Venture Debt: Taking Start-Ups to the Next Level

Key Takeaways

• Venture debt, unlike traditional types of debt financing, is usually provided by venture debt firms or specialized lenders who, in exchange for potentially higher returns, are willing to assume elevated risk levels.

• Debt financing also serves the important purpose of diversification – creating a portfolio comprised of a variety of asset classes and types to lessen risk exposure.

• Venture debt is a kind of financing that is frequently used by early-stage, fast-growing companies that need capital but do not yet have a revenue-generating history.

Also known as venture lending, venture debt is a sort of melding of a traditional bank loan and venture capital. New and fast-growing companies often rely on such financing for growth. But what is venture debt, and how does it compare to venture capital? To answer that and more, here is venture debt: taking start-ups to the next level.

What is Venture Debt?

This is a kind of financing that is frequently used by early-stage, fast-growing companies that need capital but do not yet have a revenue-generating history.

Most commercial banks do not provide venture debt loans. Unlike traditional types of debt financing, venture debt is usually provided by specialized lenders who, in exchange for potentially higher returns, are willing to assume elevated risk levels. In addition, such lenders sometimes provide strategic and operational advice to assist the company in reaching its goals.

Venture debt is typically provided in the form of a loan and often complements equity financing, which is the process of raising capital through the sale of shares. In such cases, as a supplementary type of financing, amounts usually do not exceed 35% of the most recent equity round total, and tend to be closer to 20% to 25%.

Venture debt is used for a myriad of purposes, including for buying equipment, funding research and development efforts, increasing company operations, or as a cushion for working capital.

Note that venture debt differs from equity financing in that the former usually does not entail turning over company ownership and does not weaken existing equity ownership. However, it does typically involve a higher interest rate.

How Venture Debt Works

Venture debt financing usually involves a specialized lender or venture debt firm giving a credit line to a new or fast-growing company. It usually begins with an assessment of the company’s financial state, business plan, and prospects for growth, aimed at determining loan terms and the amount of funding that will be offered.

Loan types and sizes vary markedly depending on the business’s scale, the amount and quality of equity raised to date, and the loan’s purpose. The loan amount is usually aligned with the amount of equity raised by the company. 

A word of caution here, as too many startups concentrate exclusively on loan size and price. This is often done to the exclusion of developing a relationship with a lender who has the experience and capability to demonstrate flexibility and calmness when companies are faced with strategy pivots, delays, and missed milestones.   

Terms will likely include the interest rate and repayment terms, in addition to any other conditions or limits. To help the company reach its goals, the lender may also provide extra support such as strategic or operational advice. Loan in hand, the company is responsible for loan repayment as per contract terms.

For example, say a new investor gets 20% ownership from a Series A, $10 million round. In that case, the existing shareholders’ stake held is valued at $50 million. 

The assumption here is that the company burns through $1 million monthly, which means the Series A proceeds yields a runway of 10 months. In this scenario, a $3 million venture debt loan could necessitate warrants with dilution equivalents of between 25 and 50 basis points. Here, the venture debt would add another three months to the operating runway.

Even with a 50 “basis points” pricing warrant, the loan provides about 30% more runway but carries just 1/40^th of the dilution.  

Venture Debt vs. Venture Capital

In general, venture capital investors prefer to see more venture debt than excessive venture capital investment. Early investors benefit because equity dilution is minimized.

Technically, venture debt is a form of venture capital. However, when many individuals consider venture capital, they frequently reference equity capital raised for new businesses. 

With equity venture financing, company shares are bought in return for cash, with the shares representing an ownership stake in the venture. Voting rights and sometimes a company board seat accompany equity.

By contrast, venture debt is a loan but is frequently only issued following, or along with, equity financing. The company must repay the loan, plus interest and fees such as origination, and repayment penalties.   

