Venture debt and warrants are two important tools in startup financing, often used in conjunction with traditional equity investments. While venture debt provides startups with much-needed capital without sacrificing equity, warrants allow lenders to share in the company’s success by acquiring shares later.
Understanding how venture debt and warrants work together can help startups and investors make informed decisions when structuring financing deals. This guide breaks down venture debt and warrants, their key features, how they function, and how they can be strategically utilized in the startup ecosystem.
TL/DR: Key takeaways from this article
- Venture debt is a loan designed for fast-growing, venture-backed startups. It is typically secured alongside or shortly after an equity raise.
- Startups use venture debt to lower their overall cost of capital, safeguard against unexpected operational or funding challenges, and extend their runway without sacrificing equity.
- While venture debt doesn’t dilute ownership like equity financing, startups must meet regular repayment obligations, which can strain cash flow if not managed carefully.
- Warrants are a common feature of venture debt agreements. They allow lenders to purchase equity at a predetermined price, offering them upside potential as the startup grows.
- When used strategically, venture debt and warrants can bridge gaps between funding rounds, empower startups to scale, and create a win-win scenario for founders and investors.
What is venture debt?
Securing the right growth capital is essential as you scale your startup. Venture debt is an increasingly popular option
Definition of venture debt
Venture debt is a type of financing designed specifically for startups, especially those in the later stages of growth (post-Series A or Series B). Unlike traditional bank loans, which require established cash flow and profitability, venture debt is tailored for venture-backed companies that may not yet qualify for conventional lending.
This form of funding complements equity financing, offering startups an additional capital source without immediate ownership diluting.
How does venture debt work?
Venture debt is a loan that requires regular interest payments and repayment over a defined maturity period. Given the higher risk of lending to startups, interest rates are generally higher than traditional loans.
To mitigate this risk, lenders may include covenants—specific conditions startups must meet, such as achieving revenue targets or maintaining certain financial metrics. While venture debt provides non-dilutive funding, it may also include warrants, allowing lenders to purchase equity later, creating a hybrid debt and equity benefits model.
This structure makes venture debt highly flexible. It enables startups to secure funding for growth initiatives, fill the gap between funding rounds, or sustain operations without giving up equity.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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When do startups use venture debt?
Startups leverage venture debt for various strategic purposes:
- Working capital: Fund daily operational expenses like payroll, marketing, and utilities.
- Extending runway: To prolong the time between funding rounds, giving startups more room to hit critical milestones or boost valuations before the next equity raise.
- Capital expenditures: finance larger purchases, such as new equipment, software, or other major business investments.
What are the benefits of venture debt?
Venture debt offers several advantages for venture-backed startups. Here are the key benefits:
1. Access to capital
Venture debt provides an alternative funding option for startups that might not meet the eligibility criteria for traditional bank loans. Since it doesn't require substantial cash flow or fixed assets (like property or equipment) as collateral, it opens up opportunities for fast-growing, asset-light businesses, such as SaaS startups, to secure much-needed funding.
2. Reduce the average cost of capital
By combining venture debt with equity funding, startups can lower their overall cost of capital. Venture debt offers operational capital at a competitive rate, making it a cost-effective solution, especially for companies scaling rapidly or managing high cash burn rates.
3. Minimize equity dilution
One of the biggest advantages of venture debt is that it doesn’t require giving up equity. Founders and employees can retain a larger ownership stake in the company, preserving their control and maximizing the potential financial benefits of future growth or an eventual exit.
4. Extends cash runway
Venture debt can provide an additional three to nine months of funding, giving startups more time to meet critical milestones or enhance their valuation before their next equity raise. This extended runway can significantly improve a company’s growth trajectory.
5. Provides a financial safety net
Venture debt acts as a financial buffer, offering flexibility to address unexpected capital needs. It can be particularly useful during fundraising delays, operational hiccups, or when achieving planned milestones takes longer than anticipated, helping startups navigate uncertainties more confidently.
What makes venture debt different from other types of loans?
Venture debt differs significantly from traditional loans in assessing a company’s eligibility and repayment potential.
1. Focus on equity rather than cash flow
Unlike conventional loans, which evaluate historical cash flow and collateral, venture debt focuses on a company’s equity funding history and ability to attract future investment. This makes it ideal for startups scaling fast but lacking steady cash flow or substantial tangible assets.
2. Not secured by assets
Traditional loans, such as asset-based lending, are secured by liquid assets like accounts receivable or inventory, with repayment tied to converting those assets into cash. Startups in early or pre-revenue stages often lack these assets, making them ineligible for such loans.
