The Pros & Cons of Raising Venture Debt as a Startup in 2024

Venture debt is a financing option for startups and growth-stage companies that may not have positive cash flows or significant assets to use as collateral for traditional loans. It is a form of debt financing provided by specialized banks or non-bank lenders to venture-backed companies. Understanding the pros and cons of venture debt is critical for startups that are considering this funding avenue to fuel their growth, let’s dive in! 

The Pros and Cons of Venture Debt

Pros of Venture Debt

Runway Extension

One of the primary advantages of venture debt is that it can extend a startup's runway. This provides more time for the startup to achieve its next set of milestones, which is particularly important if those milestones can increase the company’s valuation before raising the next round of equity financing.

Retain Ownership and Control

Venture debt is less dilutive than equity financing (all things equal). When startups raise venture capital, they give up a portion of their ownership in exchange for capital. Venture debt, on the other hand, allows them to raise capital without immediate dilution (warrants eventually cause dilution), preserving the equity for founders and early investors. By minimizing dilution you can maintain decision-making authority.

Quick Funding

Compared to equity fundraising, securing venture debt can be a faster and more streamlined process. With less due diligence and negotiation involved, you can access the funds quickly, enabling you to seize growth opportunities promptly.

Complementary to Equity Financing

Venture debt can complement equity funding by providing a non-dilutive capital injection. It allows you to extend your runway and bridge the gap between funding rounds, enabling you to achieve key milestones and increase your valuation before raising additional equity.

Other Benefits of Venture Debt

• Flexible - Venture debt often has more flexible repayment terms than traditional loans, which can be crucial for startups with uncertain revenue streams.
• Attractive to Subsequent Investors - Showing that you can secure venture debt following an equity raise can be a positive signal to future investors.
• Tax Deductible - The interest on venture debt is tax deductible, which can provide a significant tax benefit for your startup.

Cons of Venture Debt

Interest and Repayment

While venture debt does not result in immediate dilution, it does come with the obligation to pay interest and repay the principal. That said, the cost of capital for venture debt is often lower than other forms of debt available to startups.

Warrants and Financial Covenants

Venture debt often comes with warrants, which are options to purchase equity, and covenants, which are terms that borrowers must adhere to. While these are usually less onerous than the dilution from an equity raise, they can still have implications for control and future flexibility. Check out our guide on the venture debt covenants, clauses, and provisions to avoid.

Risk of Default

If a startup is unable to meet the terms of the debt, there is a risk of default, which can have serious consequences, including the potential for bankruptcy. Startups need to be confident in their ability to generate revenue to cover their debt obligations.

Transactional Relationship with Lenders

Unlike venture capitalists, debt lenders do not typically offer mentorship or strategic advice. The relationship is purely financial, and the primary focus for the venture lender is the return on their loan, not necessarily the success of the business.

Limited Flexibility

Venture debt can be inflexible, as it typically has strict repayment terms and interest rates that can't be easily adjusted. This fixed repayment schedule can strain cash flow, especially if your revenue projections fall short or unexpected expenses arise. This can make it difficult for startups to adapt to changing market conditions or unexpected setbacks. If you are new to raising venture debt, consider reading the startup founders' guide to raising venture debt.

Venture Debt Overview

Venture debt is a type of financing that allows startups to borrow money from lenders to fund their growth. Unlike traditional bank loans, venture debt is tailored specifically to the needs of startups and typically offers more flexible repayment terms. Venture debt lenders often have experience working with startups and understand the unique challenges that come with scaling a business. 

Strategic Considerations for Startups

When considering venture debt, startups need to assess their strategic position and plans. It is crucial to evaluate how venture debt aligns with the company's growth trajectory and financial health. Here are key strategic considerations:

• Product-Market Fit: Before taking on debt, ensure that the product has a strong market fit and that there is a clear path to generating revenue.
• Financial Projections: Realistic and conservative financial projections should show the company's ability to service the debt.
• Use of Funds: Startups should have a clear plan for how they will use the venture debt, whether for capital expenditures, working capital, or to extend the runway to the next equity round.
• Exit Strategy: Understanding potential exit scenarios can help assess the suitability of venture debt, as it must be repaid upon a liquidity event.

Venture debt should be part of a broader financial strategy, not a hasty reaction to immediate funding needs. A thoughtful approach will ensure that venture debt acts as a tool for growth, rather than a financial burden.

The Venture Debt Market

The market for venture debt has been growing, as it offers a complementary financing solution for startups alongside traditional equity fundraising. The venture debt market includes a variety of players, from banks specializing in venture lending to non-bank lenders who may be willing to take on more risk for potentially higher returns. The terms of venture debt can vary widely based on the lender, the amount of debt, the stage of the company, and the perceived risk. Startups need to shop around and negotiate the best possible terms.