Benefits of Venture Debt

Risks notwithstanding, there are advantages to going with venture debt:

• Leverages startup equity. The main benefit of venture debt lies in leverage. In other words, venture debt leverages the equity a startup raises, which lowers the average cost of the capital needed to keep operations going when a company is generating less cash than it burns.  
• No need to relinquish company ownership. Venture debt financing gives start-up companies the capital required to expand and develop their business – without diluting their equity.
• Flexibility in repayment terms and conditions. For startups and swiftly growing companies that need more capital, venture debt can be a viable option since repayment terms and other conditions are often flexible and tailored to suit the borrower’s current circumstances. Most venture debt loans have a timetable of three to five years.
• Possible options. There is also the possibility of lender-provided options such as loan redemption following a period of growth, so that the lender gets early repayment. There also may be an option for loan refinancing at current terms, rendering it easier for the borrower to pivot as its borrowing needs change.
• Growth acceleration. Having attained funding, young companies can grow faster than they would likely be able to without a loan.
• Quick process. Venture debt is usually a relatively fast and convenient process. Compared to traditional bank loans, the amount of paperwork necessary to gain venture debt is significantly less.  

Risks of Venture Debt

Just as there are potential benefits with venture debt, there are risks as well:

• Interest payments. Venture debt lenders charge interest on their loans. The rate will vary based on factors such as the borrower’s financial state, where the company is stage-wise, and the loan’s overall risk.
• Potential for default. Because loans usually involve early-stage companies, such debt can be risky and lead to default. Should that occur, debt investors can take legal steps to declare the company bankrupt.
• No repayment flexibility. Because they know that half of their investments will fail – even though they usually profit enough from the other 50% to cover their losses — venture debt investors tend to be quite rigid regarding repayment terms and schedules.

Successful Companies That Have Taken on Venture Debt

There are thriving companies that have assumed venture debt, namely:

• Shopify. A leading ecommerce and retail platform, Shopify 10 years ago closed on a $100 million Series C investment led by OMERS Ventures and others. The funding helped Shopify completely expand its then-new offline retail offerings. 
• Twitter. Elon Musk paid for Twitter by assuming $13 billion in debt and the balance in equity, some of which was contributed by multiple investors. Musk recently tapped Twitter’s cash reserves for $2.5 billion of the $5.3 billion employed to shed its pre-purchase debt.
• Tesla. In 2018, Tesla, Musk’s other company, had about $12 billion in debt. After stanching the cash burn, Tesla was able to turn its finances around then used the cash to redeem its highest-paying obligations. Tesla’s debt, by the end of 2021, dropped to $6.8 billion.

Investing in Debt: Expand Your Portfolio Today

Investors interested in debt financing have a number of options in Yieldstreet, the leading platform for alternative investments, on which almost $4 billion has been invested to date.

Alternative assets are increasingly popular with investors weary of the constant fluctuations of public markets. Because of alternatives’ low correlation to stocks and bonds, they can mitigate portfolio volatility in addition to protecting against inflation or other economic disturbance.

Yieldstreet seeks to help retail and accredited investors generate secondary income through private markets, which have performed better than stocks in every downturn in nearly the last two decades. Yieldstreet offers more asset classes than any other platform, with highly vetted opportunities including real estate, art, transportation, crypto … and debt financing.      

With debt financing, a company borrows money from a lender with the agreement to repay it with interest. The loan permits the company owner to retain ownership in their business. With its debt financing opportunities, Yieldstreet makes certain the loans are backed by securities – assets that serve as collateral should the borrower default.

In addition to the potential for high returns, debt financing also serves the important purpose of diversification – creating a portfolio comprised of a variety of asset classes and types to lessen risk exposure. In fact, such diversification is the cornerstone of long-term investment success.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Early-stage companies, particularly those that are quickly growing, frequently depend upon venture debt financing to raise capital since they lack a history of generating revenue. Venture debt leverages the amount of equity a startup raises and companies need not relinquish ownership. 

Remember that investors may also go through an alternative platform to get involved with debt financing.