What Is Venture Debt? A Comprehensive Guide For African Startups

In 2022, Flutterwave (one of the most popular Unicorns in Africa) secured a whopping $250 million in funding — one of the highest single-round raises on the continent. This cash injection from investors allowed the company to expand its operations and processing infrastructure and reach even more merchants and customers worldwide. But what exactly does this have to do with venture debt?

Venture debt is a loan investment that provides companies (mainly startups) with capital in exchange for a higher interest rate. This investment mode allows businesses to retain control over their company shares without diluting ownership or relinquishing considerable control.

Let’s be clear: venture debt is an excellent option for startups that have gained enough traction and are scaling fast. However, you must understand how it works to make the most of it. In this article, we’ll show you how venture debt works, the benefits for startup founders and investors, and when you should consider venture debt.

How does venture debt work?

Venture debt is a loan given to startups as capital to scale up their products or services and pay back with interest higher than traditional banks. Without giving up their company ownership, startups that become successful after the loan pay the lenders their ROI.

Unlike other investments that ask for a percentage share in the startup; venture debt doesn’t require you to give equity unless used as collateral when you can’t pay back the debt. Venture debt is mainly provided by venture debt firms, specialised banks, and non-bank lenders—like private investment firms. 

Although venture capitalists do not independently offer venture debt, they collaborate with large commercial banks to offer venture debt products or a larger startup funding initiative. 

The startup (the borrower) is expected to repay this loan with interest using collateral. The loan repayment is structured in a way that there’s a period of grace (due to a potential delay in repaying the loan). This grace can be an extended payback period or a conversion of the payback equivalence to equity (ownership). 

So, is venture debt the same as VC funding? No, not exactly. Because of how similar they seem, many people confuse venture debt with VC funding.

In VC funding, startups give up equity in exchange for investment, while venture debt allows for full founder ownership. And where investments from VC funding are usually converted to cash (profit) through IPOs or buyouts, venture debt allows for structured repayments with interest.

What are the components of venture debt?

Although the whole process might sound straightforward, there are specific features to the venture debt. Typically, conventional loans have fixed components (like fixed interest rates and fixed payback dates) and similar items exist in venture debt.

These critical components of venture debt include:

• Floating Interest rates: the interest rates for venture debt are usually higher than that of traditional bank loans due to the risk involved in taking on startup companies. Therefore, the interest rates can be adjusted according to market conditions.
• Principal: this is the exact amount borrowed by the startup.
• Covenants: these are restrictions placed on the borrower to protect the lender in the case of irresponsibility. These restrictions could include limiting additional debt.
• Warrants: these are optional liberties given to the lender to acquire shares in the company at a future projected price, should the company succeed. 

How does repayment work for venture debt?

There are repayment structures placed when having venture debt deals.

Some of these common payback structures for venture debt are: 

• Payment-in-Kind (PIK) interest: instead of paying the cash interest, you can pay it back in kind and channel the interest to the principal. 
• Balloon payments: if a part of the principal is due as a lump sum at the end of the loan term, it will be paid.
• Conversion to equity: if you fall short or struggle to repay the loan, it can be converted to equity using a predetermined future price.

Since this loan will be borrowed using collateral, let’s discuss some collaterals you can use.

The collateral used in venture debt deals are usually intangible assets like:

• Intellectual property: Trademarks, patents, and copyrights are valuable assets for startups and can be used as worthy collateral.
• Inventory: If you are a product-based startup, your products can be used as collateral.
• Future revenue streams: If you have a promising startup that has gained traction or has the potential to gain traction, lenders could give you the option of using future revenue as collateral for the loan.

How does venture debt benefit startups?

Being the ones at the receiving end of this loan, startups gain a lot from venture debt. There are many benefits for startups that choose venture debt during their growth stages. 

The benefits of venture debt for startups include: 

1. It provides funding through cash injection to capital for your startup’s growth opportunity.
2. It allows you to retain your full ownership when giving up equity, unlike VC, which demands a share in your company.  This will enable you to be at the helm of your startup’s affairs, making the decisions and calling the shots. 
3. The loan structures can be adjusted to the specific needs of your startup. 
4. Venture debt frees up your existing capital and allows you to manage your daily operations while supporting your startup’s growth with funds. 
5. It can be a good motivator since it is a loan you must pay with interest that forces you to focus on your startup’s profitability. 

