What is Venture Debt?

How Does Venture Debt Work?

  • It is a debt provided by the banks or financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more to the companies for the short or medium term. The number of sanctioned funds is based on the last round of equity raised by the company. Usually, amounts equivalent to 30% of the funds raised in the previous equity funding are approved for lending to the companies as venture debt funds. The interest rates attached to the borrowings may either be a prime ratePrime RatePrime Rate (also known as Prime Lending Rate i.e. PLR) is the basic interest rate charged between commercial banks (i.e. charged by the lending bank to the borrowing bank) and serves as the basis for interest rates on business loans, personal loans, vehicle loans, home loans, mortgages, and so on.read more or a benchmark rate, such as the LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more rate.This kind of funding is highly risky due to the lack of significant collateral or potential cash flows, which is warranted upon the company’s equity capital to protect against the risk. Such a warranty may range from nearly 5% to 20% of the amount of the loan sanctioned. These warranties can be later redeemed as company equity shares at the price that prevailed at the last equity round.Further, based on the type of lender, the financing agreement may contain other specific conditions. For example, banking companies may impose strict requirements, whereas non-banking companies may relax some conditions.

Types of Venture Debt

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  • Equipment Financing: This financing allows a company to finance the equipment necessary for its operations.Accounts Receivables Financing: This financing is provided by the lenders against the accounts receivable, reflected in the financial statements of the borrower company.Growth Capital: Such funds serve as a source for working capital and milestone financing. These are known as growth capital since they help an organization accelerate its growth.

When to Avoid?

Although raising funds through venture debt may sound prudent, a company should keep itself at bay from such debt in the case of the following scenarios.

  • Suppose a company does not have a road map or means to repay the debt. Then, if the loan is not repaid on time, the lenders may overtake the company’s assets to make good on its loss.One should avoid this debt if the amount payable in installments is greater than nearly 20% of the aggregate operating expenses of the company.Do not agree if the additional conditions that form an agreement part are too risky.If the company does not have any capital source left, the only option is venture debt.

Venture Debt vs. Venture Capital

The key differences between the two are enumerated below:-

  • The major difference between venture capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more and venture debt is that this debt needs to repay.Capital control is diluted in the case of the venture, which is not the case in venture debt since no equity stocks are issued.The conditions are harsher in venture debt, and the consequences can be serious when needs are not met.It is cheaper compared to venture capital.

Advantages

  • It is easy for start-up companies to raise funds through debt once they have raised venture capital.The companies can get funding without diluting their control by issuing equity shares.It is a much cheaper way to raise funds than equity.It helps companies to meet their growth objectives.

Disadvantages

  • The financing arrangement may contain strict covenantsCovenantsCovenant refers to the borrower’s promise to the lender, quoted on a formal debt agreement stating the former’s obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more, non-fulfillment of which can lead to penalties.The repayments of the amounts, if not made, can enable the borrower to take control of the company’s assets and sell them off, leading to significant risks of bankruptcy.

Conclusion

After a round of equity has been closed recently, going for a venture debt will be easier for the companies since creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more will be highest. The companies should ensure that they have sound business plans, ensuring that one can repay such loans at the time. These funds can help companies accelerate their growth and performance.

This article is a guide to Venture Debt and its definition. We discuss venture debt fund, venture debt financing, how it works, advantages and disadvantages. You can learn more about it from the following articles: –

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