How Startups Use Venture Debt
New businesses take on debt for many reasons. Recruiting great employees is easier with higher pay, marketing efforts reach more people when they’re backed by a budget, and getting your product on its feet happens faster when you have the funds to put towards development.
Whether startups choose to bootstrap or fund their ventures with loans, venture capital, or alternative financing, how the funds are obtained can sometimes be just as important as how they’re used. Bank debt adds new liabilities to your books, while interest payments mean extra overhead in lean times. VC requires giving up part of your stake of the company. Venture debt, on the other hand, can be a win-win for everyone involved — which is why it’s becoming more and more popular.
What is Venture Debt?
Venture debt is sometimes used as a broader term for loan products targeted at early stage, high growth startups. While traditionally venture debt was offered as an option following investment from venture capitalists (and required the issue of share warrants), the larger idea of venture debt can also include financing your receivables or your revenue in exchange for a loan.
The key difference between venture debt and other forms of lending is that venture debt is issued on the basis of a company’s potential for future returns, rather than its creditworthiness. A SaaS startup may have a slim credit history, but could have revenue streams that are interesting to investors. They could then use this revenue as the basis for a loan.
Why Do Startups Use Venture Debt?
Since different forms of lending ultimately have both pros and cons depending on how they are used, many startups have chosen to use a combination of funding methods. They may use a traditional loan to finance the purchase of equipment, plus venture capital to get access to business expertise or high profile investors. Venture debt comes into play when startups want to:
- Minimize Dilution
Even though venture capital typically requires no payment, it does mean giving up a portion of the firm. Startups want to get the highest valuation possible when they give up their piece, so between funding rounds they may try to get their product to the next stage of development, hire marketers to boost revenue, or expand the services they offer.
By taking on debt in between funding rounds, founders can increase the company’s valuation without diluting equity. When it’s time for the next round, the startup is in a better position to attract funds at favorable terms.
- Extend Cash Runway
While a startup may have cash on hand, it might need more time to reach profitability. In this case, types of venture debt (such as revenue based financing) can be used to extend the runway of the business, helping it pay overhead costs while products are waiting to hit the market or the company seeks its next round.
- Maximize Growth
In the technology sector, startups often need to make the most of a certain ‘moment’ in the market — customer demand is peaking, and the startup has a solution. However, getting it out in time takes cash the company doesn’t have. In this case, venture debt can step in to fill the gap.
Venture debt is a ‘win win’ mentality for both the investors and the organization. In revenue based financing, for example, investors only get paid if the organization begins to earn revenue. Their funds help the organization reach its milestones in time for the next big opportunity, and the company pays them back out of their returns.
Whether it’s less dilution or a chance to perform, venture debt gives technology companies the right tools to get ahead — and that’s good for everyone involved!
