What is venture debt?
Venture debt is a term loan provided to scale-ups (young companies that have already matured from the start-up phase, but still need financing for their growth). Typically this loan is provided when a new equity round is raised or immediately afterwards. Venture debt has three typical purposes:
1. extend the runway of the equity round or,
2. finance the asset base (for example a loan book in the fintech sector) a company builds as a critical component of its business or
3. finance M&A.
Venture debt is typically paid back over 36 months. The money is “spent” in the first 15 to 18 months of the term. The cost is significantly lower than equity costs. The debt provider will charge a closing fee, monthly cash interest and will require a small equity kicker.
For traditional lenders/banks, scale-ups are virtually the exact opposite of what they would generally consider “bankable,” because such companies: burn cash, lack current and/or long-term assets on their balance sheets and operate in yet-to-be-proven environments. Traditional loans also do not fit the needs of scale-ups. These loans have financial covenants in place that grant strong rights to the lender if the borrower under-performs. But scale-ups can have (and probably will have) a weak quarter or two.
When underwriting a loan, a traditional lender will place heavy emphasis on cash flow or leverage ratios (such as DSCR and debt/EBITDA multiples) and/or balance sheet values (the liquidation value of current and long-term assets).
In contrast, a venture debt provider will rely more on the substance of the business model, the market size and robustness of business growth and going concern value. (In other words, if growth disappears and VCs stopped funding - who would likely buy this company and what would it be worth?)