What is venture debt, and when should you use it?

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Extend your runway, preserve your equityExplore Venture DebtMercury is a financial technology company, not a bank. Banking services provided by Choice Financial Group and Evolve Bank & Trust®; Members FDIC.
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Startups need capital to grow, but they’re not always able to access the same financing options as traditional businesses. Venture-funded startups tend to prioritize growth over profits and might not have easy access to capital as they’re growing their businesses.

Many venture-funded startups turn to venture debt. It’s affordable, minimally dilutive, and can be used on anything that helps your startup grow. And while debt can be a scary term, it’s important to remember that it works like all other financing—if you plan well and choose a partner who you trust, you can come out with the upper hand.

In this article, we walk you through the ins and outs of venture debt, including how it works and when to raise it.

Key takeaways

  • Venture debt loans are 30-50% of your recent VC round and can help you extend your runway with minimal dilution. The capital can be used on anything you’d like.
  • It’s important to choose a lending partner who will work with you through your startup’s ups and downs.

What is venture debt?

Venture debt (more specifically, venture term loans) refers to loans structured for startups that have raised venture capital.

Unlike traditional loans, which look for cash flow and other assets as indicators that a startup can pay their loan back, venture debt lenders focus on a company’s VC investors, its growth potential, and the possibility that it will be able to raise VC again. These lenders might also consider a company’s team, its performance history, and the market the company is targeting.

Venture debt works so closely with venture capital that many VC investors ask their portfolio companies to raise venture debt soon after a round. Venture debt is typically worth 30% to 50% of your previous round and can add cash to your existing fundraise without diluting you—or your investors—too much.

Remember: Venture debt isn’t just free cash. Like commercial loans, venture term loans need to be repaid with interest over time.

Venture lenders also ask for compensation in the form of stock warrants, which dilute your company by a very small amount (typically less than 0.5%). Warrants work like the equity you might give out to employees—they give your lender the option to buy a small portion of your company at a later stage, valued at the time that the loan was created.

Venture debt is often considered to be a repeatable loan—not a one-time expenditure. Many companies work with their lenders as they grow and refresh their loans over time. For that reason, it’s important to choose a venture debt provider that can act as a partner as you continue to grow and raise VC.

When should I consider venture debt?

You’ve just raised venture capital—or are planning to raise soon. Venture term loans are only available to startups that have recently raised venture capital. If you’ve raised venture capital in the past three months—or within the past year, for more flexible venture debt lenders or providers like Mercury—and want to extend your raise, you should consider venture debt. It might also be smart to start chatting with venture debt lenders before your fundraise, so you can turn to them as soon as you close your round.

You’ve raised from well-known, trusted investors. The stronger your investors, the better your chances of securing a loan—venture lenders are taking bets just like VCs. Good investors are a useful signal that your startup will continue to grow and that venture lenders will be able to continue to work with it for a long time.

An investor’s strength is usually determined by details like their ability to continue investing into your business, their track record with supporting portfolio companies, and how often they’ve helped startups get to their next equity raise. Venture lenders also look at who’s sitting on your board—are they making decisions that will benefit your startup?

You can commit to a payback plan. Venture debt requires fixed monthly payments. Make sure that you have the cash necessary to commit to a payback plan—and that these monthly payments won’t eat into your growth. Some lenders (or venture debt providers, like Mercury) allow you to draw your loan when you’d like—even if that’s never—and negotiate for a payback plan that works for you.

Remember: As you factor a venture debt payback plan into your plans, it’s also useful to account for interest-only periods, during which you can withdraw a loan and don’t have to pay anything but interest. For example, the venture debt offered through Mercury allows for an 18-month interest-only period.

You’d like to extend your runway. Runway is the length of time your startup has until cash runs out. Venture debt gives you cash until you’re ready for your next stage, whether that’s the next round of venture capital, an IPO, or just becoming profitable. It’s also flexible enough to be used like venture capital—you can spend it on anything you think will help your startup grow.

