What is Venture Debt?
Venture Debt refers to a kind of debt financing arrangement wherein companies which are in their start-up or early phase, being backed by venture capital, are funded by the banks or financial institutions in order to meet their working capital requirement or to finance their capital expenses. There is a high risk involved in such debts and thus the financers acquire the right to purchase equity shares in the company as a security.
How Does Venture Debt Work?
- It is a debt provided by the banks or financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. to the companies for the short or medium term. The number of funds that are sanctioned is based on the last round of equity raised by the company. Usually, amounts equivalent to 30% of the funds raised in last equity funding are approved for lending to the companies as venture debt funds. The interest rates attached to the borrowings may either be prime ratePrime RatePrime Rate (also known as Prime Lending Rate i.e. PLR) is the basic interest rate charged between commercial banks (i.e. charged by the lending bank to the borrowing bank) and serves as the basis for interest rates on business loans, personal loans, vehicle loans, home loans, mortgages, and so on. or a benchmark rate, such as the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions. rate.
- This kind of funding is highly risky due to lack of any significant collateral or potential cash flows, is warranted upon on the company’s equity capital, to serve as a security against the risk. Such a warranty may range from nearly 5% to 20% of the amount of loan sanctioned. These warranties can be later on redeemed as equity shares of the company at the price that prevailed at the last equity round.
- Further, based on the type of lender, the financing agreement may contain other specific conditions as well. While banking companies may impose strict conditions, non-banking companies may relax some conditions.
Types of Venture Debt
- Equipment Financing: This kind of financing allows a company to finance its equipment that is necessary for conducting its operations.
- Accounts Receivables Financing: This financing is provided by the lenders against the accounts receivable, reflecting in the financial statements of the borrower company.
- Growth Capital: Such kinds of funds serves as a source for working capital as well as milestone financing. These are known as growth capital since they help an organization in accelerating their growth.
When to Avoid?
Although raising funds through venture debt may sound prudent, but a company should keep itself at bay from such debt in case of the following scenarios.
- Suppose a company doesn’t have a road map or means for the repayments of the debt. It is because in the event the loan is not repaid on time, the lenders may overtake the assets of the company to make good of its loss.
- One should avoid this debt in case the amount that is payable in the installments is greater than nearly 20% of the aggregate operating expenses of the company.
- If the additional conditions that form part of the agreement are too risky to be agreed upon too
- If the company doesn’t have any source of capital left and the only option is venture debt.
Venture Debt vs. Venture Capital
The key differences between the two are enumerated below.
- The major difference between venture capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. and venture debt is that this debt needs to repay.
- In the case of the venture, capital control is diluted, which is not the case in venture debt since no equity stocks are issued.
- The conditions are harsher in venture debt, and the consequences can be serious when conditions are not met.
- It is cheaper as compared to venture capital.
- It is an easy way for start-up companies to raise funds by way of debt once they have raised venture capital.
- The companies are able to get funding without diluting their control by way of issue of equity shares.
- It is a way much cheaper way to raise funds as compared to equity.
- It helps the companies to meet their growth objectives.
- The financing arrangement may contain strict covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements., non-fulfillment of which can lead to penalties.
- The repayments of the amounts, if not made, can enable the borrower to take control of the assets of the company and sell them off, leading to significant risks of bankruptcy.
After a round of equity has been closed recently, going for a venture debt will be easier for the companies since creditworthiness will be highest at such time. The companies should make sure that they have sound business plans, which should ensure that repayments of such loans can be made at the time. These funds can help companies accelerate their growth and performance.
This article has been a guide to What is Venture Debt & its Definition. Here we discuss the types of venture debt, when to avoid this and how it works along with advantages and disadvantages. You can learn more about from the following articles –