Venture Debt 101: Navigating the Fundraising Process

A common problem facing startup founders is how to adequately fund their businesses from inception through profitability.

Many rely on equity raises to climb up the J-curve, but the dilution that results is often a hefty price to pay. Fortunately, that isn’t the only option.

Venture debt is a potentially attractive alternative that we believe founders tend to under-utilize. Whether you’re looking for a source of growth capital with minimal dilution, a way to extend your runway between equity financings, or both, venture debt is an important component of the capital structure for many venture-backed startups.

What’s best is that you don’t need to be an expert in debt financing to make venture debt work for your business. What you do need to understand, however, is how and when to access the venture debt markets.

What is venture debt?

Venture debt is a form of financing specifically for early-stage businesses that provides non-dilutive or minimally dilutive capital (in the form of debt) to borrowers (your company).

Venture debt is meant to complement, rather than replace, traditional equity financing. In fact, a condition precedent to access venture debt is that your business is backed by a top venture investor. By extension, lenders assume your company will most likely get further rounds of financing from the same investors and others. This assumption is what gives lenders like banks the comfort to provide start-ups with relatively cost-efficient debt.

Adding venture debt to your capital structure could offer additional flexibility for early-stage businesses. Debt can extend the runway between rounds, which is significant when just one or two more months of execution can be critical for hitting key benchmarks. It also avoids the necessity for a potential premature equity raise in the event capital is urgently needed.

So if the borrower isn’t getting significantly diluted, what’s in it for the lender?

First, in the case of a liquidation event, venture debt is senior, meaning it’s paid out before equity. As collateral, lenders can be entitled to an all-asset lien, which includes intellectual property.

Second, the downside for lenders is that they are limited in their ability to participate in a company’s success. For this reason, many venture debt agreements come with warrants, giving the lender the right to purchase equity shares at a predetermined price (usually equal to or lower to the most recent or the proceeding round of equity). Warrants sweeten the deal for lenders, while only modestly diluting founders and early investors.

When should you raise venture debt?

We believe the optimal time to raise a venture debt fund is immediately after key valuation drivers, like a fund raise or a strong growth quarter.

That said, there are multiple points in the financing journey where your business may choose to strategically obtain debt. The benefits of financing with debt become especially clear in the following scenarios:

  1. In conjunction with an equity round. Raising a smaller round of venture debt following equity financing avoids raising overall equity for a business. So a business can still run with additional capital, while reducing any dilution and having an extended runway targeted on execution rather than fundraising.
  2. As a cash bridge to the next milestone or equity raise when needed. Venture debt can provide a cushion in case something goes wrong and the business needs to extend the runway to the next valuation driver. For instance, if a company has customers that were expected to sign this year slip to next year, they may leverage debt to keep the business afloat until then. In this case, it may even be enough to avoid a penalizing down round.
  3. To fund more predictable cash outlays. Debt offers an efficient way to fund working capital or other capital expenditures. If a company is in need of immediate cash to make a crucial leadership hire or get any product development past the last hurdle, this is where venture debt can step in.
  4. To extend runway without a priced round. Debt can be used to see the company through to an inflection point, like signing a large contract, without having to consider the implications on valuation. Not only can it add insurance runway as a net, but it could potentially eliminate the need for a final round of equity financing.

Tips on running a debt raise process

With many types of lenders to choose from and many terms to understand and negotiate, running a debt process can be an intimidating process. That’s especially true for any first-time founders. Don’t let this dissuade you. Keep these five tips front of mind to ensure you make the best financing decisions for your business:

  1. Establish priorities. Think through what amount of capital you need, your near-term cash flow expectations, and what degree of dilution with which you’re comfortable. This will allow you to determine how much debt to aim to raise and make a repayment plan.
  2. Understand your options. Start by discussing options with venture banks. They typically have the lowest interest rates. Debt funds may be more flexible with repayment​, but it comes at a cost. Start by asking your investors for input and introductions–venture debt lenders will find comfort in investor support of the business.
  3. Be direct and ask around. Venture debt comes in all shapes and sizes, so know what your wants and needs are and advocate for them. Negotiate early and often, aiming for three to five term sheets to create leverage​.
  4. Consider the cost. Build a side-by-side matrix comparing term sheets to share with your board. Graph interest rates, amortization schedules, and fees to compare cost. Often, it will become clear which offer pulls ahead after taking the time to map out the full cost.
  5. Conduct references. Ask to speak with the lender’s current or previous customers, especially those who’ve gone through a default or near-default situation. Your prospective lender should be able to provide reference information upon request.

We’ve compiled all the information that we believe you’ll need to confidently navigate the debt raise process—including lender ecosystem comparisons, key economic terms, and representative diligence list—into a single source of truth: the Openview Venture Debt Guide. Access the slide deck below and keep this information on-hand throughout your financing process.

Disclaimer

This blog is for informational and illustrative purposes only and has been prepared by OpenView Advisors, LLC. This information contained in this blog shall not constitute an offer, solicitation, or recommendation to sell or offer to purchase any securities, investment products, financial instruments or investment advisory services. All investments involve substantial risks and there can be no assurance that any investment objectives described herein will be achieved. All information and forecasts presented in this blog are speculative and subject to change at any time and may not come to pass due to economic, market and/or legal conditions. Recipients should bear in mind that past and present performance is not indicative of future results, nor does it ensure that investors will not incur a loss with respect to any investment. 

Sam Johnson
Sam Johnson
Corporate Development Associate

Sam is a Corporate Development Associate at OpenView, where he supports creation and execution of strategic and financial outcomes across OpenView’s portfolio, including M&A, private capital raises, IPOs, and secondary transactions.
Vinnie McSweeney
Vinnie McSweeney
VP of Corporate Development

Vinnie is Vice President of OpenView’s Corporate Development team. He works closely with OpenView’s portfolio to create and execute strategic and financial outcomes, including M&A, private capital raises, IPOs, and secondary transactions.
You might also like ...
Product-Led Growth
Time To Refine Your Metrics: Defining Growth And Success At A PLG Company
It comes as no surprise to our OpenView audience that product-led growth (PLG) as a GTM strategy is more popular...
by Mikaela Gluck
Investor Relations
10 Best Questions To Ask Venture Capitalists Amid An Uncertain Market
The dominating force in the market right now is uncertainty. Inflation, wars, climate change, recessions—we've written before about how global...
by Casey Renner
Investor Relations
Investment Bank Overview: Working With An Advisor
Investment banks can provide a tremendous amount of value to your business. This might be most clear when it comes...
by Sam Johnson, Vinnie McSweeney