What Is Venture Debt? What Every Entrepreneur Needs to Know in 2024

Entrepreneurs and founders of high-growth technology companies have numerous choices when raising funds to fuel their business growth - the better your company is, the more choices you have.

One less commonly known but increasingly popular option for high-growth companies is venture debt. This financing solution is gaining traction among start-ups seeking to expand without diluting their equity. 

Firstly - before we get started - if you want the complete list of venture debt providers in Australia - click here!

My Experience with Venture Debt

I explored venture debt financing around 2022 during my Series C capital raise - a capital raise that I would eventually abort at the onset of the 2022 tech wreck. I talk quite a bit about this experience in my eBook: Guide to Valuing Your Business in 2024.

I would also eventually abort my exploration of venture debt, instead using a shareholder debt structure instead. Looking back, I'm really glad I made this decision! That said, I understand now that my business at the time, didn't meet the ideal parameters of venture debt.

Our ARR was up 81% YOY at the time we explored venture debt. So we were high growth, but we didn't have a lot of cash at bank, or runway. At the time both the equity market was changing and construction (the industry of my business iseekplant) was getting more difficult. Headwinds were blowing.

The thing that made our board decide against venture debt was the confluence of our changing environment, and the KPIs - which are tied to your debt covenants. The KPIs are growth metrics that you set with the venture debt lender that indicate whether you are going to hit your growth targets, or miss them. I'll talk more about them below. The scary thing here is - if you miss your growth targets, you breach your debt covenants and the lenders can take over your company's assets (and it's operation).

You therefor need to be very sure that your growth targets are predictable and achievable. We weren't in that place yet, so we abandoned our venture debt deal.

Here's some more information about venture debt so you can be fully informed.

What is Venture Debt?

Venture debt is a form of debt financing provided to early and growth-stage companies backed by venture capital. These loans are typically offered by specialised banks, financial institutions, or venture debt lenders - who have raised a venture debt fund with a mandate to make these types of investments. Unlike traditional loans that rely heavily on collateral or profitability, venture debt serves as a complement to venture equity financing, providing additional capital to extend a company’s cash runway or finance growth initiatives without immediate equity dilution.

Typically, venture debt is used to supplement equity financing rather than replace it. This means that it can help extend a company’s cash runway, allowing it to reach key milestones before the next funding round. Additionally, venture debt can be used to accelerate growth, finance large capital expenditures, or cover operational costs. By providing this additional capital, venture debt enables start-ups to maintain momentum without immediately diluting their equity.

How does venture debt work?

Acquiring venture debt follows this process (more or less):

1. Initially, start-ups need to identify and approach potential venture debt lenders. You can download our researched list of Venture Debt providers operating in Australia here.

2. Once a lender is interested, you have to provide the venture debt investors with comprehensive financial projections and business plans. This is an essential step to get right - because these projections and plans will form part of KPIs and goals tied to certain debt covenants (which we'll explain more about soon). You're ability to deliver accurately on these forward plans will be baked into the contracts you have with the venture debt lender, so be excessively careful around what you present at the pitch phase.

3. The venture debt funding company will determine whether your pitch meets their mandate. They will measure things like you cash at bank, your runway, your growth rates, your retention and churn and do a level of light due diligence before presenting an offer.

4. They will present a term sheet to you, which will include the quantum, interest rates, level of warrants and some of the other elements that will be required (reporting and the presence of any guarantees). 

5. No doubt this decision will be a board level decision for your business - so if your board accepts the commercial aspects on their term sheet, then a deep due diligence will occur focused mostly on the financial aspects of your business. The venture debt funding company will need to deeply understand the drivers of your customers and revenue.

6. If due diligence is successful, then you will move to negotiating the investment and loan documents - and a very big part of this process will be the negotiating of the KPIs that will determine if you are hitting your growth targets. In order to de-risk a venture debt funding round, your company has to continue to grow fast, and predictably, so the KPIs will be the measures you agree with the venture funding investors. These will be arrived at by mutual agreement.

Venture debt is usually structured in the following way:

Loan Size (Principal):

The loan amount typically ranges between 20% to 50% of the company’s most recent equity raise. For example, if a start-up raised $10 million in equity (or has that quantum as cash-at-bank), they may be able to secure $2 million to $5 million in venture debt.

