Venture debt: What benefits does this type of financing offer to entrepreneurs?

Obtaining financing is a common challenge for every entrepreneur, but there are many ways to get it: public institutions, business angels, venture capital or risk capital, etc. However, there are other alternative and less known formulas that allow startups and high-growth companies to gain the necessary liquidity to secure their future. One of them is venture debt, and its main advantage is that the shareholding of the entrepreneur and their shareholders is not diluted.

Traditionally, startups raise capital in order to obtain liquidity. With the involvement of new investors or the new participation of former partners, the ownership of entrepreneurs and early investors is reduced, as their ‘share’ of the company is smaller than before. This process is known as dilution. Venture debt helps to mitigate this: it is a loan consisting mainly of debt that is repaid with interest, to which a small portion is added to acquire shares in the company.

When did venture debt first come about?

Venture debt came about in Silicon Valley (California) in the 1960s and 1970s, mainly to facilitate the leasing of machinery when this area was on its way to becoming a technology mecca with the production of silicon and chips. However, it was in the 1980s when this model took off and began to be offered by financial institutions and private funds, as they realised that companies were devoting a large part of their efforts to raising capital rounds. In this way, they began to offer an alternative that allowed them to obtain liquidity in a more flexible way.

Main advantages of venture debt

With the passage of time and the emergence of small investment funds, the purpose of this alternative has expanded so that emerging, high-growth, technology-based companies can develop their operations.

Venture debt has five features that make it attractive as a financing alternative, according to CB Insights.

1. The founders of the company do not relinquish the majority of their control, so they can develop the business with their vision.
2. The necessary financial leverage is obtained before starting the next round of capital.
3. The business can obtain liquidity quickly to deal with unforeseen events or adverse market situations.
4. The company increases its valuation.
5. It enables the development or improvement of the company’s solutions and drives the company to reach its next goal.

Differences between venture debt and venture capital

As aforementioned, venture debt is a complementary alternative to venture capital. The main advantages of this formula compared to private equity funds are as follows:

• Independence. Unlike venture capital, venture debt issuers, by raising only a small portion of equity, do not usually require a seat on the company’s board of directors.
• Dilution. In venture capital financing rounds, those who do not participate in the capital increase see their shareholding percentage reduced. In other words, the share of the capital pie of these investors is smaller, as the size of the pie expands with the entry of new investors. In the venture debt model, the entrepreneur and the company’s shareholders do not see their shareholding reduced.
• Due diligence. The process of due diligence (an audit that startups undergo before any operation and that offers a complete analysis of the company to discover its potential) is less exhaustive in venture debt than in venture capital.
• Stability. In venture debt, the debt is limited to the agreed interest rates. However, in venture capital, the value of the equity (the money that would be returned to shareholders if all assets are liquidated and the company’s debt is paid off) may fluctuate less.

A global financing formula

Gradually, venture debt has established itself in different regions, albeit unevenly. In the United States, it represents 15% of transactions, while in Europe the figure is around 3%, according to data from the European Investment Bank (EIB). In Latin America, venture debt deals worth US$700 million (more than 650 million euros) have been closed, accounting for 13% of total investment, according to LAVCA, the Latin American Private Equity Investment Association.

Both in that region and in Spain, venture debt is a model that is taking off thanks to players such as BBVA Spark, which promotes high-growth companies. In addition, it complements this financing proposal with other alternatives for companies in advanced stages such as growth lending and through specialists who guide companies as growth bankers and growth specialists, among other support resources.

Little by little, venture debt is gaining traction as a solution for entrepreneurs to obtain liquidity to ensure the continuity of their business and to keep growing and addressing the challenges they face.