Finding investors and lenders isn't always easy for young, growth-oriented companies. Additional equity investors require additional company shares, and loans are often measured based on cash flow. Venture debt can close this financing gap. Which companies are suitable for venture debt? And when is the right time for a venture loan? An overview.
A guest article by Oscar Jazdowski, Co-Head of Silicon Valley Bank Germany
Raising venture capital through equity is a common way for many startups to continue investing and growing: Venture investors or VCs acquire equity stakes in young, innovative, privately held companies that, despite insufficient ongoing profitability, exhibit above-average growth potential. However, the cost of equity fluctuates considerably throughout the economic cycles of the innovation economy. There are always phases in which equity is scarce on the market.
Loans could then be an attractive financing option. However, in practice, this often proves difficult for companies. The majority of loans are granted based on generated cash flow. One dilemma: Naturally, this is almost always negative for younger companies. Lenders also usually require financial evidence for the past three years in the form of annual financial statements – requirements that young companies can rarely meet. For most tech companies, the situation is further complicated by the fact that they predominantly rely on so-called asset-light business models, in which everything that requires high investments is outsourced to suppliers in case of doubt, or is not even necessary because they focus on purely digital products.
How can venture debt help?
The venture debt concept becomes attractive when companies that are no longer in their early stages or have even grown beyond the early stages have successfully raised equity financing but now don't want to significantly dilute their shareholder structure. Instead of focusing on historical cash flow or working capital as a source of repayment, venture debt emphasizes the borrower's ability to raise additional capital to finance growth and repay debt—true to the underlying idea that debt is cheaper than equity. The average cost of capital decreases, thus justifying the loan. If collateral can be provided, this is also helpful.
Venture debt capital primarily provides young growth companies with flexibility and extends the impact of the equity raised. From the perspective of equity investors, this additional venture capital is therefore a positive sign: It increases the portfolio company's liquidity, boosts its momentum, and also contributes to its reputation. Just like equity, venture debt can make a valuable contribution to further development, for example, new innovations or expanding the team. At the same time, it can be seen as a hedge against performance slumps or valuation hurdles.
Which companies are suitable for venture debt?
The typical venture debt borrower is a fast-growing company that has, for example, raised money from venture capital firms and has a defined strategy for further capital raising. Ideally, the company is not at the very beginning of its financial journey and has already secured Series A funding of at least five million euros. The business model should have proven viable and scalable, implemented by an experienced management team. Revenue and customer base should demonstrate sustainable growth. During this phase, business-critical technology risks can usually be excluded.
Which criteria receive which weighting depends closely on the respective company and its specific situation. The amount of risk loans generally depends on the size of the equity round and the current and projected cash burn rate.
When is the right time for venture debt?
Venture debt financing is typically synchronized with a traditional equity round. Often, both negotiations take place in quick succession, with closings often only a few weeks or months apart. At first glance, it may seem silly to take on venture debt just as new capital is being infused into the company. However, in many cases, the debt can be structured with an extended grace period, eliminating the need to fund the loan immediately.
Regardless of when the loan is actually to be financed, the company's creditworthiness and negotiating leverage are highest immediately after the new equity round is closed. Furthermore, the additional effort is lowest during this phase: The venture debt provider can utilize most of the content of the investor due diligence prepared for the equity round.
What should you consider when choosing a lender?
Hardly any company grows exactly as envisioned in the original business plan. Debt capital provided without traditional collateral can serve as a financial buffer and simultaneously accelerate growth. But not at any price: Just as debt providers carefully screen their potential borrowers in advance, companies should carefully evaluate their financiers.
Industry experience, transparency, and reliability are important criteria for a successful collaboration. Inquiries about a solid track record as a venture debt provider are just as appropriate as pre-contract discussions about what happens if performance develops unexpectedly, milestones are missed, or other bottlenecks arise. This is inevitable, especially with innovative business ideas. It is therefore of great value to establish a partnership with a lender who has the experience and ability to remain flexible and calm.
