The Rising Popularity of Venture Debt, Structured Equity and Advice for Founders

In the current economic landscape, characterized by higher interest rates, lower valuations, and considerable dry powder sitting on the sidelines, companies are increasingly turning to a mix of structured equity and debt to raise capital. We’ve seen this recently with notable financing rounds such as Shield AI’s $200 million Series F and Forward Health’s $100 million Series E. These cases illustrate a growing preference for leveraging both equity and debt—a strategy that is likely to gain even more traction in the current challenging conditions.

Why is this? Equity has become significantly more expensive. Declining valuations mean that startups have to give up more equity for the same amount of capital, a trend highlighted by the Pitchbook’s 2023 Annual US VC Valuations Report. When you see the next Series B, C, D, and so on, expect a mixture of equity and debt funding as founders and management teams attempt to minimize dilution. The stark decline in the median exit valuation for startups makes venture debt an increasingly attractive option. 

Its rising popularity can be attributed to several key factors: 

• Reduced dilution: Venture debt is less dilutive than equity financing, which enables startups to maintain a larger share of ownership. This can be particularly advantageous for founders and early investors seeking to maintain control and maximize returns over the long term.
• Faster Access to Capital: Raising equity financing can be time-consuming and cumbersome. Depending on the company, it can take 6 to 9 months or more. However, raising debt financing can be done in as little as 4-6 weeks. Venture debt provides the capital necessary to scale operations and capture market share while pursuing the next equity round.
• Enhanced valuation: By bolstering their balance sheets with debt financing, startups may enhance their overall valuation and attractiveness to investors. A strong financial position, coupled with a diversified funding strategy, can signal stability and confidence in the company's prospects, potentially leading to more favorable terms in future equity rounds.

As the equity capital markets remain challenged, founders may delay public offerings in favor of blended rounds that can provide more favorable terms, control, and flexibility for founders and management teams. This approach diversifies funding sources and reduces reliance on a single form of capital to help mitigate risks associated with fluctuations in credit markets, changes in investor sentiment, or disruptions to equity fundraising activities. It also preserves ownership and control for the original stakeholders and optimizes the overall cost of capital, enhances financial flexibility, and maximizes valuation and investor appeal.

How should founders think about venture debt to complement or supplement their next equity round?

First and foremost, startup founders need to understand that venture debt is not a one-size-fits-all solution. The suitability of venture debt varies depending on the company's stage, cash flow stability, and overall financial health. Generally, venture debt is more appropriate for startups that have a clear path to profitability or are already generating revenue, as lenders will look for the ability to service the debt. In turn, before pursuing venture debt, founders should critically assess their company's financial projections and ensure they can meet the obligations associated with debt financing.

Another crucial consideration are the terms of the loan agreement. Unlike equity financing, where the cost is diluted ownership, the cost of venture debt comes in the form of interest payments and, sometimes, warrants (options to purchase equity at a predetermined price). Founders should negotiate favorable terms and pay close attention to interest rates, repayment schedules, covenants, and any attached warrants. It's important to strike a balance that allows the company to leverage the debt for growth without overburdening it with financial obligations that could stifle flexibility and innovation.

Founders should also evaluate the strategic value that venture lenders bring to the table. Some venture debt providers offer not just capital but also access to a network of potential partners, customers, and advisors. This can be invaluable for startups looking to scale and expand their market reach. Therefore, when selecting a venture debt partner, founders should look beyond the capital and consider the long-term strategic benefits.

Finally, in navigating the venture debt landscape, due diligence is paramount. Founders should thoroughly vet potential lenders and seek out those with a track record of supporting startups through thick and thin. This involves reviewing the lender's portfolio, talking to other companies that have worked with them, and understanding their approach to situations where a startup might struggle to meet its debt obligations.

Ultimately, the decision to incorporate venture debt into a startup's financing strategy should be made with a clear understanding of its implications on the company's financial health, control, and growth trajectory. By carefully considering these factors, founders can effectively harness venture debt as a tool to fuel sustainable growth, even in the face of economic headwinds. The right blend of debt and equity can provide the financial stability and flexibility needed to seize market opportunities, drive innovation, and build a resilient, thriving business.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.