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  • Writer's pictureAmna Najeeb

Why Startups and SMEs should raise Venture Debt?

Updated: Nov 27, 2020

Access to capital is of prime importance especially to the emerging growth companies. The first thing that a startup should consider is to secure a particular amount of capital which allows it to grow efficiently. Too little capital will make it difficult for the startup to thrive. However, the good thing is that the startups have now more lending options as compared to just venture capital.

Venture debt has emerged as an essential part of the entrepreneur’s instrument because of the rise in demands of the peripheral forms of financing. Venture debt is also known as venture lending and it is that type of debt that is obtained by startups and early growth stage companies. This is basically a supplementary method to equity venture financing and can be provided by both; the non-bank lenders and the banks that specialize in venture lending.

So, what is venture debt and what is it intended for?

Venture Debt is different from other forms of credit as it is not much likely to be affected by other factors such as the cash levels, inventory held, or the accounts receivable. This type of funding is aimed at startups who have clear and concise prospects of growth but are yet to achieve profitability. As compared to the traditional bank loans, the funding is available in larger amounts without any personal guarantee. So, the thing is that if you have a company that is doing well but needs investment to expand, venture debt would be a good choice for you.

The figure above explains the shareholder’s value over time and how venture debt raising makes the venture more efficient.

There are many fast-growing companies with bright future but since they have very limited trading history, they don’t get money easily from the conventional sources. This is because most of the banks and conventional landing sources are not ready to take risks for these startups. Venture debt provides flexibility and is a very attractive financing option for the startups.

What are the benefits of venture debt?

Venture debt normally consists of a three to four year term loan or equipment lease. There are a number of companies that are considering venture debt to help themselves adapt to a new market. Venture debt can offer a lot of benefits when structured properly, some of which are as follows:

· There is less equity dilution for the investors and entrepreneurs. This means that with venture debt, there is no requirement of giving a big portion of equity and the founders can retain much of their company while they are still raising the capital.

· The cash runway is extended which allows the startups to quickly raise the cash that helps them in reaching milestones between raising equity rounds.

· There is no valuation to be set for the company and the lenders don’t need board seats.

· Startups that are facing challenges or are suffering due to unexpected market conditions can also benefit from the venture debt.

· As compared to equity, the due diligence process is less exhaustive and is easier too.

However, it must be kept in mind that in spite of all these benefits, Venture debt has some considerations too and it is not a direct replacement of the Venture Capital backed equity rounds. In this post we’ll explain why as a startup you should raise venture debt and that how venture debt compares to the venture capital.

How do venture debt lenders assess the startups?

Venture debt lenders take some factors into consideration for evaluating the startups. The factors include market traction, investors, the management team, product, and other factors that drive value. To be a good prospect, a company must be capable enough to raise future rounds. So, basically the venture debt lenders get repayment through future equity rounds. These lenders make money from warrants, fees, and interest payments. Unlike other business loan lenders, the venture debt lenders can also participate in the upside that a venture capital has, which is later changed into shares just like acquisition or IPO during an exit.

To evaluate the credibility of the startups, the venture debt lenders also go through a complex underwriting process during which they consider the capital strategy and the life stage of a company. If your company has a limited operating history, then the lenders will look for recent equity rounds, investor quality and the projected cash burn rate. Companies that have a high burn rate are dependent on the external capital to a large extent and they are considered riskier. The later stage companies are evaluated on the basis of their skills to hook the non-dilutive capital from the investors.

How does Venture Debt compare to Venture Capital?

Like I said earlier, Venture debt isn’t a direct replacement of Venture Capital as its purpose is not to completely fund a startup as it expands and move towards the exit. In fact, the early-stage companies can’t avail venture debt if they haven’t received Venture Capital, this is because the venture debts complement equity funding from VC firms. Check this graph that explains the types of fundings:

Apart from this relation between the venture debt and venture capital, there are many differences between these two which are as follows:

VC takes a large stake in company while venture debt is paid back over time

One of the biggest factor that differentiates ventures capital from venture debt is that when VC provides capital to a company it takes a significant stake in it. However, venture debt involves warrants that can be converted into equity in future at a pre-agreed price. The venture debt is basically paid back over time over an agreed rate of interest. In short, this means that venture debt allows more equity to stay in the firm which makes it easier for the founders to make bigger profits at the time of exit.

