Venture Debt — A financing alternative to Venture Capital
To most of us, venture capital is a well-known financing instrument for startups. But have you heard about venture debt already? Let’s have a look at venture debt as a complementary, alternative financing instrument for young, fast-growing startups.
What is venture debt?
Venture debt is a type of debt financing obtained by early-stage companies. This type of debt financing is typically used complementary to venture capital. Venture debt providers play in the space between VCs and banks, combining elements of both. While they can assess the risk of early-stage companies and the risk of refinancing by VCs efficiently, venture debt lenders provide a unique product that especially helped to accelerate growth in the US tech industry in the past two decades. In Europe, venture debt became increasingly popular as the availability increased, and the general perception of venture debt changed positively in recent years.
How does venture debt work?
Most venture debt takes the form of a growth capital term loan. It typically incorporates three elements: a fee of between 1% and 2% of the approved loan amount, an annual interest rate of between 10% and 12%, and an equity kicker worth 10% to 20% of the loan. The loan usually has to be repaid within three to four years, but often starts with a 6- to 12-month interest-only (I/O) period. During the I/O period, the company pays accrued interest, but not principal. When the I/O period is complete, the company begins paying down the principal balance of the loan. The duration of the I/O period and the terms under which the loan can be drawn are key points in the negotiation process.
The growth of venture debt in Europe
While venture debt was mainly beneficial to the US tech scene in the past two decades, it is also on the rise in Europe with a CAGR of 37,7% from 2015 to 2021. According to Dealroom.co, startups in Europe have raised a record EUR 10.8 billion (USD 12.5 billion) in venture debt so far in 2021, surpassing the previous high set in 2017. It is worth knowing that in 2015, the figure was just EUR 1.6 billion (USD 1.85 billion) with the UK being the dominant market. Although the above figures for venture debt financing already sound impressive, they are still comparatively low if compared to venture capital financing in Europe, both in absolute and relative terms. After all, according to Bloomberg, more than EUR 100 billion (USD 114 billion) in venture capital has been raised by European startups last year 2020.
Venture debt vs. venture capital — What are the differences?
While venture debt and venture capital serve the equal goal of providing growth capital to startups, they can differ in a few ways. We have prepared an overview to compare both financing instruments below:
For whom can Venture Debt be the right alternative?
Venture debt is ideally suited as an innovative, low-dilution financing instrument for young, dynamically growing technology companies. Most of the time, it is used complementary to venture capital in one of the following use cases:
1) The startup is growing steadily, is close to cash breakeven, and is looking for a financing instrument that can be repaid from its own cash flow.
2) The startup needs financing that can be provided at short notice, is cheaper than equity, and is provided without strategic interests.
3) The startup wants to implement a project (e.g., an expansion, product or market extension, an acquisition) that pays for itself promptly and has predictable and recurring revenues.
4) The startup is so far advanced in its development that bridge financing does not make sense in terms of giving up more equity.
5) The cash flow is close to positivity and venture debt can help to achieve the next milestones before seeking another equity round.
6) From a cash flow perspective, the company is creditworthy, but banks are not (yet) lending to the startup.
Prominent examples for European startups that have used venture debt are TIER Mobility and GetYourGuide.
This newsletter is fully independently produced by the members of the Nova Venture Capital and Private Equity Club. This club is run by students of the Nova School of Business and Economics.
You can access directly the sources we used:
CB Insights Research (2020). Venture Debt Vs. Venture Capital in One Graphic. CB Insights Research. Retrieved from https://www.cbinsights.com/research/venture-debt-venture-capital-vc-comparison/
Corporate Finance Institute. (n.d.). Venture Debt — Overview, Breakdown, and How It Works. Corporate Finance Institute. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/venture-debt/
Gordan P. (2012). Venture Debt: A Capital Idea for Startups. (n.d.). Kauffman Fellows. Retrieved from https://www.kauffmanfellows.org/journal_posts/venture-debt-a-capital-idea-for-startups
Levingston, I (2020). Europe to Surpass $100 Billion in Startup Funding This Year. Bloomberg. Retrieved from https://www.bloomberg.com/news/articles/2021-12-07/europe-to-surpass-100-billion-in-tech-startup-backing-this-year
Teare, G. (2021). The Q3 2021 Global Venture Capital Report: Record Funding Trend Held Strong. Crunchbase News. Retrieved from https://news.crunchbase.com/news/q3-2021-global-venture-capital-report-record-funding-monthly-recap/
Szalontay, M. (2021). Venture Debt: Leverage For Enhancing Venture Capital Returns. Forbes. Retrieved from https://www.forbes.com/sites/forbesfinancecouncil/2021/11/01/venture-debt-leverage-for-enhancing-venture-capital-returns/?sh=6184d067f467
