Venture debt: What it is and how it works

When we hear the word “debt,” we usually give it a negative connotation. However, venture debt (when used correctly) can help your startup access capital to overcome challenges, seize opportunities, and scale your business without diluting your company’s ownership.

While equity financing and traditional loans have long been the primary sources of startup funding, venture debt financing provides an alternative financing mechanism that better serves founders and young, growing companies. It’s essentially a specialized loan designed for high-growth startups, and it’s gaining traction—especially as we face an economic downturn and venture capital funding is dropping globally.

But why has venture debt become such a hot topic in the startup ecosystem? And more importantly, is it the right choice for you?

Below, we cover everything you need to know about venture debt and how it works to empower you to make informed decisions that align with your growth strategy.

What is venture debt?

Venture debt is a type of debt financing provided to venture-backed startups. It’s essentially a loan but with a twist.

A venture debt loan is typically secured against your startup’s intellectual property, future revenues, or equity warrants, making it a more accessible financing option for early-stage companies that might not have valuable assets or steady cash flow (yet).

While traditional bank loans rely heavily on collateral like physical assets and steady revenue streams, venture debt is more lenient—it looks primarily at your startup’s growth potential. On the other hand, equity financing and venture capital involves selling a portion of your company’s ownership in exchange for capital.

Debt can be repaid, but equity, once it’s gone, is usually gone for good. Venture lending allows you to raise funds without diluting ownership, offering a balance between debt and equity.

Typical structure of venture debt deals

Venture debt deals usually include three main components:

1. Principal: This is the actual loan amount that the startup receives. The principal amount is determined based on the startup’s valuation, financial health, and perceived risk associated with the loan. Startups need to repay this amount over the agreed loan term, which typically ranges from one to four years.
2. Interest rate: The interest rate on venture debt is usually higher than traditional bank loans but lower than the cost of equity. It reflects the risk the venture debt lender is taking, as startups are often in their early stages with limited assets and revenue. The interest rate can be fixed or variable, depending on the terms of the deal.
3. Equity warrants: These options give venture debt lenders the right (but not the obligation) to purchase equity in the startup at a predetermined price. Warrants are a sweetener for venture capital investors, providing them with potential upside if the startup succeeds. The percentage of equity offered through warrants is typically small, ranging from 5% to 20% of the loan amount.

The inclusion of warrants is what differentiates venture debt from other traditional loans, providing a potential upside to lenders while keeping interest rates relatively lower.

How does venture debt work?

Like with most new things, venture debt can look a bit intimidating at first, but it’s not too complex when you break down the step-by-step process.

Let’s walk you through the journey of how to raise venture debt for your startup:

1. Research and identify potential lenders: Start by identifying venture debt providers that cater to startups in your industry or stage of growth. Venture lenders could include specialized banks, venture debt funds, or other financial institutions.
2. Initiate discussions and due diligence: Once you’ve shortlisted potential lenders, start discussions to understand their terms, interest rates, and other conditions. The lender will also conduct due diligence, assessing your startup’s financial health, growth potential, and overall risk.
3. Negotiate terms: After the initial assessment, both parties will negotiate the terms of the loan. This includes the principal amount, interest rate, loan duration, and any equity warrants or other conditions.
4. Sign the documentation: Once terms are agreed upon, both parties will draft and sign a formal agreement. This document will outline all the specifics of the loan, including repayment schedules, interest rates, and any associated covenants or conditions.
5. Receive the funds: After the agreement is signed, the lender will disburse the loan amount to your startup. Depending on the agreement, this could be a lump sum or in portions.
6. Use the funds: Use the funding to meet your growth objectives, whether it’s building out your product roadmap, implementing marketing ideas, or addressing your technical debt.
7. Repay the loan: Over the agreed loan term, your startup will repay the principal amount along with interest. This could be on a monthly, quarterly, or other agreed-upon schedule.
8. Exercise of equity warrants (if applicable): If the loan agreement included equity warrants, the lender might choose to exercise these options at some point, converting them into equity shares in the startup.
9. Complete the loan term: Once all repayments are made, and any equity warrants are exercised or expired, the venture debt agreement comes to a close.

