A Complete Guide to Venture Debt Financing

In the startup world, venture debt is common as a type of debt financing. For venture-backed companies, venture debt enables entrepreneurs to access capital, often at a lower rate than equity financing and even standard business loans. Taking on venture debt also means you don’t need to give up more company ownership.

Not every startup can access venture debt—it’s important you have the right qualifications and growth plan to get it—but for those who can, it can be a strategic tool to help your business grow. Here’s a primer on venture debt financing, which will help you understand how it works and whether it’s for you.

What Is Venture Debt?

Venture debt is debt-based financing that a small business or startup uses to access capital. Entrepreneurs often access venture debt if they’re between larger financing rounds and capital raises or if they want to finance a targeted opportunity.

Venture debt is different from more commonly used equity financing. In equity financing, startups obtain funds in exchange for a percentage of company ownership. Because not every company wants to or is able to give up an equity stake, venture debt can be an alternative. This can be a big advantage for startups of many sizes, as long as they can handle additional debt on their balance sheets and tolerate some of the risks involved.

How Venture Debt Works

Venture debt comes from specialized lenders who focus on this kind of higher-risk lending. These may be financial institutions that cater to startups or other financial firms, such as private equity or hedge funds.

Venture debt is secured by a company’s physical or IP assets. It’s usually senior debt with a blanket lien and generally structured like a lump-sum business loan (though it can occasionally be issued as a line of credit). Its repayment terms can vary, though it’s often short-term debt—think a timeline of a few years. 

If you take on venture debt, it doesn’t limit you from raising equity-based financing. You can take on both at the same time. It can also serve as a bridge between capital raises, so you don’t have to dilute your ownership the minute you need access to more capital.

Venture Debt vs. Convertible Debt

Venture debt is different from convertible debt. They’re both loans, but convertible debt converts the loan amount into equity at a certain point in lieu of repaying the full loan amount. On the other hand, venture debt does not involve equity, and you must repay the full balance of the loan.

Who Is Venture Debt Financing For?

Venture debt financing is for businesses of all sizes. Larger startups may be able to better handle putting debt on their balance sheets, but a company’s size doesn’t disqualify them from taking on venture debt.

Just like a small business loan, lenders look for certain qualifications. These generally include a strong financial record and business plan for investment. In the underwriting process, venture lenders will look at investors’ track records for raising financing, including how much they’ve raised and how quickly. Often, startups with existing relationships with venture-debt providers can have an advantage in securing venture debt.

Common Uses for Venture Debt

There are a lot of costs involved with starting a business, which is where venture debt can help. Technically, there are no restrictions on uses for venture debt financing (unlike traditional business loans, which sometimes come with restrictions or specific uses). However, your lender may stipulate that your company can only use the money for certain things. Be sure to have this conversation with lenders before you accept the capital.

That said, common uses for venture debt financing include:

• Real estate
• Equipment
• Product production and development
• Logistics and distribution
• Payroll
• Projects and campaigns
• Acquisitions

Again, the possibilities are endless. The key is to use the money strategically, just like any other type of capital.

Pros and Cons of Venture Debt Financing

There are many upsides to venture-debt financing that can make this approach appealing to entrepreneurs. However, it’s also important to consider the downsides before deciding.

Venture Debt: Pros

No Dilution. Entrepreneurs don’t have to give away any ownership of their company. This can be especially helpful if you’ve already given away a lot of equity and don’t want to dilute your ownership further.

Speed. You’ll be able to access capital faster than raising a full equity round.

Less Expense. It can also be less expensive than traditional business financing in certain cases.

Young Companies. As nascent companies may struggle to access capital due to their lack of business history, venture debt financing can be a good alternative.

Control Over Amount. Venture debt comes in many different amounts, enabling companies to choose how much additional debt they put on their balance sheet. This can be good if entrepreneurs want to finance a specific product rather than access huge sums of capital.

Good Bridge. It can provide a strategic bridge round between big capital raises, act as a flexible financing tool, and help extend the runway for startups.

Venture Debt: Cons

Eligibility. Companies that haven’t yet raised venture capital equity financing aren’t likely eligible for venture-debt financing. In general, it’s harder to access venture-debt financing than venture-capital financing.

Risks. Repayment timelines can sometimes be short, depending on the venture-debt lender you work with. This can make it risky if you aren’t sure your company will grow fast enough to cover the repayment. Plus, it’s generally issued as senior debt, which means that venture-debt lenders are in first lien position in case you default. That can make this a risky financing instrument, especially if you are in a restrictive debt covenant.

High Interest Rates. Like any other type of debt, you’ll still have to pay interest on your loan, which can make it expensive. Some venture debt interest rates can run up to 15% or more. To keep interest rates down, venture debt lenders may sometimes take common or preferred stock to mitigate risk. This means that there may be a small dilution of equity in some cases.

Alternatives to Venture Debt Financing

Venture debt isn’t for everyone—and if you’re not sure it’s the right option for you, it can be prudent to explore other financing options before you take the plunge. After all, this is a high-risk option for many startups and can be costly, in every sense, if your growth projections don’t pan out. Other options include:

Equity Financing 

You may not want to give up more equity in your company if you’re at a point where you’re looking at debt financing. But if the debt risk is too high, you may want to consider more equity financing. Raising a new round can take time, and you may not want to dilute your ownership, but if you’re at a point where you need capital but can’t add debt to your balance sheet, it may be worth looking into what another round of equity financing might mean for your startup. 

Term Loans

If you’re comfortable taking on debt, there are other options for lump-sum loans that don’t come from venture debt providers. For instance, you can look into business term loans from traditional financial institutions, such as banks, credit unions, or online lenders. Sometimes, online lenders may be more expensive, but younger startups with limited track records may find more options.

The most cost-effective approach is an SBA loan, which generally carries the lowest interest rates and longest repayment terms. However, these are the most difficult to secure and can take a while, so it’s worth looking into several options, depending on your revenue and timeline.

Business Lines of Credit

Similar to business term loans, both traditional financial institutions and online lenders issue business lines of credit at different interest rates. Many businesses find these lines of credit good to finance specific projects since you only borrow and pay interest on what you need.

Equipment and Inventory Loans

Venture debt financing can be useful for paying for specific equipment purchases or product runs. Other debt financing can serve the same purpose. In this case, this financing is secured against the equipment or inventory itself. As a result, it may be easier for younger startups to access.

Other Options 

If you cannot get any kind of business financing, you can look into a personal loan to finance your business. In this case, your personal financial records are considered for approval, and the loans are secured against your personal assets. Personal loans can be risky, but for nascent businesses that cannot secure business financing, it can be an option to explore.

In some cases, for smaller projects, you may be able to finance them with business credit cards. Most experts don’t recommend putting big purchases on credit cards, as interest rates are even higher than other loans, and carrying credit card debt can put a dent in your credit score.

Is Venture Debt Financing the Right Choice?

Venture debt financing can be a good tool for startups that have already raised venture capital and want access to money without further diluting their equity or raising another big round from investors. However, these are specific conditions, meaning venture debt financing may not be right for many businesses. As with any type of loan, it’s important to figure out where you are in your business, both now and in your projections, and evaluate your appetite for risk.