When private companies and startups raise money, they often do so through venture equity investments. This gives a growing company much-needed funds to build their business in exchange for equity ownership given to venture capital firms.
Yet venture equity is not the only way for startups to raise money. These fast-growing private companies can opt to take on debt between, before, or after equity fundraising rounds to increase the capital needed to continue scaling their company.
This type of debt is called venture debt — also referred to as venture loans — and it is increasingly more common in the startup world. Like other forms of debt — including those featured on Percent — investors can now invest in venture debt as an asset class, adding it to their portfolio and generating interest.
What is venture debt?
Venture debt is a specific type of debt financing that venture equity-backed companies can raise to further fund expenses and seize growth opportunities. Taking on venture debt in the form of a corporate loan often compliments past capital raised through venture equity capital (or VC), further extending the amount of time a business can continue operating without profitability (also known as “runway”).
Non-bank lenders or banks specializing in venture loans lend these companies capital with the promise of full repayment plus interest. Should a venture-backed company not adequately repay their debt on time, lenders can take measures including (but not limited to) gaining access to equity in the company and/or foreclose on the company’s assets. Venture debt agreements often come with an option for investors to buy or receive equity in the business, regardless of successful repayments.
Why would a company want to take on venture debt?
Companies often take on venture debt between fundraising rounds. This allows them to do anything from funding acquisitions, hiring new employees, increasing spend on advertising, and a near-infinite number of actions a company can take to grow their existing business and revenue. Raising money through venture debt could eventually lead to a more lucrative fundraising round for that company in the future and higher equity valuations.
Raising only venture debt does not dilute much equity for those who own shares of the company — including the company itself and its employees. As no new shares are created with venture debt, it allows the valuation of previously held shares to remain the same until the next round of fundraising or an exit event. (It is worth noting that many traditional venture debt providers only extend venture debt with additional rights to purchase equity in the future at typically favorable prices, thus diluting existing shareholders.)
How is venture debt different from corporate loans?
Corporate loans (or corporate debt) afford large, often publicly-traded companies the ability to raise debt for expansion endeavors. Venture debt exists in the world of corporate loans, but is only applicable to venture-backed companies.
Corporate loans and venture debt are similar in the sense that they both involve companies taking on debt for expansion purposes. Venture debt deals are often smaller in scale (sometimes $5 million or less in debt), whereas corporate loans taken on by multi-billion-dollar entities – many of which are publicly traded — can value in the billions. Venture debt is also a tool to help venture-backed companies bridge the gap between equity fundraising rounds, something not needed by sizable corporations and publicly-traded companies.
What are the risks of venture debt?
Startups or venture-backed businesses are full of risks and challenges, as is venture debt. As not all companies will be successful and few in this stage are profitable, some venture-backed companies have little to no ability to actually service this debt. These are often newer companies, many of which are in new or emerging industries with untested products, and profitability may elude them for most or all of their existence. Their newness also means they have less of a track record (or, in many cases no track record at all) in terms of paying back past debts.
Venture debt borrowers usually rely on future fundraising or refinancing to repay these venture loans. Key people at a small venture-backed company could depart, be removed, or pass away, leading to “key person risk,” or the partial or total collapse of the company due to the sudden absence of one or more individuals.
How can investors evaluate venture debt offerings?
Given that the risks in venture debt differ from other investments, the analysis of a venture debt offering is unique. Of course, an investor will look at a company’s financial statements, but because venture debt borrowers tend to be young companies and are often unprofitable, the focus differs.
On an income statement, revenue is perhaps the most critical item for venture debt analysis, because it is often the basis of VC valuations which support future equity financing rounds that can be used to repay the debt. An investor looks at revenue growth and tries to understand the source of the revenue. Relevant factors include customer diversity, customer stickiness and churn, and the portion of revenue that is recurring. Investors will also attempt to understand a company’s unit economics and gross and net profit margins.
On the balance sheet, cash matters most — especially if the company is unprofitable. Comparing cash to an unprofitable company’s negative net income, or cash burn rate, allows an investor to measure how much runway a company might have before they run out of cash to pay salaries, vendors, etc. For companies burning cash, it is also useful to know how much of that cash burn is temporary or avoidable if necessary.
Qualitative information also deserves attention. Investors usually attempt to understand a company’s business plan, sales process, management team, intellectual property, and product-market fit. Knowing where a borrower fits in its industry is also important since the prospects for the industry may determine future earnings and company valuations.
Since venture debt usually relies on equity fundraisings or future debt refinancing as the means of repayment, it is important to know the strategy and their existing equity investors. For example, a company with strong equity backers in an environment where the market for venture equity or initial public offerings (IPOs) is strong should have an easier time repaying debt than a company backed only by a single angel investor in an environment characterized by weak markets for IPOs, venture capital, and private equity.
How is venture debt structured?
Venture debt offering structures usually address collateral, covenants, and capacity to repay. Collateral for a venture debt offering often consists of all of the assets of the borrower, potentially including intellectual property.
Covenants are requirements imposed on borrowers over the life of a transaction. For venture debt offerings, these may include requirements to maintain a minimum cash balance, prohibitions on distributions to shareholders, prohibitions on mergers, acquisitions, and divestitures, and regular reporting of financial results. Capacity to repay is addressed by sizing a loan appropriately against a company’s equity valuation, runway, and/or its revenue.
How does venture debt investing work on Percent?
Percent offers venture debt investment opportunities to accredited investors on its investment platform. Accredited investors can create an account to receive news of future venture debt offerings, or partake in existing venture debt offerings under the Opportunities page of their Percent account dashboard. Information on each offering is provided on the transaction’s offering page and private placement memorandum. Our customer success team is also available to answer questions about venture debt offerings on Percent.
Sign up for Percent to add venture debt investments to your diversified portfolio. First-time investors can get up to $500 credited to their account just by making their first Percent investment.