What is venture debt, and how does it work? (with examples)

Alvaro Morales

Starting a business requires substantial funding, which is no surprise. However, it doesn’t always mean you’ve got to give up ownership in the process. 

Venture debt is a way of getting the money you need while holding the reins. But that’s not where the benefits end. Venture debt can give your SaaS company the extra push it needs to penetrate the market and become a household name. 

Let's examine the details of venture debt and why startups use it as a launchpad to start scaling. 

We’ll cover:

  • What venture debt is
  • The intricacies of how venture debt works
  • A list of reasons why using venture debt is a good idea
  • A list of reasons why you should sometimes refrain from using venture debt
  • Three real-life examples of company successes with venture debts
  • Scenarios where you should consider venture debt

What is venture debt?

Venture debt is a form of debt financing. It’s for young, high-growth companies that have already secured venture capital backing. 

So, what sets venture debt apart?

Unlike typical loans, it often comes with a sweetener for the lender. This could be warrants or the right to buy a portion of the company's stock at a set price. This allows lenders to share in the company's potential success alongside the equity investors.

Have you ever wondered why a startup would take on debt?

Venture debt isn't meant to replace equity investments but rather to complement them. It's a way to get extra funding without giving up more ownership in the company. 

This additional capital can be used for several purposes:

  • Extending the runway: Think of this as giving the company more time to hit key milestones before needing to raise more money from investors.
  • Funding big purchases: Venture debt can cover the cost of new equipment, inventory, or even acquiring another company.
  • Smoothing out cash flow: Startups often experience revenue fluctuations. Venture debt can help manage those fluctuations and keep operations running smoothly.

How does venture debt work? 

Venture debt offers a different approach compared to traditional bank loans. Let's break down the key elements:

How is venture debt usually structured? 

Venture debt usually comes in two forms:

  • Term loan: This is a one-time lump sum of money borrowed for a specific period, typically one to three years. It's like a mortgage - but for a business - with regular payments made over time.
  • Revolving line of credit: This works more like a credit card, allowing the company to borrow up to a certain amount, repay it, and borrow again as needed.

As we mentioned earlier, most venture debt deals also include warrants. These give lenders the option to purchase company stock in the future. We’ll touch on this topic later, but for now, you should keep this concept in mind.

How does venture debt repayment work?

Venture debt repayment terms are designed with startups in mind. They understand that young companies don't always have steady cash flow. Instead of requiring immediate payments, venture debt often starts with an "interest-only" period. 

This means the company only pays the interest on the loan for the first 6 to 12 months, giving them some breathing room. After that, the company starts paying back the principal (the original loan amount) and the interest.

Who are the typical lenders? 

Who provides venture debt? It's not your typical bank. You'll usually find it from these sources:

  • Venture debt funds: These are firms specifically set up to invest in — and lend to — startups.
  • Banks focused on startups: Some banks have divisions that specialize in working with growing companies.
  • Other financial institutions: A variety of other lenders in the market cater to startups. Private equity firms are one of many examples. 

Why would businesses choose venture debt? 

Venture debt isn't the right fit for every company. However, it can be a powerful propelling force for those who qualify. Here's why:

  • Ownership stays with you: This isn’t like equity funding, where investors get a piece of your company in exchange for funding. Venture debt allows you to raise capital without giving up any ownership. It’s a win-win for lenders and owners.
  • Get more time to grow: Venture debt can provide a financial cushion. This means extending your runway. This means you’ll get more time to achieve milestones, attract customers, and become profitable. Think of it as giving yourself extra time to build your business.
  • Receive money where you need it: Venture debt isn't restricted to a single use. Whether you need to invest in new equipment, expand your team, or make a strategic acquisition, venture debt offers the flexibility to use the funds where they'll have the most impact.

Why venture debt might not be such a good idea

While venture debt offers some clear advantages, it's important to be aware of the potential downsides before jumping in:

  • Regular payments can be tough: Venture debt, like any loan, has a repayment schedule. You'll need to make regular interest payments and eventually have to pay back the original loan amount. 

