Venture debt is a powerful tool to grow your business – here’s how it works.

Growing a business is a balancing act. Founders try to fuel growth while using funds efficiently. To embed a clear strategy while staying flexible enough to pivot. To scale at speed without sacrificing customer experience.

One way to achieve that balance is to use venture debt to complement equity. Designed specifically for equity-backed, high-growth companies, it is a powerful tool to grow without further diluting your ownership.

But what is it, how is it different to equity, and who is eligible? This article answers those pressing FAQs.

Venture debt is a loan designed to help start-ups and scale ups, typically Series A, B, and C, who are fast-growing but lossmaking, to reach strategic milestones.

Like any other loan, venture debt needs to be repaid, typically over 33 - 36 months. The debt can be used in a variety of ways – discussed and agreed in advance with the lender - from performance insurance or lower-cost runway extension to funding acquisitions, capital expenses or inventory.

Crucially, venture debt is often less expensive than equity – and it’s less dilutive. That makes it an attractive option, but it is important to note that debt follows equity – it does not replace it.

In fact, the two are closely linked.

When underwriting a loan, venture lenders assess a business’s venture capital support. They will consider the performance objectives associated with their latest round of equity – timing, targets, strategy, and objectives – to determine the loan size, although this is also influenced by investor syndicate, market traction, and unit economics amongst other factors.

The main difference between venture debt and equity is that while some sort of future liquidity event is expected when raising venture capital, it is not usually contractually required, whereas venture debt will need to be repaid in accordance with its agreed structure.

Venture debt can only be unlocked by venture-backed businesses. That means it’s not an option for bootstrapped business, who could consider traditional debt options such as cashflow-based term loans or asset-based lines of credit if they have positive cash flow.

Venture debt is also not widely available to Seed stage companies. Even if you can source a loan with an angel-backed profile, taking significant debt at the Seed stage isn’t optimal if substantial additional equity capital is required to fund the company.

Unlike other loan types, venture debt lenders don’t assess historical cash flow or working capital assets. They rely on the borrower’s access to venture capital as the Primary Source of Repayment, or PSOR. That means they will question whether the borrower will be able to raise additional equity to fund their growth and repay the debt. They’re likely to ask:

• Will additional equity be needed?
• Which metrics will influence the next-round valuation?
• What level of performance correlates to nondilutive access to capital?

Lenders may also monitor a company’s burn rate and liquidity to determine how many months’ capital is available (referred to as runway).

Companies with enough momentum and liquidity to achieve key milestones on the road to their next round of financing are more likely to attract nondilutive next-round term sheets from outside investors. That means they’re better placed to take on debt.

Much like raising with the “right” investors, it’s important to find a venture debt partner that can provide greater strategic or performance flexibility over time.

But how can you identify those lenders who offer added value?

There may be signals that the relationship is not ideal. Be wary of lenders who change critical deal terms as the negotiation migrates from term sheet to final loan documents. “Deal term drift” is a good indication that the lender has a winner-take-all, contract-centric mindset.

In other cases, you may not get the most advantageous position on every deal term, but in exchange, you benefit from the safety of working with a lender that’s willing to navigate the inevitable ups and downs that will impact your financial performance and strategy over time. Let’s be clear: deal terms matter. But working with a partnership-focused lender that values flexibility can help both your business and your investors in the long run.