For a startup company, there are two things that must be set in place: access to capital and cost. If there’s too little capital, then company might not be able to survive. But if there’s too much influx of capital, it could swell and lose the ability to grow efficiently. On other hand, the cost needs to be considered because in many cases, companies find that their efforts have been diluted and success is wrongly measured.
Finding that balance between capital and cost can become very frustrating. Luckily, supplemental forms of financing that give startups with the capital they need at a reasonable cost exists. Called a venture debt, this is a form of financing offered to venture equity-backed companies that do not have the asset or the cash flow to be eligible for traditional financing. Venture debt is also applicable to startups that simply want greater flexibility.
How does venture debt work?
Venture debt is the perfect complement to equity financing. It is a three-year loan, or series of loans, that is justified by the company’s stock. Yes, it’s a “risk capital” that can be less costly than equity if you are able to structure it properly. What this means is that can qualify for the said loan given that you have your company’s assets or valuable equipment to back it up.
What are the benefits of venture debt?
When considering the benefits of venture debt, think of a stair-step fashion. It’s pretty easy to understand actually. The financial agency would give you the capital that will allow you to generate milestones or income to pay off the debt over the three-year period.
Think of it this way, with the value capital afforded via the venture loan, you get the chance to achieve more for the next valuation, while minimizing the dilution should you secure additional capital. Thus, there is incremental ownership through the debt but reduced by the additional equity that will be incurred later to repay the debt.
For example, you get a $1 venture debt with an 8% warrant coverage. With that, 20 cents need to be paid prior to the next round, which will allow you to gain the use of 80 percent of capital of about 6 cents of dilution. This reduces dilution by more than 90% for that round. The company will then raise additional capital to repay the debt but by the next round, dilution will be reduced to 45% compared to raising more equity. What this does is that at the end of the three-year-loan, greater ownership of the company is retained, which means that management and shareholders get more proceeds too.
Other benefits of venture debt
• You get to apply and be approved for venture loans more quickly than you would with equity financings. This quicker process saves you time and other valuable resources.
• You get to meet unforeseen needs like an acquisition through venture debt
• There is no need to establish valuation of the company so venture loan is great before a potential sale, ahead of a new round of equity or in avoiding situations where management and investors need to negotiate on a price.
• Also, venture loans do not need observation rights or board seats.
Because of the popularity and effectivity of venture loans, more players came into the picture. Now you have sources like banks, select traditional leasing companies, hedge funds, among others. So even if your business is not under the category of industry generalists, chances are high that you’ll still get the funding you need via venture loans. But remember that your funding source will ultimately dictate your behavior and your approach on risk-reward tradeoffs.
When should you not use venture loans?
Of course, venture loans are not the end-all and be-all of financing. There will still be instances when they are not recommended. Examples of these situations include: a.) if your company has low cash balance and financing is considered the last resort. Why? Because you have to remember that the terms of the venture loans depend on your company’s records. So the lower your cash balance, the worse the terms you will expect.
b.) do not use venture debt if upon calculation, the payments will be 20 percent of the operating expenses of the company. You just can’t afford it. And c.) it is not advisable to use venture loans if the company has very high and stable streams of revenue and receivables. At this point, you might be better off with a line of credit tied with accounts receivables.
As always, weigh the pros and cons of venture loans as financing options before sending in your application. Consult with a licensed financial adviser to be better guided.