In Short
- Venture debt is a loan designed for high-growth startups and can be used alongside equity funding.
- It helps businesses raise capital with less dilution, but comes with interest and repayment obligations.
- Common structures include term loans, revolving credit facilities and convertible debt.
Tips for Businesses
Venture debt can be a useful way to extend your runway and fund growth without immediately giving up equity. However, it is still a form of debt, so you should carefully assess your cash flow and ability to repay. Always review the terms closely, especially interest, covenants and any security or guarantees, before proceeding.
Capital is essential for any startup that wants to grow. While borrowing money is an alternative to raising equity, traditional banks often are not a good fit for startups because founders are usually asked to risk their personal assets. New types of lenders, including venture debt funds, are helping to fill this gap by offering startups more suitable and competitive loan options than big banks. This article explains what venture debt is and how startups can use it to fund growth with less dilution.
What is Venture Debt?
Venture debt is a form of debt financing tailored for venture-backed, high-growth companies. Unlike traditional bank loans, venture debt providers are, by and large, willing to lend based on a startup’s potential rather than its current assets or cash flow. This makes venture debt an attractive option for startups.
Key Features of Venture Debt
1. Less Dilution
One of the main advantages of venture debt is that it lets companies raise money with less dilution. Instead of issuing new shares, the business borrows funds to support growth, so founders and existing investors keep a larger share of the company. This is especially useful for startups that are close to reaching key milestones or expecting their valuation to increase soon.
2. Flexibility
Venture debt is flexible, which makes it attractive to startups. The money can be used for many purposes, such as:
- hiring staff;
- buying equipment; or
- paying for marketing.
This gives startups the ability to meet urgent needs or take advantage of growth opportunities, without being locked into the stricter conditions that often come with equity funding.
3. Warrants
It is worth noting that venture debt agreements can incorporate warrants, which grant the lender the right to purchase equity in the company at a future date. The value of these warrants is typically tied to a percentage of the loan amount.
Although this can dilute existing shareholders in the future, it is usually less immediate and less significant than raising money by issuing new shares. The warrants give lenders a chance to benefit if the company grows, which helps compensate them for the higher risk of lending to an early-stage start-up.
4. Interest Rates and Repayment Obligations
One of the biggest limitations of debt financing is the obligation to repay the loan amount. Early-stage companies often have limited cash flow, meaning the obligation to repay debt may be far-fetched and could lead to financial hardship.
Similarly, venture debt typically comes with higher interest rates compared to traditional bank loans. This reflects the increased risk profile of lending to startups. Venture debt agreements often include restrictive covenants, such as:
- specific financial or operational requirements; or
- restrictions that the company must adhere to during the term of the agreement.
Common Venture Debt Structures
Venture debt can take different forms, such as:
- term loans;
- revolving credit lines; and
- revenue-based financing.
The most common type is a term loan, where a company borrows a set amount of money and repays it over a fixed period, usually three to four years. These loans can also be structured in more flexible or customised ways.
Another common structure is the revolving credit facility, which provides a flexible line of credit. This arrangement allows the company to draw down funds up to a maximum amount as needed and then repay those funds. Overall, this offers greater adaptability to:
- changing capital requirements; and
- gives the company comfort that it will only be “on the hook” to repay the funds it actually needs and uses.
Interest is generally paid only on the amount drawn, although there may be a commitment fee on the undrawn portion to provide the lender with a minimum return amount in the event the company does not draw down any of the facility.
This handbook aims to help startup founders understand the benefits of venture debt, how a venture debt deal works and how to prepare for taking on this form of capital raising.
If your startup is in a high growth phase and looking to extend its cash runway, venture debt can be an ideal capital raising avenue.
What is a Convertible Debt?
Convertible debt is another type of hybrid funding. It begins as a loan but can later turn into shares in the company if certain conditions are met. It is popular with early-stage startups because it is flexible and works well for both the company and the investor.
At first, the company simply borrows the money and pays interest, like a normal loan. However, the agreement also allows the debt to be converted into equity instead of being repaid in cash.
For example, the debt typically converts into equity upon the occurrence of specific events:
- a qualified financing round (usually when the company raises a substantial amount via equity financing);
- an exit event involving the disposal of a substantial portion of the company’s shares or assets, or an IPO; or
- on a fixed date, known as the “maturity date.”
Considerations for Australian Startups
Venture debt is still a developing market in Australia. For this reason, startups considering this funding option are advised to:
- seek legal advice in relation to the key terms of the arrangement, particularly for the following:
- any restrictive covenants;
- repayment and interest obligations;
- the existence of any security interests; and/or
- personal indemnities and guarantees on default;
- ensure a clear plan for using and repaying the funds. It is prudent to consult a financial or accounting professional to assess the company’s ability to service the debt;
- consider the impact on future equity rounds. This is because while venture debt can help extend the runway to the next equity round, it is important to ensure that the terms of the debt do not negatively impact the company’s ability to raise equity in the future.
Key Takeaways
Venture debt can be a powerful tool for Australian startups looking to accelerate growth without immediately diluting equity. However, there are a number of additional considerations that do not apply to equity financing options, such as interest and repayment obligations, among others. When used wisely, venture debt can give a company the funding it needs to reach important milestones and grow its value before raising its next round of equity.
LegalVision provides ongoing legal support for Australian startups through our fixed-fee legal membership. Our experienced lawyers help businesses in the startup industry manage capital raising, contracts, employment law, disputes, intellectual property and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 1300 544 755 or visit our membership page.
Frequently Asked Questions
Venture debt is a type of loan designed for startups. Instead of giving up shares in the business, the company borrows money and repays it over time, usually with interest. It is often used alongside equity funding to reduce dilution while supporting growth.
Not always. Venture debt works best for companies that have a clear growth plan and the ability to repay the loan. Because it involves interest and repayment obligations, it may not suit very early-stage businesses without reliable cash flow or funding visibility.
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