Venture Debt what it is and how it works

Venture debt has long been widespread in the U.S. and Israel, but it only started gaining traction in Germany in 2018, when Silicon Valley Bank established its European branch. This marked the introduction of tailored loan products specifically designed for startups in the region.

Venture debt is a tailored financial instrument crafted for rapidly expanding startups supported by venture capital (VC). Unlike VC, which involves investors providing capital in exchange for equity or ownership in the company, venture debt involves borrowing funds that must be repaid, typically with interest, but without giving up any equity. This enables startups to bolster their growth and operational capabilities between equity funding rounds without relinquishing control. While venture capital is often employed for substantial growth initiatives, scaling operations, and expanding into new markets, venture debt is typically used to extend the runway, cover short-term operational costs, or bridge the gap until the next equity funding round. In this article, we aim to answer your most important questions about venture debt.

HOW DOES VENTURE DEBT WORKS? 

Startups already backed by VC initiate the process by applying for venture debt. Lenders assess the company's potential to secure future equity, recent funding history, and the credibility of its investors, rather than traditional metrics like cash flow or collateral. The funds are typically disbursed in tranches aligned with specific milestones or needs, allowing startups to strategically allocate resources for operations, growth initiatives, or extending their financial runway until the next equity round. Repayment involves regular payments of principal and interest, along with any origination fees and warrants. The funds can be used to accelerate growth, achieve business milestones, hire staff, expand marketing efforts, invest in research and development, or purchase equipment for commercialization and scaling.

WHAT ARE THE ADVANTAGES? 

As previously mentioned, it provides non-dilutive capital, allowing founders and existing shareholders to retain ownership and control since it doesn’t involve issuing new equity. This proves cost-effective, especially for high-valuation companies, with potentially tax-deductible interest payments. The capital extends financial runways, bridging gaps between equity rounds and supporting uninterrupted growth. It offers flexibility in fund utilization and acts as a financial cushion against unforeseen capital needs or fundraising delays. Securing venture debt can signal robust market confidence, demonstrating that the company is strong and has access to various funding sources. This can attract customers, vendors, and talent, enhancing bargaining power for future financing. Venture debt is complementary to equity, designed to supplement rather than replace it, providing an additional layer of financial support. Its underwriting focuses on the startup’s ability to raise further capital, making it suitable even for pre-profit or early revenue stage companies.

WHO IS IT SUITABLE FOR? 

Venture debt is advantageous for startups in advanced stages of VC backing, poised for substantial expansion and supported by investors. Sectors requiring significant upfront capital, such as technology, biotech, or clean energy, find it especially beneficial. Ideal candidates include startups progressing from initial rounds of equity financing and needing additional capital to reach pivotal milestones. Mid-stage startups with validated market fit and revenue generation, yet requiring further capital for scaling or market entry, also benefit. On the other hand, venture debt may not be suitable for very early-stage startups at the pre-seed or seed stage that have not yet raised significant venture capital or proven their business model. Companies with limited growth potential or those in industries with lower capital requirements may also not find venture debt advantageous.

WHAT CAN BE TRICKY ABOUT VENTURE DEBT? 

Regular principal and interest repayments can strain cash flows, particularly for startups that have not yet achieved profitability. Agreements often include restrictive financial covenants, which can limit operational flexibility. Moreover, debt increases financial risk, potentially leading to equity dilution through warrants and severe consequences if repayment obligations are not met. Founders must strategically time debt acquisition and navigate complex terms, such as various fees and warrant implications, to effectively manage risks. Over-reliance on debt can also over-leverage startups, magnifying risks during adverse market conditions. Therefore, selecting a lender familiar with the startup’s industry and growth trajectory is crucial for establishing a beneficial partnership.

Discover more financing alternatives to venture capital in our recap of the HHL SpinLab Investors Day 2022.

This article was written with Emelie Christiani.