How does venture debt benefit investors?

Although it looks like investors are more at risk with venture debt since it is a means of empowering startups, it also benefits them equally. Compared to other traditional investments, investors gain a lot when they lend out funds as venture debt.

The benefits of venture debt for investors include: 

1. Compared to equity investments, there is a layer of security that comes with venture debt. Since these loans are backed with collateral of intangible assets like intellectual property, it reduces the risk involved in this investment.
2. Venture debt allows for much higher returns compared to typical VC investments due to the high risk involved. Investors with an appetite for taking great risks will have the potential to have a significant amount of financial rewards.
3. The way venture debt works allows startups to focus more on profitability. With investors knowing that the debt will be repeated with interest, investors can rest assured of getting lucrative returns through warrants when the startup succeeds.
4. Venture debt qualifies investors to diversify their portfolio beyond typical VC investments. This can result in a broader range of opportunities within the startup ecosystem for the investors. 
5. With venture debt comes covenants given by the investors to the startups. This creates a level of control and influence over their operations. This can help with quality financial tracking to ensure the startup’s success and, invariably, the loan is repaid. 

What are the downsides of venture debt for startups?

It is assumed that startups enjoy the most from funding options. However, no matter how smooth the investment is, there are risks.

These risks of venture debt for startups are:

1. Higher interest rates: Venture debt has higher interest rates than traditional banks due to the inherent risk involved. 
2. Unpleasant covenant and restrictions: Venture debt comes with restrictions that could make decision-making—like hiring and infrastructure purchase—hard for startups. This gives you less control of some operations in the company. 
3. Pressure to perform: Because of the consciousness of how much was invested, there could be sudden pressure to outperform your target, and this can cause wrong and hasten decisions.
4. Debt burden: The high return rate could take a toll on the cash flow of startups, especially if it doesn’t meet the target.

What are the downsides of venture debt for investors?

Known to be at the brunt of all financial risks when it comes to investment in general, investors are exposed to others risks when dealing with venture debt.

Some of the risks investors may face when venture debt is concerned include:

1. Dependence on startup’s success: The success of venture debt rests on the success of the startup’s business plan. This means, if it fails, there is no ownership stale to fall back to—except if stated in the initial agreement.
2. Subordination debt: Venture debt is at the bottom level of other forms of debt., which means that when it is time for liquidation, senior lenders are paid first before venture debt lenders. This can lead to the risk or not recouping the full investment.
3. Intensive due diligence:  Due diligence when it comes to venture debt has to be thorough, considering the weighty risk involved. Hence, the whole process is time-consuming and resource-intensive for investors.

When should you consider venture debt?

Knowing when to choose venture debt as a fundraising option is essential for your startup. Before choosing venture debt as a fundraising option, there are certain factors you should consider.

Here are factors you should consider before going for venture debt for your startup:

1. Startup stage: Startups that are past the pre-seed and seed stages and are now undergoing rapid growth are in the best position to obtain venture debt. If your startup is post Series A or B funding rounds, you can consider going for venture debt.
2. Business model: When your business model has a solid sales funnel and recurring customer contracts, you stand a chance of bagging an investor of venture debt. Lenders like it when they can predict revenue streams—it is like music to their ears.
3. Financial performance: If your startup has a solid financial history, getting a venture debt will be an easy slide. Lenders tend to consider startups with healthy revenue growth and a clear path to profitability. 
4. Use of funds: If your startup’s needs fall in the line of scaling a targeted market campaign, strategic management of inventory, or pushing the development of a product, you can go into venture debt. It is ideal in this case of specific financial growth initiatives, with a lead to promising significant ROI.

Final thoughts

Ingressive Capital has been investing in African startups since 2017. Over the last few years, we’ve been a part of success stories like Paystack and Bamboo — powerhouses that have revolutionised their industries. Now, we want to partner with you!

Are you a pre-seed or seed-stage company looking to grow? Then apply to join our fund. We offer up to $500,000 in VC funding and would love to be part of your journey to sustainable success.