Lesson #220: Venture Debt Financing, A Hybrid Between Debt and Equity

Back in Lesson #109, we compared equity to convertible debt to bank debt as finacing options for your early stage business.  There is actually another class of investment called venture debt, which is structured as a hybrid between equity and bank debt.  It has a lot of the debt features associated with a loan, although at typically higher costs, plus some equity-based incentives through the form of warrants or other royalty on revenues.

The weighted average of cost of capital for venture debt ends up around 25% per year, in the middle of bank debt at 5-10% per year and equity at 40-50% per year.  And, it is designed for companies that financially sit in between the two stages (e.g., have some revenues and traction, but not large enough to secure a typical bank loan).

Below are representative terms for venture debt:

Amount:  Depending on lender, but in the $250K to $2.5MM range
Term:  Up to 5 years (more flexible than bank debt at up to 2 years)
Interest Rate:  10-12% (which is about double a typically bank loan)
Structure:  It is a debt instrument and must be repaid (unlike equity which does not)
Ranking:  Suborbinated to senior bank loans, and senior to everything else
Security:  It is often secured by the assets of the company (just like bank debt)
Paydown:  Interest only for two years, then principal paydown starts in last three years (vs. bank debt which is interest only until balloon payment of principal at end of term)
Board Rights:  Most venture debt lenders want rights to participate with your board of directors, as member or observer (much like equity investors, but unlike bank debt that does not typically require any board rights)
Equity Incentive:  1% to 5% "equity value" through warrants to purchase stock or some other royalty on revenues, based on the amount raised (where bank debt has no equity incentives, and equity investors would want a much larger stake).

In terms of a few lenders in the venture debt space, here are some that I am aware of:  Super G (Novus), Monroe Capital, Gibralter, Point Financial, Triple Point Capital, ATEL Capital Group, Trinity Capital Investments, Western Tech, Plymouth Ventures, Aldine Capital, Amerifi and Cambridge Capital Mangement.  And, sometimes hedge funds like Citadel and Fortress play this space, depending on size.  I am sure there are many others to research, as well.  But, before reaching out to them, research their industry focus and investment criteria on their websites, to ensure a good fit.

But, beware the key pitfall to consider here:  venture debt must be repaid, just like bank debt.  So, only take on debt, of any form, if you are 100% sure you can pay it back per the terms of the agreement.  Otherwise, any inability to repay your debt will be a noose around your neck and could force you into bankruptcy.

So, if you are having trouble raising bank debt, but you have pretty good traction and revenues (at least $1MM), venture debt could be the way to go.  Especially, if you are trying to protect dilution of your equity and stockholders, and are willing to pay a high cost of capital to do that (albeit not as high as raising straight equity).

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