Venture debt offers direct payback while VC doesn’t

Another difference between VC and venture debt is that venture debt allows the startups to payback venture debt over time while also investing in growth, while VC can’t be paid back directly.

VC offers value-adds that venture debt doesn’t provide

There are various value-adds such as access to networks, partnership opportunities, helping with filling key roles, helping in increasing exposure to media, and offering business advice. These value-adds are offered by venture capital which the venture debt doesn’t provide.

Venture debt has a lower failure rate

Venture debt has a lower failure rate as compared to venture capital as around 1 to 8% of the invested capital is written off as said by Kruze Consulting. The VC model on the other hand relies on some big wins to balance many of the losses.

For what reasons should startups and SMEs raise venture debt?

The Small and Medium Enterprises make around 99.9% of the 5.9 million businesses in the United Kingdom and this is why I encourage entrepreneurs to do businesses and then make them grow to the point of scalability. However, to make sure that your firm is ready for venture debt you must consider some factors that are explained in the picture below.

Venture debt is ideal for startups and SMEs as it allows you to quickly access an influx of cash that helps in getting rid of challenges with fundraising, operational glitches, or market downturns (short term). Following are the main reasons why startups should raise venture debt:

For extending cash runway

Startups use venture debt for a plethora of reasons such as indulging in large capital expenditures, extending cash runway, or providing cushion to themselves as explained above. The venture debt can provide much relief to a loss-making company as it focuses on the company’s value and the business model instead of considering its past financial performance.

For receiving working capital

Companies that are yet to make profits should manage their cash flow carefully as it is difficult for startups to raise funding for working capital requirements. Venture debt is flexible enough and is ideal for accessing working capital.

For funding M&A activity

If a company is planning to expand by merger or acquisition, it will need funding to quickly respond to the opportunities. Venture debt makes this easier by as once it is secured by the company, it can be drawn over time and is ideally suited for acquisition growth strategies.

For supporting capital expenditure

Some businesses struggle to fund the investments that would allow them to grow further. Big purchases such as the cost of software licenses and purchase of equipment can be challenging in such case. In such a situation, venture debt can be handy as it offers loans in tranches so that the companies are able to plan the future investments too.

Steps to prepare for venture debt:

Best time to raise venture debt is soon after or alongside a fresh round of equity. When a new equity round is closed, the bargaining leverage and credit worthiness of a startup is the strongest and thus this is the ideal time. Now that you’ve decided to prepare for venture debt, consider these steps that will help you answer the questions of the venture debt lenders:

· Collect all the financials which include recent management accounts, forecast for the next three years, a capitalization table, and last three years of accounts.

· Collate a detailed company profile which tells the business history, ownership, and funding raised to date.

· Explain your business model by presenting the customer profile, routes to market, your unique selling points, and the issues your company solves.

· Analyze your market by telling the M&A activity in your sector and the key trends. Also state your competitors and tell how you are unique from them.

· Describe the management team, the key people in the business, their backgrounds and roles, and the board of directors.

· Outline your funding needs which include when and where it will be invested, the amount required, and the funds that are available for your business.

· Consider the assets that can be sold, cost efficiencies, the potential visibility on future revenues, and the details of what a third party would buy in this case.

· In the end tell your aim, business goals, and the exit routes that are the most interesting for you.

What is the future of venture debt?

During the last 6 months, many firms have raised venture debt and the total venture debt deals accounted for $841 million in October in total funding this year. This amount is four times the amount that was raised through venture debt funding in 2019. Though venture debt is not in position to replace venture capital yet but a huge number of firms are raising capital in the form of venture debt from many investors.

Venture debt is becoming very popular but I still recommend the startups and SMEs to be careful when raising venture debt. If the capital is free-flowing, there won’t be any issue in raising debt but remember that it can become a bottleneck if your firm’s performance is not up to the mark or is not getting the expected returns.

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