When to Consider Raising Venture Debt

So, when should you consider raising venture debt for your startup? Here are a few scenarios where venture debt might make sense:

• You have a clear growth plan: If you have a well-defined plan for how you'll use the funds and how you'll repay the loan, venture debt may be a good option.
• You need capital quickly: Venture debt can provide startups with capital faster than equity financing, which can take months to close.
• You want to avoid dilution: If you're not ready to give up ownership of your company, venture debt can be a way to access capital without sacrificing equity.

For a more in-depth look at whether venture debt is right for your startup, check out the startup founders’ guide to raising venture debt in 2024.

Venture Debt Terms and Structures

The structure of a venture debt deal can be complex, and founders need to understand all the components. Key terms include:

• Loan Amount: The total amount of debt provided, which is often based on a multiple of the company's revenue or a percentage of the last equity round.
• Interest Rate: The cost of borrowing, which can be fixed or variable, and is typically higher than traditional bank loans due to the risk profile of startups.
• Draw Period: The period when the startup can access funding from the facility.
• Maturity: The length of time over which the loan must be repaid, usually ranging from 3 to 5 years.
• Warrants: Options for the lender to purchase equity in the company, which are typically a small percentage (0.05 - 0.25%).
• Covenants: Terms that the borrower must abide by, such as minimum cash balances or restrictions on further debt.

Negotiating the terms of venture debt requires expertise and, often, the assistance of a financial advisor or lawyer to ensure the agreement aligns with the company's long-term objectives. For more details on this, check out our guide on comparing and negotiating venture debt term sheets.

Venture Debt vs. Equity Financing

It's essential to weigh the pros and cons of venture debt with the equivalent pros and cons of equity financing to understand which is most appropriate for your situation. Venture Debt is less dilutive, faster, and comes with more flexible terms. However, it comes with interest payments, risk of default, and restrictive covenants. Equity financing on the other hand has no repayment obligation, and your investors become your strategic partners, however, you are subject to significant dilution, and the fundraising process is much more drawn out. Ultimately, venture debt may be attractive for companies that want to minimize their dilution and are confident in their ability to repay the debt, while equity financing is more suitable for startups that need significant “permanent” capital and are okay with the subsequent dilution.

Qualifying for Venture Debt

These are just a few of the most common qualifications for venture debt, for additional information check out this guide on how to qualify for venture debt: eligibility & requirements.

Backer Quality

Historically, the quality of a startup's investors played a significant role in qualifying for venture debt. However, this factor has become less important over time. Bootstrapped companies can now qualify for venture debt even if they don't have a tier-one VC backing them.

Cash Balance

Most venture debt providers will lend up to 35-40% of a startup's current cash balance, regardless of whether it's "new" or "old" capital. Bootstrapped companies with minimal cash balances may still qualify for venture debt if they have a large amount of non-cash collateral, such as equipment or intellectual property.

Collateral

Most venture debt providers require collateral that is valued at 1.25-1.5x the outstanding loan balance. Bootstrapped companies can use inventory, equipment, accounts receivable, and intellectual property as collateral.

Current Ratio

The current ratio measures a startup's ability to satisfy its short-term debts by comparing the company's current assets to its current liabilities. Bootstrapped companies should ensure they have a healthy current ratio to increase their chances of qualifying for venture debt.

Best Practices - Post-Venture Debt Raise

There are a few best practices to follow post your venture debt raise, we’ve outlined them below. After reading through these, be sure to check out the 7 venture debt pitfalls and "gotchas" to avoid, and the ten tips for raising venture debt.

• Detailed Planning: Have a robust financial plan that accounts for debt servicing and repayment.
• Communication with Lenders: Maintain open communication with lenders, especially if encountering cash flow issues.
• Monitoring Covenants: Regularly review covenants to ensure compliance and avoid penalties.
• Debt Servicing: Prioritize the allocation of funds for interest payments to avoid default.
• Contingency Plan: Startups should also consider having a contingency plan in place in case their financial situation changes, which could impact their ability to service the debt.

Wrap-Up: pros and cons of raising venture debt in 2024

Venture debt can be a powerful financing tool for startups when used strategically and responsibly. Understanding both the benefits and risks is essential for founders to make informed decisions that align with their company's goals. While venture debt offers a less dilutive form of capital, it requires careful management and a clear-eyed assessment of the company's ability to handle debt obligations. If you are interested in raising venture debt, we’d love to help out! Fuel your growth with Venture Debt from Arc.