Before you go for venture debt, there are a few things you must know so that you are sure it is the right time for you to take on such debts. It all depends on the situation and circumstances, and a lot depends on your foresight. Therefore, for a better foresight, you must have a better insight into venture debt.
You must start your learning process by knowing that only the fortunate entrepreneurs who receive funding from a Venture Capital firm can avail venture debt. This is an obscure form of funding that is not tracked even by the National Venture Capital Association though it publishes stats and market data on venture capital.
However, venture debt makes up only 10% of the venture market, but it is an ever-growing scenario every year. This is a supplementary form of business financing that has its merits and demerits that you should look out for.
Table of Contents
The idea behind
The concept of venture debt is very simple for you to understand.
- It is designed to offer additional capital to a company in the form of debt
- It helps in reducing the heavy dilution that you and the founding team may already suffer
- It helps the entrepreneurs to meet their need to purchase more equipment
- It helps in funding advertisement for further growth and finally
It does not add to the dilution but helps the entrepreneurs to add some venture debt to raise and save future dilution in the Series B round.
The working process
Venture debt has a very simple working process as well. The funds that are let out as venture debt set percentage of the last raise in equity. This amount of the loan offered is ideally about 30% of the previous round.
However, the terms of venture debt is a little complicated. You will have to pay the cost of borrowing such money, a cost when the amount is being loaned, and also a cost when you want to exit the loan.
In addition to that, such debts have only a period of interest repayment which is usually for a short time such as six months. After that, repayment and interest repayment is granted over a period of two years.
Ideally, venture debt is a short-term financing instrument. It will cost you around 20% of the loan spread over a two year period. This fund also obtains a number of warrants that makes this type of loan very lucrative. If a company is sold down the road, it can turn that 20% into double or even more in terms of returns for the lender.
Time to take it
You must know the best time to go into venture debt but make sure you learn the debt reviews prior to that. Venture debt usually has a very significant place in the capital structure for a company. Most importantly, it is good for a company in the growth phase and needs money to purchase equipment and has passed the concept phase and eliminated the risks involved as well as has found the product or services market fit. With the venture debt, such companies will be able to reduce the investor and founder dilution and at the same time have enough additional capital that is needed for growth. However:
- The decision of the company to go into a venture debt will primarily depend on whether or not the company wants the capital required to purchase enough inventory.
- Raising more venture capital for the holiday season may not sometimes make any sense especially if you hold on to equity.
- It is not only about exploiting your payout but is also about maintaining control over operations and business strategies down the line.
- Equity is precious for any business, and therefore you must make sure that the venture debt will maximize the opportunity offered to you for a short time to capitalize on it.
Remember, anything that can be funded just as easily with any debt is the most careless way to run a business.
Time to avoid
Therefore, it is needed to know when to avoid venture debt to make the right decision at the right time. Having said that, remember that there are a number of downsides of venture debt that can cause devastating outcomes. These are:
- If you fail to pay any of the repayment covenants or terms, the managers of venture debt will call the loan and force to sell or liquidate your company. Though such situations arise very rarely, there is always a risk of such an instance.
- Most of the times, an existing venture capital company may renegotiate new terms if it sits on the board. However, this can once again prove to be costly.
- You must also know at this point that a company that had experienced a bump in their plan will also experience that the founder equity has disappeared when the managers of the venture capital need to create extra funding.
- It may also happen that the managers have to sell the business to repay the debt
- In such situations, whatever will be left will be paid to the angel investors and the venture capital firm. In short, the founders will get nothing.
Therefore, the most prudent advice regarding venture debt is that you should not raise capital through it if you do not have access to capital already. It will be a very bad example of financial management if companies with debt have no apparent means other than the VC investors to repay the loan.
You may also face problems due to venture debts in the later equity rounds. It is necessary that the new investors agree to invest below the debt or repay the debt in their order of preference when you take on venture debt to raise further capital with an equity round. In most of the times, the situation is not favored and is not ideal for the new investors. They would rather see it go to the company directly and therefore may be discouraged to make any investments.