3. Tailored for growth-oriented startups
Venture debt aligns with startups that prioritize growth over immediate profitability. Rather than penalizing companies for reinvesting revenue into scaling operations, lenders base their decisions on the company’s investor backing and growth trajectory.
How is venture debt priced?
Three factors determine venture debt pricing:
1. Interest rate
This is the rate charged on the outstanding loan balance. It’s often higher than traditional loans due to the higher risk involved in lending to startups.
2. Origination fee
Lenders may charge an upfront fee when the loan is issued. This fee compensates for the time and effort spent underwriting the deal.
3. Stock purchase warrants
As part of the agreement, lenders often receive warrants allowing them to purchase startup equity at a predetermined price. This provides lenders with potential upside if the company performs well.
What influences venture debt pricing?
The overall cost of venture debt varies based on several factors:
- Company stage: Early-stage startups with limited track records typically face higher pricing, as they are seen as riskier investments. On the other hand, later-stage companies with demonstrated growth and increasing enterprise value are more appealing to lenders and often secure better terms.
- Investor backing: Strong backing from reputable investors can help lower the cost.
- Sector: Startups in high-risk sectors, such as those with significant regulatory hurdles or unproven technology, may face stricter terms and higher costs.
- Loan structure: Loans with tighter structures—such as financial covenants, milestones that control loan disbursements, or broader lien rights—tend to have more favorable pricing because these mechanisms reduce lender risk.
Key considerations when selecting a venture debt lender
Choosing the right venture debt lender is as important as securing the financing. To ensure a successful partnership, startups should carefully evaluate potential lenders and perform due diligence.
Here are some key factors to consider:
1. Reputation and track record
- Look for lenders with a reputation for being supportive, even during challenging periods. A patient lender understands the nature of startups, including the unpredictable nature of growth timelines and market fluctuations.
- Assess how the lender has performed in past economic downturns. Did they remain flexible, or did they enforce stringent repayment terms?
2. Regulatory compliance
- Is their credit framework approved by regulatory bodies? Ensure the lender operates within established regulatory guidelines. This reflects their credibility and the safety of partnering with them.
3. Terms and flexibility
- Evaluate their terms, including interest rates, warrant coverage, and loan structure. Are the terms aligned with your company’s growth stage and financial outlook?
- Check for flexibility in repayment schedules or performance covenants. A rigid framework could create unnecessary strain during slower growth periods.
4. Value-added services
- Beyond financing, some venture debt lenders offer strategic advice, networking opportunities, and introductions to potential investors or partners.
- These additional benefits can significantly impact your startup’s growth trajectory.
What are warrants in venture debt?
Definition of warrants
Warrants are financial instruments commonly included in venture debt agreements. They give lenders the right—but not the obligation—to purchase equity in a startup at a predetermined price (known as the strike price or exercise price) within a specified timeframe.
Essentially, warrants allow lenders to benefit from the company’s growth and success alongside the interest payments they receive on the loan.
Types of warrants in venture debt
When investors receive a warrant, they are issued a warrant certificate.
Here are two common types:
1. Call warrants
This grants the holder the right to purchase a specific quantity of shares from a company at a predetermined price on or before a future date.
2. Pull warrants
This gives the holder the right to sell a specified number of shares back to the issuing company at a set price within a defined timeframe.
How warrants work in venture debt deals
Warrants function similarly to stock options granted to employees.
If the startup's valuation significantly increases, the warrant holder can purchase shares at the original, lower strike price, potentially yielding a substantial profit.
For startups, warrants can sweeten venture debt deals without immediately sacrificing equity ownership.
Key elements of a warrant include:
- Number of shares: This determines how many shares the holder is entitled to purchase.
- Strike price: The pre-agreed price at which shares can be bought. It’s also known as the exercise price.
- Expiry date: The timeframe during which the warrant can be exercised, typically ranging from one to 15 years.
Why do lenders use warrants in venture debt?
Venture debt lenders often view warrants as a way to share in the potential upside of a high-growth startup. While the interest rates on venture debt (typically 10-15%) are lower than the returns investors expect from equity financing, the addition of warrant coverage allows lenders to offset their risk.
Pros and cons of warrants
Pros
For lenders:
- Warrants provide an additional return on investment if the startup performs well, making venture debt more appealing despite the inherent risks of lending to early-stage or scaling businesses.
- Warrants require no upfront payment, as lenders only pay when they exercise the option.
For startups:
- Warrants are less immediately dilutive than equity financing, as no shares are issued upfront. However, they can lead to equity dilution in the future if the warrants are exercised, particularly when the startup's valuation has significantly increased.
- Warrants are generally issued at the prevailing equity value, ensuring a fair deal at the time of issuance.
