- within Corporate/Commercial Law topic(s)
- in United States
- within Wealth Management and Finance and Banking topic(s)
After closing a priced equity round, early-stage companies often find that their runways shrink faster than expected. Before selling additional equity and diluting the founders and existing investors even more, there is another tool worth considering: venture debt. When deployed thoughtfully, venture debt can be a valuable tool to help an early-stage company extend runway, serve as a strategic insurance policy in uncertain fundraising environments, fund discrete initiatives, or hit milestones that support a higher valuation in the next equity round. But venture debt comes with obligations and constraints that founders should evaluate carefully before signing on.
This installment of the Founders’ Toolkit provides a high-level overview of venture debt, when it should be used, and how founders should approach negotiating the terms.
What Is Venture Debt?
Unlike a traditional bank loan, venture debt is designed for startups that may not yet be cash flow positive or have substantial assets to pledge as collateral. Venture debt lenders often focus on the strength of the company’s investor base and the projected growth of the business, instead of just the current balance sheet.
There are two primary structures for these types of loans. A term loan provides a lump sum upfront that is repaid over a fixed schedule. A revolving credit facility functions more like a line of credit, allowing the borrower to draw, repay, and redraw as needed. The right choice depends on the intended use of capital and the nature of the company’s business.
When Should Founders Pursue Venture Debt?
Timing matters. Venture lenders are not looking to serve as bridge financing to the next equity round. They want to see institutional investors on the company’s capitalization table that can support the company through challenges. The sweet spot is typically concurrently with, or shortly after, a priced equity round, when sophisticated investors have recently performed extensive due diligence on the business, making the company a more creditworthy borrower.
If the company’s investors have relationships with venture lenders (and many do), founders should lean on those connections. A warm introduction can open doors, accelerate diligence, help to build stronger relationships, and sometimes lead to more favorable terms.
Key Terms of Venture Debt Facilities
The economic terms (e.g., loan amount, interest rate, repayment schedule, and fees) are where founders typically focus their attention, but it is equally important to understand how the non-economic terms can impact the company’s operations.
Venture debt facilities are almost always secured, meaning the company is pledging substantially all of its tangible and intangible assets as collateral. Bank lenders will also frequently require the company to move its operating accounts to their bank, and non-bank lenders will require control agreements, which gives the lenders the ability to access the company’s bank accounts if they need to foreclose on the company’s assets.
Founders should also pay close attention to the covenants, which generally fall into three categories:
- Affirmative covenants — things the company must do, which typically includes delivering regular financials and maintaining insurance.
- Negative covenants— things the company cannot do without lender consent, which typically includes restrictions on incurring additional debt, making acquisitions, and paying dividends.
- Financial covenants— ongoing metrics the company is required to maintain, which typically includes minimum cash balances or revenue thresholds.
Of these, negative covenants deserve particular attention. Startups move fast, and needing lender approval before making critical business decisions can create friction. Founders should ask prospective lenders how quickly they respond to consent requests. Lenders with active venture lending programs are typically well-equipped to move at startup speed. If a specific transaction is on the horizon, such as an acquisition or strategic partnership, the company should try to carve out explicit permission upfront in the term sheet with the lender.
Soliciting and negotiating multiple term sheets is the best way to benchmark market rates and build negotiating leverage.
Equity vs. Debt: Understanding the Trade-Off
Venture debt comes at a cost, as the company is paying interest, fees, and potentially granting warrants to the lender, but compared to equity, the cost of capital can be meaningfully lower, especially at early stages when the valuation might not yet reflect the company’s full potential.
That said, debt has a maturity date. Unlike an equity investor, who rides the ups and downs alongside the company, the lender expects to be repaid on a set schedule. Missing payments can have serious consequences, including enforcement of the lender’s remedies against the company’s assets.
The Bottom Line
Venture debt is a legitimate and often smart tool for extending runway and preserving ownership.
Founders should know what they’re pledging and understand what they’re agreeing not to do.
Want to go deeper? Listen to our full conversation on venture debt on The Founder's Hour podcast: Borrowing Smart — Venture Debt and Other Financing Alternatives.
Originally published by Gildre For Founders Newsletter.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
