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It is alternative financing to Venture Capital, it is suited for those companies that have shown both traction and ability to generate cash in the long run.
Highly suited for startups and scaleups as it reduces financing costs (vs. Venture Capital). It has no political rights associated so the company remains independent from third parties. However, the loan includes a small remuneration in shares, so that we can share the value created for entrepreneurs.
Venture Debt is an alternative source of funding to Venture Capital (VCs) and not to bank financing*. As an entrepreneur you will be able to raise the similar funding amounts to Venture Capital. However, the repayment is different.
Venture debt loan is paid back faster (3-4 years) than Venture Capital (eventually repaid at exit). The nature of these loans offer cheaper conditions for the entrepreneur (less dilution and no political rights involved).
* Bank financing should be cheaper than Venture Debt or Venture Capital, although, given the negative cash flow generation of these companies it is hard to find substantial funding from banks.
Venture debt is a mid-term loan with an approximate interest rate of 10%, it also has a 12 months grace period and 24-36 months of amortization. Venture debt backed companies tend to grow fast enough to achieve their repayments through positive cash flow generation many of them refinance their debt position through banks whenever they achieve a sustainable credit profile.
The magic word is dilution. The entrepreneurs know that their companies’ shares are highly valuable. The shares that Venture Debt receives correspond only to a fraction of the loan (20%-30% of the loan), known as Equity Kicker.
Imagine a company with €10M pre-money valuation that is trying to raise €2M. Founders can finance through Venture Capital or Venture Debt.
Venture Capital: the founders will dilute up to 17%* and will give away political rights.
Venture Debt: the founders will dilute up to 5%** without giving away political rights.
Now imagine that in a few years the company increases its valuation up to €40M. If the company had been financed through VCs, the VC shares would value c. €6,8M. If the company had been financed through Venture Debt, the Venture Debt shares would value c.€2M, but also, the company would have paid back the €2M loan and its associated interests (c. €600k***). The total cost for the company & founders if funding was through Venture Debt amounts to c. €4,6M versus that of Venture Capital that amounts to c. €6,8M.
As you can see, there is a €2,2M difference. It corresponds to the savings that the founders keep in their pockets. Who would not keep €2,2M worth shares of their own company?
* The share that the VC would take will correspond to the new funding divided by the post-money valuation. In this case €2M/(€10M+€2M)=16,67%, approximately 17%
** The shares that the Venture Debt would take will correspond to the new funding divided by the post-money valuation. In this case, with a 25% Equity Kicker: 25%*€2M/(€10M+25%*€2M)=4,76%, approx 5%.
*** We are assuming a €2M loan with 10% interest rate, 12 months of grace period and 36 months amortization
Equity (shares) has an economic cost (the dilution) and a political cost. The political cost implies to deeply know your partners, Who are they? What are their intentions within your company? What are their political rights? How will they behave during adversity?
Choosing the right partners is key for businesses success or failure, thus through Venture Debt, that do not take any political rights, founders reduce this risk.
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