Interest Rates:

Interest rates for venture debt are higher than traditional loans but lower than equity costs, generally falling between 8% to 15% per annum, depending on the risk profile and the lender’s terms.

Payback Period:

Venture debt loans typically have a repayment period of 2 to 4 years. Some deals may include an interest-only period (usually the first 6 to 12 months), after which principal payments are made.

Warrants:

As part of the deal, venture debt lenders often receive warrants (options to purchase equity in the company at a set price that is usually very low), which provide them with upside potential if the company grows successfully. Warrants usually represent around 0.5% to 3% of the company’s equity.

Covenants:

Venture debt agreements may include financial covenants or restrictions, such as maintaining a certain level of cash flow or liquidity. Part of the covenants are also that the company meets it's growth targets more or less as it predicts it will over a 3 year period. These are where the KPIs come in.

Security:

Lenders usually take a senior secured position, meaning they have priority over other creditors in the event of default. The loan is typically secured against the company’s assets, including IP, receivables, or equipment, but not against personal assets of the founders. One of the more attractive elements of venture debt is that it rarely requires director's guarantees. This however means you can't have any other types of traditional debt (as they won't usually agree to being subjugated to the venture debt provider) including any level of asset based loans or overdrafts etc.

Drawdown Periods:

The loan may be structured with tranches, where the company draws down funds in stages, tied to milestones or metrics, rather than taking the full loan upfront. This provides flexibility in accessing capital as needed.

Flexibility:

Venture debt is seen as a flexible, non-dilutive form of financing, allowing start-ups to preserve their equity while still accessing growth capital. However, the fixed repayment schedule adds a layer of financial discipline for the company and risk if anything changes in the company's performance.

How Venture Debt Differs from Other Types of Loans

Venture debt differs from other types of loans in several key ways. Unlike traditional bank loans, which are underwritten based on a company’s current cash flow and assets, venture debt is primarily based on a company’s growth potential and its ability to raise additional capital in the future. This makes venture debt particularly suitable for start-ups and growth-stage companies that may not yet be profitable but have strong backing from venture capital investors.

Another significant difference is the inclusion of warrants in venture debt agreements. Warrants give the lender the option to purchase equity in the company at a later date, providing a potential upside if the company succeeds. This feature allows venture debt lenders to offer relatively lower interest rates compared to other high-risk loans, as they can benefit from the company’s future growth. However, it also means that borrowers need to be mindful of the potential for future equity dilution.

How Risky is Venture Debt?

Like any form of financing, venture debt carries risks. For the lender, the risk stems from the fact that start-ups may not yet be profitable or have significant assets. However, the lender typically mitigates this risk by offering loans only to companies with strong backing from venture capital investors, or very high levels of cash-at-bank, and a proven growth trajectory.

Securing a venture capital investor is crucial before accessing venture debt products, as it provides the necessary initial investment and confidence in the company's potential. For the borrower, venture debt can lead to repayment obligations that could burden cash flow if the company faces financial difficulties. Careful management of cash flow and growth milestones is essential to mitigating these risks.

What is the Difference Between Venture Equity and Venture Debt?

The key difference between venture equity and venture debt lies in ownership. Venture equity involves selling shares of the company in exchange for capital, diluting the ownership of the founders and early investors. Debt venture capital, on the other hand, serves as supplemental funding for early-stage companies during intervals between equity rounds.

Unlike venture equity, debt venture capital does not require giving up an equity stake immediately, though warrants or options may come into play later down the line, offering some equity potential to the lender. Additionally, debt venture capital does not require a board seat and may provide alternative guidance to businesses (but does often come with hefty reporting requirements in the same way venture capital does).

How is Venture Debt Paid Back?

Venture debt is typically paid back through fixed instalments over a pre-agreed term, often three to four years. Repayment schedules include both interest and principal payments, with interest rates generally higher than those on traditional bank loans. Additionally, some venture debt agreements may allow for payment holidays, where companies only pay interest for a set period to alleviate early repayment pressure.

What is the Interest Rate on Venture Debt?

Interest rates on venture debt typically range from 7% to 15%, though this can vary depending on the borrower’s financial situation, the lender, and the specific terms of the loan agreement. Because venture debt is often riskier for lenders, these rates tend to be higher than traditional loans, but they can be lower than the cost of raising additional equity in the long-term (provided it all works out).

What are the Criteria for Venture Debt?

