning" more money than it produces. A further advantage is versatility, since venture debt may be utilized to cover a range of expenses like operational issues, funding problems, and unanticipated financial requirements, including performance bond obligations.

Venture debt does not need an executive board seat or a financial stake in the borrower. The financing is frequently utilized in between different rounds of equity funding, enabling rapid infusions of money that do not need present investors to dip into their stock reserves.

Venture debt is frequently used as a support system, providing a cushion against looming financial concerns and prolonging the current fundraising cycle's cash runway. Purchasing equipment, hiring new employees, and funding day-to-day operations all need enough (and fast) money.

Companies can attain growth benchmarks, such as higher value, by using a bridge across equity funding rounds. Venture debt is used to accelerate expansion until less expensive funding becomes available to the startup.

The most obvious benefit is that debt is always less expensive than equity. While equity shifts with the value of the startup, venture debt is generally issued with more advantageous terms for the borrower.

When to use venture debt?

When you're in the process of putting together an equity term sheet, you could think about talking to a lender regarding venture debt. Venture debt is often set to close a few months following a new equity round. Raising debt while the startup is cash-flow positive may seem paradoxical, but in many situations, the debt may be designed with a longer "draw term" so that the loan does not have to be funded immediately. Your credibility and negotiation leverage are at their peak soon after closing on additional funding, regardless of when you wish to actually accept the loan.

Seeking venture debt when liquidity is low and the operational runway is short, on the other hand, will certainly be more complicated and expensive. It's useful to keep in mind that the venture capital business is extremely cyclical, and venture debt accessibility is inextricably linked with industry valuation patterns. The amount of venture debt available and the types of loan structures available will change in reaction to venture capital trends, the direction of valuations in your industry, and the overall economic cycle. Assume the role of the traditional "umbrella shopper."

Why does venture debt make sense for startups and fast-growth companies?

The type of investors financing your startup has a big impact on the availability of venture debt for seed-stage and pre-revenue companies. A classic venture debt user is a fast-growing company that has secured cash from venture capital firms or other major sources and has a clear strategy for raising further funds. Because of the structure of their investor base, numerous seed-stage startups will not fit these criteria. Should the startup prove unable to rope in additional "outside" investors, venture debt financiers base their assessment on the likelihood and capability of the current "inside" shareholders to fund one or more follow-on stages independently. Most seed investors fall short of these criteria, either because they lack the promised cash or because they don't plan to participate in subsequent stages.

How does venture debt work?

The three major aspects of venture debt pricing are: 

  • The rate of interest paid on the outstanding loan amount
  • An origination fee
  • Share purchase rights provided to the lender

The total cost fluctuates substantially depending on the lender's risk analysis. Investors with a proven track record and a large pool of follow-on capital will mitigate a lack of business history by lowering the cost of venture financing for early-stage startups. Lenders are more interested in later-stage firms that show incredible growth and rapidly build asset value. Companies that operate in industries with binary risks, such as administrative monitoring or untested technology, are less appealing in this regard. 

The structure of the loan also has an impact on the pricing. Because they decrease lender risk, loans with additional structure -- financial constraints, milestones that restrict loan draws, or larger lien rights –- are more aggressively priced.

How to choose a provider?

Even the most optimistic, growth-oriented businesses can crash. Companies looking for venture debt should choose their investor carefully, since an unskilled one might leave them with the burden of hefty repayments.

It's best to consult multiple lenders at once to talk about pricing and terms. Even if the lenders wouldn’t be engaged in the startup’s daily operations, they can still be useful to borrowers. What is the lender's degree of expertise? What advice can a lender give a startup at a critical juncture in its development? What kind of reputation do they have among other borrowers in a similar situation?

Startups should favor lenders that can help them prolong their cash flow while also arranging warrants (contracts that provide you the opportunity to acquire a security) in a favorable way. When a startup is purchased or goes public, lenders frequently want warrants that could be converted into stock.

Before you sign anything, think about factors like the overall loan amount and the lender's costs. Lenders may occasionally request the option to invest or specific cash flow covenants.

Top Venture Debt Firms

Silicon Valley Bank

Silicon Valley Bank, a subsidiary of SVB Financial Group, is a high-tech financial bank located in the United States. More than 30,000 startups have benefited from the bank's assistance. SVB is one of the major banks in the world, and, based on local deposits, it is the largest bank in Silicon Valley. In its domestic market of Silicon Valley, the bank focuses on financing tech startups, providing a variety of services such as venture capital, revenue-based funding, debt financing, and hedge funds that invest in research and biotech, as well as private financial services for high-net-worth people. The bank has venture capital and private equity departments that occasionally invest in its commercial banking clients in addition to collecting deposits and providing loans. With a market share of 25.9% as of June 30, 2016, the bank is the largest bank in Silicon Valley in terms of deposits.

SaaS Capital

Alternative finance to SaaS was pioneered by SaaS Capital. Since 2007, they've spoken with thousands of businesses, analyzed scores of financial statements, and invested in more than 60+ startups. They have the ability to make rapid judgments and it takes them an average of 5 weeks from the initial "hello" to actual financing. Several borrowers at SaaS Capital have used only an MRR credit facility to develop their company from $3 or $4 million in ARR to over $12 million (and still rising). In these situations, the equity value produced so far is between $35 and $65 million, and it surpasses the loan cost by at least 10 times.

Espresso Capital

Since 2009, Espresso Capital has evolved to become a major provider of venture debt solutions in the United States and Canada. Now, they deliver non-dilutive growth financing to top startups in tech, medicine, and other high-growth sectors from offices in Toronto, San Francisco, Los Angeles, and Chicago. They have created one of the world's top venture debt teams. The staff not only brings a wealth of expertise and enthusiasm to their work but they're also dedicated to ushering businesses through innovative growth finance and runway expansion strategies.

Flow Capital

Through their quick, adaptable, and founder-friendly alternative loan arrangements, Flow Capital aims to provide founders with the growth capital they need to develop their startups sustainably. Flow Capital Corp. is a diverse alternative asset investor and consultant that specializes in supplying high-growth companies with minimally dilutive capital. Access to world-class software and services is critical to the success of any startup. Keeping this in mind, Flow Capital has collaborated with top software and service suppliers to give discounts on a variety of products/services that will allow their portfolio companies to thrive.

Wells Fargo

Wells Fargo Strategic Capital (“WFSC”), a division of Wells Fargo & Co., provides existing and potential corporate clients, strategic partners of Wells Fargo, and authorized Small Business Investment Company (SBIC) funds with access to long-term funding in the form of stock and/or debt. WFSC's workforce primarily works with private enterprises in a variety of industries, providing innovative finance solutions to assist them to fund expansion and other capital requirements. They can supply appropriate solutions using a variety of funding arrangements, including equity, debt, or a suitable combination of the two.

Summary

Venture debt is a kind of debt funding used by startups and early-stage enterprises. This form of debt financing is frequently utilized in conjunction with equity venture capital financing. Banks that specialize in venture financing, as well as non-bank lenders, can issue venture debt. Venture debt can be a good substitute for equity venture capital. A key benefit, similar to other forms of debt financing, is that it prevents future dilution of a company's current stockholders, particularly of its team.

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