Venture Debt - A Primer

The Fed has decided to raise interest rates steeply. One rate hike has already been announced this year (2018). It is likely that there are many more rate hikes to follow until the year 2020. The cost of capital is likely to go up.

In a high-interest rate scenario, investors typically prefer to invest in debt itself. This is because the returns from equity do not seem very attractive if the returns from debt increase significantly.

In a high-interest rate scenario, the risk appetite of investor is reduced. Hence debt funding becomes more prevalent during such times. It seems like high-interest rates will be the norm for the next few years. Therefore, high-risk investments like venture capital may face a shortage of funds. It is for this reason that the popularity of venture debt is increasing. In this article, we will have a closer look at venture debt.

What is Venture Debt?

Venture debt means the wide variety of debt-based financing options that can be used by companies that have already been backed by venture capital firms. Venture debt can be raised from the same firms that provide venture equity funding. However, such companies make debt investments only in very rare cases.

Usually venture debt is raised from banks and other consortiums which have an expertise in making such investments. However, it needs to be understood that like any other debt investment, venture debt is also a loan. Hence, it needs to be paid back

Benefits of Using Venture Debt Funding

The benefits of using venture debt are as follows:

  • Less Dilution: The biggest benefit of venture debt is that the stake in the business is not diluted. Hence, promoters can raise cash in the short run. Once they pay it back with interest, they will still have ownership of the stake. If the business is run in an efficient manner, this stake will become more valuable as a result of the venture debt. In the right hands, venture debt is a tool for creating value.
  • Easier To Obtain: The due diligence process in a venture debt funding scenario is not as stringent as it is in the case of equity fund raising. This is because in case of equity financing investors are more concerned about the viability of the future project being proposed by business.

    However, in case of debt, venture firms lend against the already existing cash flows. If a firm has a relatively stable cash flow, it can easily obtain venture funds in a matter of days. However, the management of the firm will have to obtain the permission of other equity investors before venture debt can be obtained. This is because new venture investment also increases the risk of equity investments that have already been made.

  • Less Interference: Business owners are very concerned about the loss of control once they apply for venture funding. In many cases, the freedom of the management team has been severely curtailed by the venture firms. However, in case of venture debt, the lender gets no say in the operations of the firm. Only if the borrower defaults on the loan can the lender interfere in the day to day operations of the firm.
  • Immediate Cash Flow: It is common knowledge that most startup businesses die because of the shortage of cash and not because their idea was not viable. Hence, it is the job of the founders to ensure that the business never runs out of cash. Venture debt can help businesses achieve this.

    Given the changing economic scenario in the future, venture debt may become a necessity for most firms.

  • Positive Signals: When promoters are willing to undertake venture debt for their firms, it means that they are confident about their operations and the ability of the firm to generate cash flow.

    The fact that lenders are also willing to lend sends a positive signal about the firm to the market in general. It has been observed that the valuation of the firm increases in the round following a venture debt funding. It may be attributed to the confidence infused by the positive signals. Alternatively, it could also be attributed to the fact that trading on equity increases the return on investment for equity shareholders.

  • Avoiding Down Rounds: In certain market conditions, venture capital is hard to come by. For instance, if the Fed raises interest rates considerably now, it will be difficult to obtain venture capital. Since there are not enough funds in the market, the venture capital firms try to obtain a larger stake in the venture by offering a lower valuation. This is called a “down round” i.e. the successive valuation of the firm has reduced from its previous value.

    Venture debt provides the opportunity to avoid down rounds. If a startup needs funds, it need not sell equity at depressed prices to raise those funds. In such scenarios, venture debt allows promoters to hold on to their stakes and avoid dilution as well as loss of control.

To sum it up, venture debt is an important tool. This tool is particularly helpful in the era of high-interest rates. Also, if used correctly, it helps firms keep their business running by providing them adequate cash flow at the right time.

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