You want to keep the cost of capital low. Let’s say you run a startup that helps users understand how much money they’re spending on food, from groceries to restaurants. The space is hot and you need to beat out incumbents, so you just raised a $3M seed round. The round diluted your equity by 15%, but you’re finding that you could use a little extra cash to bring a new product to market. Venture term loans might be a good fit for you here. With a loan of $1M (30% of your previous round) and 0.25% dilution, that capital is cheaper than raising more venture capital.

You want to hit milestones before going out to raise funds again. When your food-budgeting startup raised its seed round three months ago, you planned to use the money to hit a few milestones. You’ve managed to hit most of them, but are finding that you won’t have the cash for one milestone—hiring a mobile development team to help launch your Android app. Hitting this milestone will help you track certain metrics that will help you when you go out and raise funding again. If you don’t hit it, you might risk a down round, meaning that VCs might lower your startup’s valuation. Venture debt can help you bridge this gap and fund you until you hit your milestone.

You want flexible capital. Traditional debt can be restrictive. Lenders will expect that you spend on specific parts of your business. Venture debt is flexible and can be used on anything you think will help your business grow.

How do I raise venture debt?

Make sure you’re incorporated. Your startup must be incorporated—the loan will be disbursed into your startup’s bank accounts and business bank accounts require incorporation.

Timing is everything—negotiate from a position of strength. Turn to venture debt lenders right after you’ve completed a major fundraising round. This is when you’ll have the most leverage.

Talk with your current investors. While most startups take on venture debt, taking too much or taking money from the wrong lender can hurt your future venture capital prospects. Investors typically don’t want to see a large portion of the money they’ve invested being used to repay old debt. Plus, restrictive covenants may limit the operational flexibility of your startup. Make sure to discuss any debt undertaking with your current investors first—especially if they’re same ones that will participate in your next round.

Get a lawyer. Venture debt can be complicated and many of its downsides come from misunderstanding term sheets. For example, some lenders may ask for the right to exercise their warrants before your company undergoes a liquidity event. Other lenders add in material adverse change clauses, which allow them to not fund the loan or ask for immediate repayment if a company is going through hardship. Get a lawyer early who can guide you through these questions.

Common law firms include:

Find a lender. Both banks and non-bank lenders can provide venture debt. The bank lenders are typically specialized banks used to dealing with startups, while non-bank lenders are usually venture debt funds.

There are crucial differences between the way bank and non-bank lenders are structured that influence the terms of venture term loans.

One key difference is how lenders fund the capital they loan out. While banks fund their loans from deposits, debt funds source it from other investors—these investors will expect a certain return on their own investment. As a result, venture term loans from banks are typically cheaper than those from venture debt funds. Debt funds may also ask for bigger warrants to meet their own targets.

Observe when the negotiation shifts from term sheet to final loan documents. With some lenders, term sheets are not fully representative of final deal terms. For instance, covenants are often only referenced at the surface level—and specific asks only emerge when lenders search for final loan documents. Keep an eye out for these, run sheets through with your lawyer, and don’t be afraid to negotiate.

Think deeply before you select your provider. Remember, while venture debt can be immensely helpful to your startup’s growth, it does impose a legal and financial obligation. It’s essential to select the right provider and negotiate your agreement.

If you’re taking venture debt from a bank, you’ll be expected to move most—if not all—of your banking over to them. Are you willing to work with your lender’s bank?

Additionally, consider what type of relationship you’re looking for with your venture debt provider—are you looking for a vendor or a long-term partner?

A partner can be especially helpful if you run into trouble and are unable to repay your loan. They might be more amenable to restructuring your loan and giving your company enough time to get back on its feet. On the other hand, a vendor may be more inclined to impose penalty costs or move straight toward liquidating your collateral (which would be the end of your business).

Remember: Many startups return to their providers throughout the course of their journey. Having a partner on your side can pay off in the long run.

What is a term sheet?

A term sheet is a nonbinding agreement that a venture debt lender will give you when they’re considering an investment.

This sheet will set the terms of your deal, including the size of your loan, your interest rate, and the warrants that your lender will take. It will also set the tone for your company’s future, whether it’s when you take on your next VC round or when you’re looking at other forms of financing. It can—and should—be negotiated.

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