Author: Tarek Bilani, M&A and Projects Attorney at Hammad & Al-Mehdar Law Firm
What is a Venture Debt?
Venture debt is a form of debt financing that can be used by early and growth-stage startups to raise capital. It can be used instead of, or in conjunction with, equity financing. Venture debt is an attractive form of raising capital for startups, because it can usually be arranged much more quickly, which might be an important consideration for startups facing a limited runway.
The main difference between venture debt and traditional debt financing is that:
- Venture debt is available for companies that lack assets or positive cash flow, or that want greater flexibility in the lending terms.
- Traditional lenders are often reluctant to finance equipment for startups based on the widely-accepted notion that startups have a high rate of failure.
Venture lenders have emerged to fill this gap; such lenders can be individuals, venture capital investment companies and funds, or banks specialized in venture lending. The market for such lending in the Middle East is still in its infancy, but we envision growth in the sector in the near future.
Venture debt has benefits for both entrepreneurs and investors. Valuation of startups proceeds in a stair-step fashion between financing rounds. This means that the inclusion of incremental capital from a loan allows startups to achieve greater progress between rounds, increasing the company’s valuation ahead of the next equity financing, and helping startups meet their milestones.
Types of Venture Debt
- Venture term loans:
Venture term loans are generally structured as three-year loans (or series of loans) with warrants for equity. They can be used for runway extension, acquisition financing, project financing, growth capital, or equipment financing. The interest rate is usually 0-4% higher than traditional loans to compensate for the increased risk to the lender.
- Lease financing:
Lease financing is a type of financing where the owner of the asset leases such assets (i.e. permits the lender to use the asset) in exchange for periodical payments. This can be especially useful for startups that require equipment to scale, and may also provide a tax benefit in certain jurisdictions where ownership of the asset is taxable (Saudi Arabia, for example).
- Revenue-based investments:
Revenue-based investments are a type of venture debt where repayments are tied to monthly revenues rather than a typical amortized payment schedule, often with a cap on the total amount (1.3x to 2.5x of principal amount of the loan). This reduces the payment (cash flow) risk on the company, as payment is only made when revenue is coming in, and offers lenders the comfort of a repayment commitment, but without a harsh-timed payments requirement on the startup that does not look to its fluctuating cash flows or revenues. This type of venture debt product is commonly seen in angel and seed financings globally.
- Convertible Notes:
Convertible Notes are the most commonly used form of venture debt, but unlike the other forms, these debt instruments can be converted into equity in the company. SAFE Notes and KISS Notes are the standard forms of convertible notes or securities, often used in venture investing as they allow parties to avoid complex term negotiations for investment in the earliest stages of growth companies.
Understand the Terms
Both startups and lenders should pay particular attention to the terms of the venture debt agreement, in particular the costs involved in borrowing. These can include a cost for borrowing the money, a cost while the money is being loaned, and sometimes even a cost to exit the loan.
The amount of the loan will be up for negotiation, but startups will generally be successful in borrowing around 30% of the last round on favorable terms. Lenders protect their rights by receiving warrants on the company’s common equity, and will often include covenants to ensure repayment, but borrowers will not be required to put up any form of collateral. The debt is usually short-term, unlike more traditional commercial loans, due to the growth trajectories of VC-backed companies and the standard equity raise path (with a new equity financing every 18 months).
When to use Venture Debt:
- To purchase equipment during the growth phase
- After eliminating the concept phase risk and identifying product market fit
- When aiming to reduce founder and investor dilution
- To avoid exhaustive due diligence
When to avoid Venture Debt:
- If a significant risk of default exists. Venture debt lenders can call the loan and force the company to be sold or liquidated.
- When a new raise is imminent. Investors will have to agree to repay the debt or invest below the debt in order of preference.
Remember: Venture debt may be an attractive means of avoiding dilution, but it should be used carefully by entrepreneurs. If you are unsure about product-market fit, venture debt can end the company before it even has a chance to begin. Entrepreneurs should remember, it is sometimes better to have a smaller shareholding, than to have no company at all.