Private equity involves several different types of transactions, which can make breaking into this class of investments daunting. While some transactions are more common than others, one form of investment that has become more popular in recent years is venture debt.

Early stage companies and startups can use venture debt as a complement to equity venture financing. Both banks and non-bank lenders provide venture debt to startups, although increasingly banks have reduced their exposure. When done properly, this approach to funding helps to reduce dilution of the equity stakes of current investors and can ultimately be a cheaper form of capital. Leaders in the venture debt lending space include Silicon Valley Bank and venture debt pioneer Western Technology Investment (WTI).

What Exactly Is Venture Debt

Today’s startups have several options when it comes to funding their ventures. Traditionally, companies opt for conventional debt financing through loans. However, this approach generally requires some sort of collateral which most early stage companies do not have.

With venture debt financing, startups do not necessarily need collateral. Instead, lenders are compensated with warrants on common equity, which hedges the high-risk nature of the investment. Stock warrants are a long term option that provides investors with the right but not the obligation to purchase equity. This approach can reduce the amount of equity the company creates.

For the most part, venture debt is given to startups that have already undergone at least one round of venture capital equity fundraising. These companies may not want to further dilute the pool of equity, which reduces the value of those shares.

The best candidates for venture debt are startups that have some history of operations, which instills confidence in lenders, but do not yet have enough positive cash flow to qualify for more conventional loans. Most startups use this type of funding to reach anticipated milestones through the acquisition of capital assets rather than for general growth and operations.

How Do Venture Debt Loans Work?

As you might expect, venture debt works differently compared to conventional loans. In general, venture debt is a short- or medium-term loan (usually a period of three or four years). The principal for the loan is usually calculated by looking at the amount raised in the most recent round of funding. Lenders typically offer about 20 percent of the total funds raised in the latest round as the total loan amount. Venture debt usually involves interest payments based either on the prime rate or a benchmark like LIBOR, the London Inter-Bank Offered Rate, plus a healthy margin for risk. The interest on these loans can be quite high, tending toward the range of 10 percent to 15 percent.

As lenders receive warrants on the company’s common equity as part of the compensation given the high risk of default, distributed warrants are usually equivalent to between 5 percent and 20 percent of the principal of the loan. These warrants can be converted into common shares by paying the per-share price of the last equity financing round, which provides more income to the company and increases the investment made by the lender.

The entire debt process may also include some covenants. Venture debt is typically considered “covenant lite.” Non-bank lenders tend to include only a few covenants, but banks may include several more to ensure they receive the required payments.

Why Would Startups Choose Venture Debt?

The benefits of venture debt for entrepreneurs can be compelling. Some people facetiously refer to venture debt as a “bonus round” to highlight its ability to allow startups to achieve key milestones that are critical in their development. The valuation of startups occurs in a stepwise fashion, and securing this additional capital can help get companies to the next highest tier before an upcoming valuation event.

In other words, this form of debt makes it possible to reach milestones and achieve more progress without diluting equity as much by going after additional capital in early rounds. Excess dilution often causes issues down the line for startups, so venture debt is often a smart alternative, especially with a clear milestone in sight.

The benefits of venture debt extend beyond the issue of equity dilution. Typically, venture loans can be arranged quicker than equity financing occurs. This timeline grants access to money faster, but it also saves management time. Venture debt loans can be closed in as little as two weeks from the initial contact. Another major benefit is that firms offering venture lending rarely request board seats or observation rights. Thus, board dynamics and operational control remain substantially intact while the company works to meet its next milestones.