What is Venture Debt ? A Basic Guide to Venture Debt
Access to capital is a major concern for emerging growth companies. Capital at a reasonable cost is extremely valuable to start-ups. As a result, venture debt, a type of risk capital, has grown in popularity.
In this article, we will cover the definition of venture debt, benefits, how it works and everything you need to know. So, read the full article.
What is Venture Debt?
Venture Debt is also referred to as venture lending. Venture debt is a type of debt financing specifically designed for start-ups and early-stage businesses.
Emerging companies oftentimes require venture capital to begin, grow, and to maintain their business, that’s why they seek funds from venture capitalists. Through venture debt financing, emerging companies with insufficient funds can achieve significant growth. The banks that specialize in venture lending, as well as non-bank lenders can provide venture debt.
It can be a viable alternative to equity financing because it does not require the company to relinquish any ownership.
Start-ups may seek venture debt funds for a variety of reasons. To begin with, it can be used as a source of growth capital in between investment rounds. It can too be utilized to fund the purchase of equipment and to make investments in infrastructure.
Types of Venture Debt
There are three different types of venture debt available.
- Equipment financing
Equipment financing is a type of venture debt (business loan) that is used to cater to capital expenses like the purchase of equipment for a business or workplace.
- Growth capital
Growth capital is a fund that is used to provide working capital or
milestone financing and the purpose of this is to help a startup
company grow. Growth capital includes term loans used to
replace equity rounds.
- Accounts receivable financing
Accounts receivable financing refers to borrowings that are against the accounts receivable item on the balance sheet.
Benefits of Venture Debt
The most significant benefit is that debt is always less expensive than equity. Unlike equity, which fluctuates based on your valuation, venture debt uses equity to take on debt at far better terms than traditional lenders, who are notoriously wary of early-stage software companies. It’s a simple add-on after a venture capital round that can help you significantly extend the runway of your current raise without giving up a lot of upsides.
How Does Venture Debt Work?
Unlike traditional loans, venture debt works differently. The debt has a short-to-medium duration (up to three or four years). Venture debt can be used by startups or emerging companies with insignificant or no cash flow.
It is a type of financing that allows companies backed by venture capitalists or firms to receive additional funding.
This funding is a supplement to and addition to equity financing. By providing additional funding, it assists startups and emerging companies in avoiding equity dilution. This is a type of business loan that is frequently combined with warrants to compensate for the higher risk of default. The principal amount of debt is usually determined by the amount raised in the most recent round of equity financing.
How Can Investors Invest in Venture Debt?
In India, venture debt funds are structured as alternative investment funds, and the infrastructure funds, private equity funds, and venture capital funds are examples of non-traditional asset classes that AIFs(alternative investment funds) invest in. They enable investors to diversify their portfolios away from conventional asset classes such as public equities and debt securities.
The Securities and Exchange Board of India (SEBI), India’s stock market regulator, has set a minimum investment limit of INR 1 crore for AIF units. An AIF’s units can be purchased directly from the fund or through distributors appointed by the fund.
The commitment period for venture debt AIFs is typically four to five years, during which the committed capital is recycled. Investors receive quarterly payouts linked to the coupon-bearing NCD instruments during the commitment period.Companies use NCDs to raise long-term capital through a public or private offering. NCDs cannot be converted into equity shares at any time, unlike convertible instruments.
Venture Debt VS Venture Capital, What’s the Difference?
Entrepreneurs may be unsure whether they should pursue venture capital or venture debt when it comes to securing investment capital. While both venture debt and venture capital have the same goal of funding startups, they differ in a few ways.
Venture capital is a type of private equity investment in which you will be required to give up some of your equity but in venture debt, you will need to pay back the debt, and while you might have to sell some of your stock in the future.
Interest payments, fees, and warrants, which can be converted into equity at a later time, are how venture debt lenders make money. But in the case of venture capital, it makes money by selling equity in a company when it goes public or is acquired.
In venture debt, the cost of debt remains constant and is limited to interest rates that the company and the issuing party have agreed upon whereas, in venture capital, venture capitalists rely on equity, which fluctuates in value over time and can fluctuate dramatically depending on the company’s stock performance.
What is the Future of Venture Debt?
The market has become more borrower-friendly as the number of venture debt lenders has increased, interest rates, more favourable loan structures, and more favourable terms. An increasing number of companies have raised capital in the form of venture debt from a growing number of investors over the last decade. Some founders have indicated that they will forego venture capital funding in order to avoid dilution of their ownership through down rounds.
Despite the fact that venture debt is becoming more popular, businesses should proceed with caution when considering it as a financing option. When capital is plentiful, adding debt to a balance sheet may not be a major concern. However, if a company’s performance lags or the market takes an unexpected turn, debt can quickly become a burden.
Venture debt is a flexible, efficient, and non-dilutive way for small and mid-sized businesses to achieve their funding goals. It also enables mid-market companies to fund acquisitions, achieve profitability, and launch new product lines. It enables startups to lay a solid foundation, realizes their full potential, and accelerate growth in preparation for future equity financing rounds. Finding the right venture debt lender is crucial, of course. Make sure to look into all of your options, read the terms and fees carefully, and find a lender who can provide sound advice.