Startup Debt Financing: What Is It and How It Works

Startup debt financing is another term for a loan that is provided to new businesses called startups. Another aspect of this type of loan is that the lender requires a portion of the new business as capital for that loan. The benefit for the startup owner is that he doesn’t need to provide cash for the guarantee and so ensuring cash flow is healthy enough to bring the new company to profitability. 

Venture debt financing is offered as a loan with interest and a repayment term.

What is venture debt financing, and why is it important for startups?

Venture debt is a type of financing geared toward fast-growing investor-backed startups and companies during the early stages of development. Access to capital is critical to a startup's success, but newer companies may not have the tangible collateral or assets yet to secure a conventional startup business loan.

Many entrepreneurs establish relationships with leading capital venture firms to secure an early funding source to grow the company to profitability.

Venture debt or venture financing is issued by:

• Banks
• Hedge Funds
• Private Equity Firms.

Since it’s issued as a loan, startups don’t have to worry about paying more equity out from profits as the business grows.

Venture debt usually comes with a 3 to 5 year repayment term and the money can be used to cover expenses and operating costs in between the next round of fundraising.

What is the difference between venture capital and venture debt?

Only venture-backed startups are eligible for venture debt. This is because with venture financing, you can usually borrow anywhere from 20% to 35% of the most recent equity funding round.  While venture debt is a loan, venture capital is a form of private equity financing achieved through fundraising.

The one issue with venture capital is that it takes a while to round up the fundraising dollars. Investors will donate to the startup in exchange for an ownership stake (equity) in the company. Venture capital has a long-term investment horizon that could last for years and there are several levels of seed funding. Startups may also have to meet certain milestones before accessing the next round of funding.

Venture lending comes in handy to extend the runway during the wait between fundraising rounds. With both venture capital and venture debt, entrepreneurs can combine financing and equity to grow their business while having a cash cushion for operating costs and even unexpected financial needs.

What do lenders take into consideration when entrepreneurs go to them for venture debt financing

Being a venture-backed startup doesn’t guarantee that you’ll qualify for venture financing. Here are some additional factors that lenders consider:

• Market opportunity: The business must have a sizable market to serve and a clear marketing strategy. The more specific the plan to use the debt to scale the company up by serving the target market, the better. 
• Metrics that will influence the next-round valuation: It’s important that the business is meeting milestones and other metrics that were discussed during previous rounds of venture capital funding. This gives lenders comfort knowing not only that other people are investing in your startup but that it's also performing and meeting goals consistently.
• Established revenue model and healthy margins: Even if you’re not making much profit, lenders want to see what your revenue model is and if it makes sense. 
• Business scalability: Lenders will like to see how the business has grown since the last round of venture capital so anything you can show about profit figures, new internal roles, and other forms of growth will be helpful.

It’s different from venture capital which requires startups to issue equity to the institution or investors providing the capital.

What are the benefits of venture debt financing for startups?

Startup debt financing offers a lot of businesses for the right startup. Some of which include:

• Growth: Having the money you need to carry out your business plan, hire help, and buy materials could equip you to focus on meeting core goals and growing profits.
• No need to continuously fundraise: Fundraising is a lot of work but with venture debt, you can take a break in between venture capital fundraising rounds without feeling the stress of not having any financial backing.
• Focus on business development: With less time and energy focused on fundraising, you can focus more on business development and improving overall performance.
• Protects equity dilution: Many entrepreneurs consider using a combination of venture debt and venture capital so all their profits are not tied up in paying equity from the company to investors. Offering equity is a nice option to have when you’re just starting out, but it’s important to avoid equity dilution by offering too much ownership to seed investors if there’s another alternative. 
• Extends runway between funding rounds: Venture debt is usually best utilized during an equity raise or within a few months of a round of funding closing. 

The risks of venture debt lending

As with any type of debt, there are risks to consider. Investing in a startup is a high-risk, high-reward endeavor but venture debt lenders use stricter terms since the only way they gain is if you repay the debt quickly. These risks include:

• Can be expensive: Debt financing for startups can be costly when you factor in the fact that you need to repay the principal plus interest. The repayment term is also short (usually 1 to 4 years) meaning you’ll need to bring significant revenue or consider using venture capital to pay back the loan.
• Considered a senior debt: Venture debt is a senior debt meaning it’s the first debt your company is required to pay if it goes under. This means, any equity investors may not be paid on-time if you need to liquidate your business. 
• Difficult for some companies to obtain: It’s more challenging to qualify for venture debt since it’s geared toward a specific type of business or startup. You’ll need to be backed by rounds of fundraising, have a solid marketing and revenue plan, and also possess a proven track record with hitting milestones and keeping investors satisfied.

