As you scale and encounter new milestones and obstacles in your business, you will be faced the question of how to finance and plan for that growth. There are many options for financing but one of the most common choices is venture debt.
Venture debt is a cost-effective way to receive capital from a big financial institution if you have liquidity or existing financial backing from an investor that is well known. Banks will loan to startups that have access to the institutional investors such as a VC firm.
However, with venture debt, while the interest rate is low there is a lot of reporting to the banks that goes into the deal on a monthly basis. There is also a good amount of legal fees that go into procuring the deal. Today we will talk about raising venture debt means for startups, when they need to consider it and how to negotiate the best terms.
Why Do People Desire Venture Capital?
A considerable number of banks and financial institutions specialize in this type of debt financing. The cost of venture debt capital is very low. You can get very low-interest rates if you are generating a lot of revenue, so it is as if you are getting free money.
Banks loan to startups that have access to institutional investors such as well-known VC firms. Banks are investing in startups with investors that will stick with their investment past the terms of the loan. They know that most VC firms will give a startup a certain amount of capital but include a reserve should the startup need more down the road.
What Type of Startups Qualify for Venture Debt?
Unfortunately, not all startups will qualify for venture debt. A great time to consider venture debt is after you have received VC or institutional funding. Banks want to know that your startup has a well-known investor that is backing your business.
Banks will not grant venture debt if you are backed by unknown investors or angel investors, which is unfortunate for many startups. For example, if you raised $3 million from family and friends and have a lot of capital, you do not have the reliable reserve from institutional investors that ensures the bank’s investment.
Banks might also look if they can grant you an asset-backed loan as part of the venture debt. So, they might loan against your revenue. Asset-based borrowings are limited by the collateral base, fixed assets, inventory, and accounts receivable, instead of your ability to generate cash. Just like traditional investors, banks will also evaluate the team and the product to determine if they see a fit.
Disadvantages of Venture Debt
You do need to pay venture debt back even though the interest rates are so low. Most banks have you sending updates on a monthly basis such as monthly income statements, balance sheets, collateral auditors, annual tax returns and more.
Lenders can take a lien against your assets meaning they can keep your assets until you pay them back. While the amount can vary based on the lender, you will cover the legal fees and can be thousands of dollars on top of your debt.
The amount varies based on the lender, but you do need to cover the legal fees associated with securing the financing. This is something to keep in mind because legal fees can add to the debt you have.
What Are the Typical Terms of the Lenders?
Terms will vary depending on the lender, but the following are some examples of how the terms differ from typical bank loans:
- Repayment: this can range rom 12 to 48 months. It can be interest-only for a period followed by interest plus principal at the end of the term.
- Interest rate: this varies based on the yield curve prevalent in the market where the debt is being offered.
- Warrant coverage: the lender will request warrants over equity from five to 20 percent of the value of the loan.
- Rights to invest: the lender might seek to obtain some rights to invest in the borrowers’ subsequent equity round on the same terms, conditions, and pricing.
- Covenants: borrowers face fewer operational restrictions or covenants with venture debt.
Startups should not have an interest rate higher than four or five percent. Most banks will charge an origination fee but should not be compared amongst providers. Banks can write into terms that they can charge you on unused funds per year if you do not use all the money. There is always room for negotiation so do not settle on terms you feel you are not comfortable with.