Venture debt lenders look at several factors before approving a loan. Selecting the right venture debt lender is crucial, and due diligence is essential for both parties. These lenders focus on specific criteria to assess the viability of providing non-dilutive capital, particularly for early-stage and mature companies:

• Recent Equity Round: Companies that have recently raised venture capital are prime candidates, as this demonstrates investor confidence.

• Historical Cash Flow: Though not as critical as with traditional loans, lenders will want to see some indication of the company’s ability to generate revenue.

• Proven Track Record: Start-ups with established growth and a promising future, often in industries with rapid scalability like tech or biotech, are more likely to secure venture debt.

• Financial Covenants: Lenders may require companies to maintain certain financial health metrics throughout the loan period.

 

The Venture Debt Industry

The venture debt industry in Australia is relatively young compared to more established markets like the United States. While venture debt has been a popular financing tool in Silicon Valley since the 1980s, it only began gaining traction in Australia in the past decade.

At the Funding Guide - we offer a comprehensive, well-researched list of Venture Debt Providers - you can download the contact list here.

Venture debt emerged as an alternative form of financing for high-growth start-ups, especially for companies that had already raised equity financing but wanted to avoid further dilution. In Australia, venture debt became more recognised in the 2010s, with a few specialized lenders entering the market. The industry grew alongside Australia’s maturing venture capital (VC) ecosystem, which has seen significant expansion over the last few years, driven by the growth of tech start-ups and an increasing appetite for high-growth investments.

In the last 5 years, Australia has seen a sharp increase in venture debt deals. A venture debt deal involves providing loans to fast-growing companies that have strong backing from venture capital firms, offering a nuanced alternative to traditional venture capital. This growth can be attributed to a few factors:

• Maturing Start-up Ecosystem: As Australian start-ups scaled, they began seeking alternative funding options to equity, fuelling the demand for venture debt.

• Increased VC Activity: With venture capital investments hitting new highs, venture debt naturally followed as a complementary financing option.

• Global Players: International venture debt providers started entering the Australian market, seeing its potential for growth. Local players also expanded their offerings to compete.

• Risk Appetite: The increasing willingness of lenders to take calculated risks on growth-stage start-ups and tech companies has also driven the availability of debt financing.

What industries use venture debt?

Industries like technology, healthcare, and biotechnology are common users of venture debt due to their rapid growth potential and reliance on innovation.

How big is the venture debt market?

In 2024, the venture debt market is expected to exceed $25 billion globally, with increasing adoption in both the U.S. and European markets.

Benefits and Drawbacks of Venture Debt

Advantages of Venture Debt

Venture debt offers several advantages for start-ups and growth-stage companies:

• Access to Capital Without Diluting Ownership: One of the most significant benefits of venture debt is that it allows companies to raise additional capital without giving up equity. This can be particularly advantageous for founders and employees who want to maintain control of their company.

• Flexibility in Repayment Terms: Venture debt lenders often offer flexible repayment terms that can be tailored to a company’s specific needs and cash flow. This flexibility can help start-ups manage their finances more effectively and reduce the pressure of immediate repayment.

• Potential Lower Cost of Capital: For companies with high growth potential, venture debt can be a more cost-effective option than traditional loans or equity financing. The inclusion of warrants can help keep interest rates lower, making venture debt an attractive financing option.

Disadvantages of Venture Debt

While venture debt can be a valuable financing option, it also has some potential drawbacks:

• Higher Interest Rates: Venture debt often comes with higher interest rates than traditional loans, reflecting the higher risk for lenders. This can increase the overall cost of borrowing for start-ups.

• Risk of Default: If a company is unable to repay its venture debt, or misses any of it's KPIs and breaches it's debt covenants, it may face default, which can damage its credit score and limit its access to future financing or even worse, allow the lender to seize the assets of the company. This risk underscores the importance of careful cash flow management and growing predictably.

• Potential for Lender Control: In some cases, venture debt lenders may take control of a company if it is unable to repay its debt or breaches it's debt covenants. This can be a significant risk for founders and employees who want to maintain control of their business.

Overall, venture debt can be a valuable financing option for start-ups and growth-stage companies, but it’s essential to carefully weigh the benefits and drawbacks before making a decision. By understanding the unique aspects of venture debt and working with the right venture debt provider, companies can leverage this funding option to scale their operations while maintaining flexibility.