How can a startup access venture debt financing

Getting venture financing is very different from applying for a traditional business loan. You can start by identifying which financial institutions offer venture financing or even scheduling meetings with lenders to get to know them and what they offer.

Here are the general steps to follow for venture debt financing.

• Find a lender: Sometimes, lenders actually reach out to startups that they discover through their network of venture capital firms and investors. Otherwise, you can definitely find your own lender and inquire about an application. Some application forms are even available online.
• Screening: When a lender determines you qualify for the loan, you’ll start the screening process which usually includes a call where you can share more about your business. Be sure to disclose your financial history, projections, any other pitches or details about your business that could be helpful for lenders to know.
• Term Sheet: If the conversation goes well and the lender determines your loan to be a low and manageable risk, they’ll send terms for the loan. The term sheet will show the loan amount, interest rate, and payment schedule. With venture debt, you’re also required to report the business’ finances. Consider discussing the term sheet with a startup lawyer or financial advisor so you can negotiate with the lender if needed.
• Underwriting: Once an agreement is reached for the loan terms, the lender will do some due diligence by looking further into your business and financial details. This is also known as the underwriting process to ensure everything in your application checks out.

Once your loan application is processed, you’ll receive a final agreement and receive your venture debt funds upon signing it. 

In order to be eligible for venture debt financing, you must have at least raised one round of equity financing (Series A fundraising).

How can I use venture debt financing in my startup?

Venture debt reduces the need for venture capital to fund everyday business operations. The money can fund things like inventory and equipment, payroll costs to hire employees, along with marketing and advertising expenses. Venture debt can even be used as startup insurance or a financial cushion for any unforeseen needs such as delayed fundraising money.

Each venture debt agreement is different and some may have specific clauses that dictate how you spend the money. For example, some lenders may have an investor clause. This means, they can call an investor in your startup and flat out ask if they are planning to invest more money into your company.

If the investor says no, the bank or lender could put the startup in default and decide what you can spend (if anything) and when or even if you should sell your business. This is why it’s important to negotiate this clause and other details on your loan term sheet before you agree to the loan. 

Tips to keep in mind when finding venture debt financing

Finding the right venture debt financing option for you takes time and you may not want to take the first loan offer you get. Here are a few tips to keep in mind when working on obtaining venture financing.

• Relationships are important with venture capital and venture debt. So prioritize choosing a lender that has a proven reputation and reliable communication since you’ll be working with them well after you receive the loan funds.
• Making sure the lender has a reliable funding process is also important. You may want to ask past borrowers or even references how quickly or slowly the funds were received and if there were any issues. 
• Consider comparing term sheets from multiple lenders to ensure you’re getting the best offer. This can also help you during the negotiation process. 
• Pay close attention to when the debt would amortize. As you review loan terms,  
  this is an important area to focus on since you don’t want to get stuck paying back a significant amount of your loan before you’re even able to use it. With immediate amortization loan terms, this is a real risk and only increases the cost of the debt. 
• Working with a venture lawyer or business mentor could be beneficial and provide new insights as you’re comparing lenders and reviewing terms. 

Before you consider venture debt financing, it’s important to check your financial projections to confirm you’d be able to pay back the loan on time. 

Business mentoring organizations that could help

Business mentorship is a valuable resource as you navigate startup debt financing and evaluate all your options. Consider partnering up with one of these organizations for mentorship services from a seasoned professional.

• Financial Solutions Lab: A community of startups, financial services companies, and nonprofit organizations make up the Financial Solutions Lab. This collaborative network hosts many events and educational opportunities to help you connect with a mentor for venture capital or venture debt financing. 
• All Raise: All Raise is an organization that caters to women with startups who are interested in learning more about venture capital. They host masterclasses and provide other mentorship opportunities. 
• Mentor Cruise: Mentor Cruise is a one-on-one online mentorship resource that helps you connect to an expert and get guidance on various topics. There are quite a few expert mentors that cover venture debt and you can communicate with them via phone or online chat multiple times per month. Each mentor sets their own rates but on average, expect to pay anywhere from $120 to $350 per month.

Conclusion

Startup debt financing is widely accessible if you have a growing startup that has already received some venture capital funding. Sometimes, a few months of additional funds in between fundraising rounds could be the difference in a business surviving those critical first years. If your business doesn’t have significant cash flow or collateral just yet, consider:

• Teaming up with a mentor or joining a collaborative to connect with other business owners and investors to expand your knowledge on venture debt
• Setting up a few discovery calls with lenders that offer startup debt financing to inquire about your options
• Assessing your startup’s current situation to determine how much you’d need to borrow, how you’d use the money, and a realistic timeline for paying it back 
   

If you're looking for alternative ways to fund expenses of your startup, you might like to get familiar with our list of the best startup business loans reviewed by financial experts.