    For startups with unpredictable revenue,
    this can be a significant challenge. If you can't make your payments, you could face financial penalties or even default on the loan.
  • Restrictions on your business: Some venture debt agreements include covenants. You have to follow these rules to keep the loan in good standing. 

    These can range from
    maintaining certain financial ratios to getting approval before making major business decisions. Breaking these rules can spell trouble for your company’s future. 
  • Sharing the potential upside: Remember those warrants we talked about? They're great for the lender, giving them a chance to profit if your company takes off.

But this also means that some of your company's potential value goes to the lender, not just your equity investors. This can be a point of negotiation, but it's vital to understand how warrants can impact the overall return for your shareholders.

Examples of venture debts that helped companies take off

Even industry giants have requested loans to finance their ideas. In fact, venture debt has played a crucial role in the growth stories of some of today's most iconic companies. 

Here are a few examples:

Example: Uber

In its early days, Uber secured venture debt to help finance its rapid expansion into new cities. This infusion of capital allowed Uber to scale its operations quickly. The money was used to increase its driver fleet and establish a foothold in the competitive ride-sharing market.

The result? Uber has become synonymous with catching a ride worldwide. 

Example: Airbnb

Airbnb, the now-ubiquitous platform for booking houses and apartments, also tapped external financing to fuel its growth. In 2016, the company raised $1 billion through a combination of equity and debt financing, a portion of which was venture debt. 

The result? This strategic use of funds helped propel Airbnb to become a household name and a significant player in the hospitality industry.

Example: Tesla

While not strictly venture debt, Tesla did benefit from a unique form of government loan in its early stages. In 2010, the company secured a $465 million loan from the U.S. Department of Energy under the Advanced Technology Vehicles Manufacturing (ATVM) loan program. This program is specifically designed to support the development of advanced technology vehicles like electric cars.

Then, in 2017, Tesla took on significant venture debt after it issued a $1.8 billion high-yield bond with a 5.3% coupon, maturing in August 2025. 

The result? These loans were crucial in helping Tesla finance the production of its Model S sedan, a major milestone in the company's journey to becoming a leader in the electric vehicle market. The combined funding allowed Tesla to significantly impact the automotive industry and its shift towards green alternatives. 

When to consider venture debt

It’s now time to assess whether or not it makes sense to use venture debt for your business. These are some scenarios when using venture debt could be the right call: 

Post-series A funding

Venture debt becomes an option after a company has raised a Series A funding round. Lenders often view a successful Series A as a validation of the company's business model and potential for growth. 

At this stage, venture debt can provide additional capital. The main draw is that it helps accelerate growth without diluting the ownership stakes of founders and early investors.

Specific funding needs

Venture debt is well-suited for financing specific projects or bridging the gap between equity rounds. Whether launching a new product or growing into a new market, venture debt can provide the targeted funding without a full equity raise. 

This gives companies more control over their ownership while still getting the capital they need to keep growing.

Revenue generation and path to profitability

Venture debt is best suited for companies that have already started generating revenue. It’s ideal for those who already have a clear path to profitability. However, venture-backed companies aren't always profitable in the early stages. 

Because of this, lenders want to see that the company has a viable business model and can generate enough cash flow to repay the loan. This ensures the company can meet its repayment obligations without jeopardizing its finances.

Next steps

Now that you know what venture debt is, remember it’s not for every business. However, you can consider it a viable option. One of the topics we discussed was having stable cash flow. To make sure your revenue stays healthy, it’s key to have a robust billing system in place. 

That’s when Orb comes into the picture. 

Orb is a done-for-you billing management platform. Orb makes it easy, whether you’re struggling with dunning, usage tracking, or invoicing

Learn how Orb helps you keep your cash flow healthy and handle billing for you.

June 26, 2024

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