What is venture debt, and how does it differ from traditional startup funding? What are the potential benefits and risks of this alternative financing option?
In Venture Deals, Brad Feld and Jason Mendelson explain how venture debt offers startups a way to secure funding without giving up equity. This specialized form of lending has become increasingly popular, but recent events such as the SVB collapse highlight important considerations for entrepreneurs.
Read on to discover the advantages, drawbacks, and real-world implications of choosing venture debt for your startup’s growth.
Venture Debt
What is venture debt? The book explores term sheet items and the different factors entrepreneurs need to consider when working with VCs and exchanging company equity for startup capital. But, what if you want to raise money without sacrificing equity? This requires a distinct type of venture finance called venture debt or venture loans.
The authors explain that venture debt is specifically designed for startups and high-growth companies. Instead of borrowing from a bank and sacrificing equity, you get loans from specialized lenders who understand the unique risks and needs of the startup world. Next, we’ll explain the biggest benefit and some drawbacks of this type of funding.
| The SVB Collapse and the Risk of Venture Debt It’s worth noting that some specialized lenders may themselves rest on a shaky financial foundation—and if you don’t choose your lender carefully, you could be putting your business at risk. In 2023, lender Silicon Valley Bank (SVB) collapsed due to a rise in interest rates during 2022-23 that made the bank’s heavy investments in long-term bonds untenable. It started when SVB—at the time the largest holder of deposits in Silicon Valley—had a glut of cash deposits from its tech startup clients. But since those companies already had plenty of access to cash loans thanks to low interest rates, SVB had to find other ways to invest and make money. What they chose to invest in were long-term mortgage-backed securities—a type of bond. SVB put 56% of its total assets into these bonds, far more than most banks do. Since bond prices fall when interest rates rise, if interest rates were to rise, the value of all these bonds SVB had bought would decline. In effect, the bank was taking a big gamble that interest rates wouldn’t rise. Then, when the Federal Reserve began raising interest rates in 2022 to combat inflation, the value of SVB’s bond holdings plummeted. As word spread about the bank’s teetering financial position, depositors scrambled to pull out their money. To meet this depositor demand, the bank had to sell its already-discounted bonds at ever-greater losses—triggering even more panic among depositors and leading to a bank run that resulted in the second-biggest bank failure in US history. |
Benefit: Greater Flexibility
According to the authors, the major benefit of venture debt is that it can offer greater flexibility than equity financing. The terms of the loans are often negotiable and can be tailored to suit the specific needs of your business.
For instance, you might negotiate a flexible repayment schedule. This could mean making smaller repayments in the early stages when your startup is still finding its feet, with larger payments coming due once you’re more established and generating higher revenue.
Alternatively, you might arrange for repayment conditions that align with your startup’s growth trajectory. For example, if you expect a significant increase in revenue after launching a new product or entering a new market, you could structure the loan so that repayments increase proportionally with expected revenue growth.
Importantly, note the authors, unlike with VCs, you’re not tied down by investor expectations about where their money should go; instead, you have more freedom to allocate resources according to what’s best for your business.
| Sectoral Over-Reliance on a Single Lender Although many lenders have industry-specific expertise that can suit your business, the relationship between lenders and clients can become problematic when a sector becomes too reliant on one lender. For example, Ampla is a VC-backed lender focused on small direct-to-consumer brands. The company carved out a niche by offering attractive terms to small companies that often struggled to secure traditional bank loans. However, it faced financial difficulties in 2024 and consequently pinched many clients’ credit lines. In the fallout, many businesses in the sector now face a sudden credit crunch, forcing them to seek alternative funding sources quickly. These businesses have struggled to find funding, since the terms offered by Ampla have proven hard to match in the broader market. Because this impacts many businesses in the same sector, it’s had a ripple effect on an entire retail segment. |
Drawbacks
The authors warn that, while venture debt offers opportunities, it also comes with significant risks for your startup. You need to carefully consider these potential drawbacks before taking on venture debt. Let’s explore two major drawbacks: high cost of capital and financial covenants.
High Cost of Capital
Feld and Mendelson note that venture debt typically carries higher interest rates and fees compared to traditional bank loans. Therefore, it increases your business’s overall cost of capital—that is, the total expense of securing financing. Since it’s a more expensive form of financing in the long run, venture debt can negatively impact your profitability and cash flow, limit your financial flexibility, and potentially hinder your ability to invest in growth opportunities.
(Shortform note: Despite the high cost of capital, one analysis shows that venture debt grew from 10% of the size of the VC market in 2017 to 14% in 2022, as startups were increasingly drawn to the idea of not diluting their equity stake through VC backing. The same analysis showed that the venture debt market will grow to 20% of the size of the VC market by 2027.)
Financial Covenants
The authors also warn that venture debt agreements often include financial covenants that your startup must adhere to. These might include maintaining certain financial ratios or performance metrics. Breaching these covenants could lead to default and other serious consequences, potentially putting your entire business at risk.
Imagine, for example, that you’re the founder of a tech startup, and you’ve secured venture debt from a lender to fuel your growth. As part of the agreement, the lender includes financial covenants that require your company to maintain a minimum cash balance of $500,000 at all times. Now, suppose there’s an unexpected downturn in the market, or perhaps a key customer fails to renew their contract. As a result, your revenue takes a hit and you burn through cash more quickly than anticipated while trying to keep operations running smoothly. By the end of quarter three, you fall short of the agreed upon $500,000 minimum cash balance.
In this scenario, you’ve breached your financial covenant, which could trigger serious consequences—like defaulting on your loan. If you defaulted on your loan, all outstanding debt would become immediately due, and your lenders might also be able to claim assets as repayment.
(Shortform note: One alternative to dealing with lenders’ sometimes onerous financial covenants and other requirements is to finance your new business with customer cash instead of lender cash. Customer-funded models allow you to support business growth while avoiding significant debt or equity dilution. Tactics include obtaining payments in advance for services, implementing subscription models that ensure regular income, and creating urgency through limited-time offers, all of which accelerate cash flow.)
Exercise
Traditional VC funding is equity-based and can dilute your ownership, while venture debt carries higher interest rates but allows you to retain more equity. How would you decide the right balance between debt costs and equity dilution?
