What Is Venture Debt? How Can It Support Diverse Founders?

This alternative to equity financing lets founders hang on to a bigger portion of their companies as they grow.

Venture debt in its current form has been around for more than 20 years, but few startups and founders know that it exists or that it can help supercharge their company’s growth.

Venture Debt Explained

Venture debt consists of loans made to venture-backed startups that have reached a growth or expansion stage. These loans are typically made to Series B through Series D companies that are producing revenue and can service debt payments. Venture debt can be a cheaper, minimally dilutive alternative to equity financing.

Venture debt consists of loans made to venture-backed startups that have reached a growth or expansion stage. These loans are typically made to Series B through Series D companies that are producing revenue and can service debt payments. Typically, a loan is made three to six months after a company has completed its equity raise and is designed to provide growth capital for founders to develop new products, enter new markets, expand their marketing and so on. Venture debt can be a cheaper, minimally dilutive alternative to equity financing.

In fact, the biggest differentiator between venture debt and venture equity is that venture debt is a lot less dilutive; equity dilution occurs when a firm’s owners sell shares in their company to raise capital. Venture loans are typically three to four years in maturity. The lender also gets some equity upside in the company through warrants worth 5 to 10 percent of the debt. Even with this equity upside, the financing package is much less dilutive, and much less expensive for founders, than a straight equity raise.

Venture Debt’s History

Venture debt originally was used by early-stage companies lacking the cash flow or hard assets, such as property and equipment, to qualify for traditional bank loans. To this day, venture debt focuses on this underserved segment of the market and is provided by only a handful of banks and non-bank lenders.

The biggest publicly traded venture lenders are Silicon Valley Bank and Hercules Growth Capital. However, a number of private venture-debt providers, including Western Technology Investment and ORIX Growth Capital, have long track records of success, as do innovative new entrants to the market such as Applied Real Intelligence’s Venture Debt Opportunities Fund. 

Collectively, venture lenders provide approximately 10 percent of the total venture funding in the United States each year, representing more than $30 billion annually in 2020 and 2021.

Venture Debt Benefits

Venture debt offers many benefits for startups. It accelerates growth and expansion, extends the runway between equity rounds (or exit) and is much cheaper than equity financing. It is also much faster to obtain, taking only four to six weeks to complete a debt raise, versus six to 12 months for an equity raise. 

Startups operate in what might be called dog years, where important events occur in weeks and months. Compare this to mature companies, where milestones are achieved over years or sometimes decades. Getting extra growth capital quickly can make a huge difference for a startup when it matters most.

Venture Debt Risks

On the flip side, venture debt should only be used by companies that have the cash flow to service the debt. Companies typically need to generate revenue of at least $10 million per year, and oftentimes multiples of this amount, to qualify for a loan. Companies without the revenue to support interest payments and repayment of the loan when it comes due are not good candidates for venture debt.

Borrowing money before a company is mature enough to effectively service the debt is risky for both borrower and lender. If the borrower cannot make its interest payments, the loan would default, and the lender could then seize the company’s assets to repay the loan. There’s a time and a place for venture debt and it’s typically when a company has reached significant revenue and has a clear vision for how additional funds will help accelerate the company’s growth.

How Venture Debt Can Help Diverse Founders

While venture debt is a great resource for startups, it has not historically been accessible to the majority of the population. Most venture funding has been concentrated in only a few regions, including Silicon Valley, New York City and Boston, and sectors such as software and life sciences. 

Furthermore, less than 3 percent of venture capital goes to women and other underrepresented groups, among them people of color and veterans, which make up more than 70 percent of the U.S. population. Applied Real Intelligence is working to change this by creating more efficient access to capital for underserved regions, sectors and founders.

Our mission is to produce great risk adjusted returns for our investors while democratizing access to funding for founders. Ultimately, we seek to identify founders who are building great companies but have a hard time raising capital.

By providing more efficient access to capital for underserved regions, sectors and founders, we not only will create significant returns for our investors but will also improve equality and economic growth. We will make more money for our investors because we will have differentiated deal flow into great companies that others cannot access. 

The Future of Venture Debt

Given the proliferation of early-stage companies entering the market, venture debt will continue to grow in visibility and usage. The barriers to entry to building a successful startup, including low costs to launch and run a business, continue to fall. 

Meanwhile, the continued inflow of human capital, including a growing number of talented graduates from the world’s leading universities, will fuel the innovation economy’s growth. In the years ahead, more early-stage companies will be successfully launched and require financing, thereby increasing the demand for capital.

Founders are becoming increasingly aware of venture debt’s many benefits, particularly the minimal ownership dilution. At Applied Real Intelligence our motto is “You Built It. A.R.I. Helps You Keep It.” This means that founders who use venture debt will keep a larger percentage of their companies as they grow.

Zack Ellison, MBA, MS, CFA, CAIA is the founder and managing general partner of Applied Real Intelligence (A.R.I.) and the chief investment officer of the A.R.I. Senior Secured Growth Credit Fund, which provides debt financing solutions to premier VC-backed companies. He previously worked as a loan underwriter, investment banker, corporate bond trader, and fixed income portfolio manager at three firms with over $1 trillion in assets – Scotia Bank, Deutsche Bank, and Sun Life. Ellison holds an MBA from the University of Chicago, an MS in Risk Management from NYU, and is completing his Doctorate in Business Administration at the University of Florida.