The pros and cons of venture debt

Like any financial instrument, debt equity comes with a unique set of benefits and drawbacks. You’ll need to weigh these pros and cons to determine if venture debt is the right choice for your specific situation.

Pros of venture debt

Venture debt can be a strategic tool for startups, especially those looking to extend their runway or gain a competitive edge in the market. Here are some of the primary benefits:

• Extended runway without dilution: Access growth capital without giving away equity. This means you retain more control over your company and don’t dilute ownership stake.
• Flexibility in capital structure: Venture debt gives startups more flexibility in their capital structure, allowing you to optimize the balance between debt and equity.
• Strategic leverage in future funding rounds: Having venture debt can position a startup more favorably in subsequent funding rounds. It can serve as a signal to potential investors that the company has mature financial management practices.
• Quick access to capital: Compared to traditional equity fundraising, venture debt can often be secured more quickly, providing startups with the funds they need without a prolonged fundraising process.

Cons of venture debt

Venture debt offers numerous benefits, but it’s not without its challenges. Startups should be aware of the potential drawbacks:

• Interest rates and terms: Venture debt typically comes with higher interest rates than traditional bank loans. Startups need to ensure they can manage these rates and the repayment terms.
• Warrants and equity components: Some venture debt deals include warrants, which give the lender the right to purchase equity in the startup. This can lead to dilution if the warrants are exercised.
• Potential for over-leveraging: There’s a risk that startups might take on more debt than they can handle, leading to financial strain and potential solvency issues.

When is venture debt the right choice for your startup?

Venture debt can be a powerful financial tool for startups, but it’s not a one-size-fits-all solution. The decision to opt for venture debt should be based on a careful evaluation of your startup’s unique circumstances, financial health, and growth objectives.

Here’s how to determine if venture debt is the right choice for your startup:

Evaluate your startup’s financial health

Start by examining your cash flow vs profit, burn rate, and existing liabilities. A healthy financial position indicates that your startup can manage the additional debt and associated interest payments. If your startup is already struggling with existing liabilities or has a high burn rate, adding more debt might be the wrong choice.

Understand your timing

Timing plays an important role in the decision to take on venture debt. Some ideal scenarios include:

• Post-equity round: After a successful equity fundraising round, venture debt can be used to extend the runway and maximize the time before the next fundraising event.
• Bridge to profitability: If your startup is close to becoming profitable but needs a short-term cash infusion to get there, venture debt can be a suitable option.
• Ahead of a significant milestone: If your startup is approaching a significant milestone that could increase its valuation (like a product launch), securing venture debt beforehand can be strategic.

Align with your growth strategy

Venture debt should align with your startup’s growth strategy. Ask yourself:

• Do we need the capital? Consider the different scenarios. What would happen if you got the money? What would happen if you didn’t?
• Will the capital accelerate growth? The funds should be used for initiatives that directly contribute to growth, such as expanding into new markets or scaling production.
• Is there a clear plan for repayment? Ensure that there’s a strategy to generate the revenue needed to repay the debt, whether through increased sales, future fundraising rounds, or other means.

Protect your startup’s financial future with DigitalOcean

There’s a lot of uncertainty when it comes to fueling your startup’s growth and securing the necessary capital. Venture debt can be a powerful tool to grow your startup, but it can also put you in a bad situation if it’s not the right time or solution.

However, when you work with DigitalOcean, you get nothing but transparency and predictable pricing.

We provide simple pricing plans so that you always know what you’ll pay with monthly caps and flat pricing—that means no nasty surprises at the end of the month. See the pricing for yourself, or talk to our sales team to find the best mix of cloud solutions to meet the unique needs of your business.