The most recognizable type of early stage lending, venture debt is a debt instrument tailored for early-stage venture backed startups. In most cases, venture debt is offered to a startup up simultaneously with an equity round, not as a replacement but as a compliment to the equity round. Venture debt lenders will typically size and price their offering based on the terms of the equity round and the contextual situation of the company.
Venture debt offers a business more time to grow until its next round of investment, at which point some investors may decide to leave, new investors may join, or the business may decide to go public by way of an IPO.
The size of a venture debt facility will be determined as a function of the amount of equity the company has raised, with sizes typically ranging from 25% and 50% of the amount raised in the most recent equity round. Loans to early stage pre-revenue companies will be much smaller than loans available to later-stage companies in expansion mode. Successful early-stage companies may develop exponentially, so if they can postpone the need to acquire further equity, they can significantly improve their valuations. Additionally, companies without VC backing will have a hard time attracting any venture debt. This is because venture debt providers rely on a company’s access to venture capital as the primary source of repayment for the loan. Instead of focusing on historical cash flow or working capital assets, venture debt lenders underwrite the borrower’s ability to raise additional equity to fund the company’s growth and repay the debt.
Venture debt is commonly structured over a 4-5 year amortization period, usually followed by a 9-12 months drawdown period and an interest-only period of 3-12 months. There are four major cost variables. An upfront fee to set up the facility, a flexible interest rate between 7 and 12%, a final closing fee, and warrants.
Because startups typically do not have significant assets that may be used as security, venture debt does not require any kind of collateral, unlike traditional loan financing approaches. For the high-risk character of the loan instruments, the lenders are paid with the company's warrants on common shares instead of collateral. Typically, 5% to 20% of the loan's principal amount is represented by the total value of the dispersed warrants.
