Five Things You Didn’t Know About Venture Debt (But Were Afraid to Ask)

Venture debt is an increasingly significant form of funding in the innovation ecosystem, allowing companies at all stages to access growth capital financing earlier than with traditional bank debt.

By assessing many of the same metrics that venture capital and private equity investors use in their investment theses, venture debt lenders provide part of the growth capital needed to fund product development, revenue growth, and market expansion at a cheaper cost of capital than raising incremental equity.

Despite its growing prominence, the fundamentals of venture debt can seem counterintuitive to entrepreneurs unfamiliar with the sector. Let’s address some common questions and misconceptions around venture debt.

Do companies need to be profitable to qualify?

Innovative technology companies often take years to become profitable as they develop products, acquire customers, and focus resources on scaling.

While this investment typically “burns” cash, it can drive a higher enterprise value. This risk profile is a red flag for most lenders, but venture debt providers recognize the larger benefit and can provide growth capital financing much earlier than traditional bank debt.

The presence of high-quality equity investors is a positive signal for venture debt providers. For a lender this signals that the company will enjoy strong external governance and advice that is aligned with the business. A progressive lender will recognize fast growing companies with disruptive technology and extend or leverage the equity they have raised with a flexible venture debt solution.

Of course, these companies will still be subject to a risk assessment, but the criteria is different than for a conventional loan. Venture debt focuses on unique indicators such as annual recurring revenue, growth rate, gross margins, and customer retention metrics.

Ultimately, companies growing 5% a year that are profitable are less interesting to venture debt providers than a company growing 40% that’s still burning cash. Venture debt finances growth.

Is venture debt dilutive?

Unlike equity funding, venture debt is minimally dilutive, resulting in little or no impact on the existing capitalization table. When equity is involved, it typically is in the form of warrants to purchase company stock at a future date and reflects a higher risk profile of the proposed venture debt facility.  This is more common in very early stage venture debt or where the level of investment or cash burn is quite high, and as companies progress beyond venture risk or reach some scale, warrants are much less common.

This is important because it allows a fast-growing company to extend its runway and head towards its next equity funding round without giving up significant chunks of the business. When the time comes for an exit event – a sale or an IPO – this will maximize the returns for the founders and early investors.

From seed stage through to Series A, B, and beyond, companies in the innovation economy need to hit milestones. The further a business can progress towards these goals before requiring extra equity investment, the higher the enterprise value at the next funding round and the less dilution there is for existing shareholders. By extending a company’s runway venture debt represents a compelling option for both founders and existing shareholders to consider.

For example, in a $100M exit, if the founders and shareholders were able to retain even 5% more equity, that would mean $5M of incremental proceeds going to the shareholders.

How does venture debt work with equity investment?

One common misconception about venture debt is that it is an alternative to venture capital investment, when in fact the two forms of financing often complement each other.

A good venture debt provider will never want to step in and serve as a proxy for equity entirely. Instead, the intention is to extend and work with the equity that is already in place by providing additional capital to fuel growth.

Venture debt can provide a pressure release valve that allows founders to contend with the inevitable setbacks or other bumps in the road and potentially avoid  having to go back to their investors for more funding.

How can the funding accelerate growth?

Venture debt is most often used as capital for growth, either through runway extension, investing in sales and marketing when a company has found a real product market fit, or for acquisitions.

One area where venture debt can make a real difference is in situations when financing is needed quickly such as an acquisition. New equity funding can include months of road shows, pitching and due diligence, whereas debt financing can be approved in a matter of a month or two, even less if your existing lender can step up for it.

In a M&A situation, venture debt providers will work closely with a company’s VC backers to optimize the sources and uses of the funds needed to close. This is to ensure there is sufficient capital to complete the acquisition (including any secondary payouts) and provide the needed capital to go forward post-close. In these situations, venture debt can serve as the perfect complement to the equity used to complete the transaction.  In some cases, it may be the only capital needed.