By Fernando Berrocal
A term loan is a loan for a set amount with a repayment schedule and a regular or fluctuating interest rate. When you obtain a term loan from a financial institution, you have venture debt funding. This is a method for funding a business without having to issue equity. Debt financing, on the other hand, is unlike a traditional business loan; it’s only available to entrepreneurs whose businesses are funded by venture capital (VC).
So, what is venture debt? How does it work? VCs invest in businesses in return for parts of ownership. Startups who pass on funding from VCs (and those that specialize in venture loan funding) are known as "venture debt lenders.” Private equity organizations, banks, and business development companies (BDCs) are examples of venture finance providers. A venture debt loan generally has three years and is called senior debt. It must be paid before any other obligations.
Venture debt often includes interest in the form of stock warrants and basis points (BPs), as well as an origination fee. The loan amount might be calculated as a percentage of the most recent round's value. In addition, the venture lender may impose interest on the loan as a percentage of the principal, ranging from 12% to 15%. This loan is secured by a blanket lien (it allows the right to seize any sorts of assets acting as collateral possessed by a debtor in the case of nonpayment) on your organization's assets. It might also include the CEO's stake in terms of intellectual property (IP). If you take out venture debt to buy equipment, the loan is secured by it; if you fail to pay, the lender gets a claim on the purchase.
Venture Debt vs. Venture Capital: Venture loan funding is distinct from traditional fundraising. It doesn´t require you to give the lender equity. The ownership of your organization doesn´t change. Venture debt can help entrepreneurs keep control of their businesses. The lender will almost always demand you issue stock warrants. However, their dilutive potential is lower than that of giving shares to a venture investor. Otherwise, venture capital firms give working cash in return for shares (which might dilute your ownership.)
Business Loans vs. Debt Finance: The main difference? In the case of a business loan, the startup receiving the loan is not required to have previously obtained venture capital. This would, however, be a necessity in the case of venture loan funding.
Debt Finance vs. Business Loan Qualification: A typical business loan examines an organization's financial history (including income and cash flow) to evaluate how risky it is to lend it money. They also look at a startup’s credit score; however, income is unusual in early-stage businesses (since they don't have much financial history.) Any financial institution would be reluctant to lend money to a business based on those factors.
This is where equity investors come in, which is why you must have completed at least a Series A before taking on venture financing. A venture loan business will look at your investors - and how much they've already supported your business in earlier equity rounds - rather than your organization's financial history. They'll also look at how much money your firm has raised and examine the quality of your product, team, and business plan using their standards.
Debt Finance With Collateral vs. Business Loan: Venture debt organizations may place a blanket lien on your firm's assets in the case of growth capital loans. They do this since your business is a high-risk borrower (and it’s new.) Otherwise, a conventional business loan may ask you to put up no collateral or a portion as security and your accounts receivable or tangible assets.
Venture Debt Funding and Stock Warrants: One notable distinction is that they provide stock warrants as part of the sale. A stock warrant assures the holder that they will be able to buy stock in a firm at a specific price before the warrant's expiration date. If a person or organization buys a stock warrant for a firm with a low exercise price and utilizes it to buy stock later, when the organization's value has increased, the warrant holder might profit. This usually happens following an initial public offering (IPO) or business acquisition.
Even with a blanket lien, lending money to startups is a high-risk gamble. That loan would come with an interest rate higher than most entrepreneurs could afford. Venture finance lenders employ stock warrants as part of their conditions to decrease risk and lower interest rates. So, regardless of your capacity to repay, you give them stock warrants when you borrow money. Keep in mind that while warrants are a kind of dilution, they normally cause far less dilution than outright equity sales. If your business succeeds, the lender may earn substantially from stock warrants, which reduces risk and guarantees you get an interest rate you can afford.
Interest Rates on Typical Venture Finance Funding: The interest rate on a typical business loan is in the single digits. When venture debt finance businesses charge interest on a loan, it ranges between 12–15%. Not all venture debt financing organizations charge a portion of the loan as interest. Some businesses will charge BPs in exchange for stock warrants.
Is Venture Debt Financing Appropriate For Your Business? In the next list, we´ll go over some common instances in which businesses employ venture finance:
- To keep the firm afloat until the next round of funding, a venture loan might offer the capital to keep your firm growing in between investment rounds.
- To get the business through the last stretch until it becomes cash flow positive. If your firm is about to break even, a cash flow loan might help you stay afloat until you reach profitability (while avoiding a final funding round.)
- During a funding round, avoid dilution. You can minimize the amount of equity and issue by complementing an equity financing round with a loan, diluting your shares, and making it simpler to keep control of your firm.
When You Should Avoid Using Venture Loan Funding: If your business isn't on a consistent, continuous development path, venture loan funding is a questionable idea. If you default on a blanket lien loan, the lender may take everything you own - including your IP - or force you to liquidate your business.
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