In the business world, funding plays a crucial role in the growth and development of startups and early-stage companies. In addition to traditional venture capital (equity) funding rounds, there is an alternative known as venture debt or venture debt.
In this article, we will explore what venture debt is, focus on the concept of “equity kicker” and analyze situations in which this option may be more convenient than an equity round.
What is venture debt?
Venture debt is a form of financing that is based on the granting of loans to growing companies, especially startups and early-stage companies. Unlike traditional loans, venture debt is offered to companies with high growth potential and is backed by their future ability to generate income.
The “equity kicker”:
One of the distinctive elements of venture debt is the “equity kicker”. This term refers to a clause in the loan agreement that allows the lender to purchase a small amount of shares (equity) of the receiving company as part of the agreement. The equity kicker provides the lender with the opportunity to participate in the company's future profits, should the company perform successfully. Essentially, the equity kicker compensates the lender for the additional risk they assume when providing the loan.
Advantages of venture debt over a traditional equity round:
- Preservation of equity ownership: By opting for venture debt instead of an equity round, entrepreneurs can keep a higher percentage of ownership of their company. This allows them to maintain control and strategic direction of the business.
- Lower dilution of capital: By not issuing new shares during an equity round, the dilution of existing capital is avoided. This is especially valuable when the company has a high valuation and the founders want to maintain a greater shareholding.
- Complement to equity rounds: Rather than completely replacing a round of equity, venture debt can complement it. This allows the company to extend its capital and finance different aspects of its growth, such as investments in R&D, geographical expansion or strategic acquisitions.
- Lower valuation dilution: In an equity round, the company's valuation can increase significantly, which can be costly for founders. By opting for venture debt, the company's valuation can remain relatively stable, since no new shares are issued.
Example of when venture debt is appropriate over a traditional round of equity:
Let's imagine a growing startup that has reached an important milestone by securing a long-term contract with a key customer. The company needs additional capital to meet contract requirements, such as expanding its production capacity and hiring more staff. In this scenario, the startup could consider venture debt as a viable option. By choosing venture debt, the company can obtain the necessary funds without significantly diluting the founders' property. The loan would allow the startup to fulfill the contract and take advantage of future profits without having to give up a significant part of the company in an equity round. To see specifically why in this case it is advisable to resort to venture debt instead of a traditional round of equity, let's visualize the previous example with numbers (which, as we always say, are the language of business, because it is the way to “land” concepts that otherwise remain very abstract and difficult for the mind to understand).
We'll start by describing the scenario. The company is a B2B SaaS that is growing, and as described above, it has just signed three very important contracts that will allow it to grow strongly from a current ARR of 1.5M€ to an MRR of about 5M€ of ARR in 3 years. If it complies with the plan, a company in the sector is willing to acquire it for a value of around 40M€. The company doubts whether it should do a round of financing or a venture debt. You have two offers from two different VCs on the table.
Offer 1: VC specializing in Venture Debt
- Quantity: 2M€- Interest rate: 8.94% per year
- Opening commission: 1.5% (for each tranche disbursed)
- Duration: 36 months- Grace period: 12 months of principal
- Equity Kicker: 25% of the loan amount
- Benchmark Rating: 10M€ pre-money
- Warranties: Current escrow accounts
- Due diligence: The company must carry out due diligence (financial, legal, fiscal, labor and innovation criteria) at a cost of €8,000
Offer 2: Traditional VC
- Quantity: 2M€
- Rating: 10M€ pre-money
- Due diligence: The company must carry out due diligence (financial, legal, fiscal, labor and innovation criteria) at a cost of €8,000
The comparison is shown in the graph below.
If the entrepreneur decides to accept the traditional VC offer, as shown in the graph above, he would have 33.2 million euros left at the time of selling the company. This is because it has ceded 17% of the company for the 2 million euros, resulting in a return of 6.8 million euros for the VC (when selling its 17% at a value of 40 million euros). On the other hand, if the entrepreneur had opted for the VC proposal specialized in Venture Debt, this VC would receive a total of 4.6 million euros (2 million euros for equity and 2.6 million euros for the return of capital plus interest) at the time of sale. This means that the entrepreneur would take home 35.4 million euros, 6.6% more than in the case of pure equity. If the interest rate had been 12% (possibly more in line with the offerings of specialized VCs in a higher interest rate environment), then the VC would receive 5 million euros, even lower than what they would receive if they had invested in pure equity.
In conclusion, the decision to opt for venture debt is beneficial for the entrepreneur as long as it is associated with a context of rapid growth and a clear expectation of a possible liquidity transaction within 24 to 36 months. However, if this transaction is not clearly defined, venture debt can become a heavy burden for the startup.
