Decoding Venture Debt Funding For Startups

Indian startups raised about INR 4,500 Cr of venture debt in 2021. For an asset class that is seen as the new kid on the block, this is more than twice the previous high. Companies went on a buying spree and investors raised larger funds. This year saw more than 100 companies raise venture debt, including Mensa Brands, Urban Company, Licious, and Zetwerk, with ticket sizes ranging from $2 to $25 Mn. 

In recent years, venture debt has become more integral to a startup’s fundraising strategy. However, as the venture equity market dries up and valuations of tech stocks in the public markets are down upto 70-80% from their peak, venture debt is becoming a much more sought after funding solution for startups looking to extend their runway. The choice for startups in the current environment is simple — do a down round where they raise additional equity at a significantly lower valuation from their last round and dilute heavily or raise venture debt where the equity kickers are struck at their last round valuation.

Here’s what venture debt looks like at different stages. 

Raising Pre-Seed And Seed

Pre-seed funding is an early funding round in which investors provide a startup business with capital (sometimes up to $2 Mn) to develop its product in return for equity in the company. If a startup raises pre-seed venture debt, it receives funds immediately instead of going through hundreds of rejections. 

It is less expensive than equity and if a company is able to access pre-seed venture debt, it could save a lot of dilution for the founders in the long run from the very beginning. Terms may include no cash interest with equity kickers instead, a convertible note, flexible payment plans, and no collateral. 

The startups will eventually have to pay this money back, and since early-stage venture debt is a novel concept and not easily available, it will be something the startup will have to explain on their captable. However, the convenience and cheap capital may be worth it. 

In light of the common practice of diluting more than 20% for capital in pre-seed and seed rounds with VCs and investors, a less dilutive alternative may be worth considering. Venture debt can be used by startups if they need fast capital without dilution as a bridge to their next fundraising round to accelerate growth before recruiting their first venture capital. In addition, international companies that are expanding into America may find it useful as well.

Seed Extension/Continuity Raise

If a startup needs more runway and more time to grow but doesn’t want to raise more money from venture capitalists or investors, venture debt can be super helpful here. Further, if a startup is interested in raising venture debt in tandem with venture capital to reduce the amount of dilution in the long run, that is another intriguing way to go about it. 

At this stage, venture debt could lengthen the runway and give the company more time to grow its valuation. This will ensure that the Series A can be raised on the startup’s own terms and be raised only when the startup wants to, not when the company has to.

Raising Series A

Bridge loan to Series A is still an early-stage venture debt, but it is sufficient if you have a good record of investor updates, a list of the investors and venture capitalists in your company. Be prepared to show these, as well as key metrics. Again, it is a good way to get access to capital without having to dilute even further. 

Raising Series B, C, And Beyond 

Venture debt in series B, C and beyond is a little different and is slightly more aggressive. Here is how. Terms are normally harsher, as we venture into the traditional venture debt sandbox. It becomes a traditional loan where terms are created to encourage payment. For example, terms might include a cash interest of 6% to 7%  and a 5% to 10% equity cover as well as collateral, cash flow sweeps, and bank account information. 

Since the terms can be harsh, finding a lender who you trust becomes, yet again, key. It is usually sought out in these stages when you have built something big and are not interested in taking more VC money and losing even more control of the company. If you need capital but are not interested in expensive equity, venture debt is your option. 

Key Takeaways

Making Venture Debt Work For You

Venture debt can sometimes get a bad reputation due to bad lenders, but there is no doubt that it has its uses. Venture debt is less expensive than equity. If you figure out how much capital your startup needs and how much you might be willing to dilute, it is possible to cut that number down by a significant amount by taking venture debt. 

Get a good lawyer to fully understand the terms of the deal. Early-stage venture debt is new and made possible by the fact that seed rounds today are the same size that series A was 20 years ago. Whether you decide to take up this type of funding at an early stage or not, find a lender you trust, as you will most likely come back to them in the future. 

Pros And Cons Of Venture Debt

To reiterate, the most compelling proof of venture debt is how cheap it is to equity and the convenience of getting the money when you need it, not when an investor decides they like you. This gives your startup more runway, it is less dilutive, and you gain a potential partner for your startup in the long run. However, you have to give this money back with interest, and if you choose a bad lender, it can harm your startup. This is why hiring a lawyer to help you understand what you might be agreeing to is important, as is researching a lender’s reputation, reviews, and past dealings.   

Conclusion

Venture debt can be an effective tool for growing your startup faster than you could without it. Its non-dilutive nature and timely convenience makes it an option worth considering for your startup. Venture debt can extend a startup’s runway and provide the lifeblood that allows startups to continue developing and growing. While it has its cons, the pros are compelling enough that every startup should seriously consider taking it and incorporating it into their growth strategy. 

All you need to do is be smart and tenacious enough to create a contract that works for you and your company in order to properly harness venture debt. Whoever you decide to do it with, if you learned even one thing from this guide or became a little less afraid of the term “venture debt”, that’s enough for us. 

Note: We at Inc42 take our ethics very seriously. More information about it can be found here.