Corporations often turn to the capital markets when they are seeking growth either through internal expansion or mergers and acquisitions. The debt markets are one such direction that companies decide to take. Start-up companies, however, often have not yet generated the profits that typically offer lenders some assurance that debts will be repaid. As a result, new businesses often approach the venture capital markets for financing. Venture debt is a specialized type of financing provided by nontraditional banks and other lenders to new companies in need of cash.
Venture debt is extended to start-up companies that are in need of financing in order to continue operations. For example, equipment may be needed or land may need to be purchased in order that the company, which has most likely already received some sort of venture capital backing, can continue operations. Lenders are either banks that specialize in this type of financing or other financial institutions that extend loans.
Typically, venture-backed companies receive more than one round of financing. Venture debt is often extended in the first or second round of venture financing. A company without any venture backing that has an existing base of customers may also qualify for venture debt financing.
Risks are associated with venture capital financing of any sort because the recipients are typically companies that have not generated profits yet. Subsequently, there is less recourse in the event that the start-up company cannot repay a debt. One way that lenders protect against the possibility of default is to provide a type of hybrid financing in venture debt.
In a hybrid situation, the lender incorporates financial securities known as warrants into the equation, which give the lending institutions some equity ownership in the borrowing entity. Warrants are often in the form of preferred stocks, which specifically give lenders greater preference over other stockholders in the event the borrower becomes insolvent and files for bankruptcy. Also, preferred stocks allow these shareholders, who in this case are the lenders, to vote on significant corporate events unfolding at the borrowing entity.
For the borrower, venture debt is attractive because it provides a new business with money to continue operations and attempt to generate cash flow in the meantime. Industry participants are encouraged to be conservative in providing profit expectations, especially during challenging economic cycles. Rates of interest that are charged to borrowers of venture debt will be based, at least in part, on those financial estimates.