- When lenders exercise their warrants, they pay for the shares, providing the company additional funds.
Cons
For lenders:
- Warrants must be exercised before their expiry date, or they become worthless.
- The value of warrants can drop to zero after exercise, leaving lenders with no additional gain.
- Unlike shareholders, warrant holders lack voting rights and other governance privileges.
- Warrant holders are not entitled to dividend payments.
For companies:
- Exercising warrants can dilute equity, potentially reducing founders’ and employees’ ownership stakes by 1-2%.
- If the equity value at the time of exercise exceeds the strike price, lenders can purchase shares at a discount, which may impact the company’s valuation.
How are warrants priced?
Warrants come with a strike price, which is the predetermined price at which the lender can purchase equity in the company. Typically, the strike price is set equal to the fair market value of the company’s stock when the warrant is issued.
There are three common methods for determining the strike price:
- Using the valuation from a recent equity round: If the company has recently raised funds, the strike price is often based on the valuation from the last equity round.
- Negotiating a value: When there hasn’t been a recent equity round, the company and the lender can agree to a negotiated strike price based on their expectations and market conditions.
- Discount to a future equity raise: If the company plans to raise another round of equity soon, the strike price can be set at a discount to the expected valuation in the future.
How venture debt and warrants work together
Venture debt and warrants offer a strategic balance for lenders and startups.
Lenders benefit from the regular debt repayments while also having the potential to share in the company’s future success through the equity upside the warrants provide.
This structure allows startups to raise necessary capital without giving up immediate equity ownership, which can be crucial for retaining control and avoiding dilution.
Key differences between venture debt and equity financing
| Aspect | Venture debt | Equity financing |
| Ownership control | Retained by the founders | No immediate equity division |
| Repayment | Must be repaid over time | No obligation to repay |
| Dilution | No immediate equity dilution | Dilution occurs as investors gain equity |
| Risk | Lender shares some risk through debt, but regular payments are required | Investors take on more risk with the potential for high rewards |
| Incentive | Lenders may receive warrants for equity upside | Investors benefit from company growth and equity appreciation |
| Use case | Debt is better for investors who want to avoid risk | Equity suits investors willing to take on more risk |
When should startups choose venture debt over equity financing?
Startups may prefer venture debt in the following situations:
- They want to avoid dilution. Venture debt allows them to retain control while securing necessary funding.
- They are confident in their ability to repay: If the startup can meet the repayment terms and has strong growth prospects, venture debt can be a cost-effective alternative to giving up equity.
Common terms and considerations in venture debt deals
1. Warrant coverage
Warrant coverage refers to the percentage of the loan that is tied to the issuance of warrants. In venture debt, warrant coverage deals usually range from 10% to 20% of the loan amount.
For example, if a lender provides $1 million in venture debt with 20% warrant coverage, they would have the option to purchase equity in the company worth $200,000 (20% of the loan) if the company performs well.
Note: Warranty coverage is not a guarantee. Lenders can choose whether or not to exercise their warrants, and the borrower must remain informed about the terms, including coverage percentage and expiration date.
2. Interest rates
Due to the higher risk associated with venture debt, the interest rates are typically higher than traditional loans. These rates help offset the lender's potential risk of default by the borrower.
3. Repayment terms
Flexible repayment structures, such as interest-only payments for an initial period followed by a balloon payment or full repayment later, may be included in venture debt deals. The specific terms are usually negotiable based on the company’s financial condition and growth projections.
4. Security
The security refers to the type of stock the lender can purchase through the warrant. This can include common stock, preferred stock, etc. Warrants don’t carry liquidation preferences, meaning the lender won’t receive priority in case of liquidation compared to other shareholders.
5. Strike price
The strike price is the price per share at which the lender can purchase the equity through the warrant. This price can be set in various ways:
- At current value: Set to the company’s fair market value (FMV) when the warrant is issued.
- At a discount to future valuation: The strike price may be lower than expected at a future funding round.
6. Expiration
The expiration date of venture debt warrants typically ranges from 5 to 10 years, though this is negotiable. The lender must decide whether to exercise the warrant or let it expire within this period. The expiration date can offer security to the borrower because it limits the time frame during which equity dilution can occur.
FAQs about venture debt and warrants
Are debt warrants good for startups?
To put it concisely, the answer is negative. While debt warrants can provide immediate capital and align lenders with a startup's success in the short term, the long-term risks—particularly equity dilution and potential cash flow disruptions—make them less favorable for many startups.
What is the difference between venture debt and private equity?
Venture debt is a loan given to startups that must be repaid over time, typically with interest. It often includes warrants, giving the lender the potential for equity upside if the company succeeds. Private equity, on the other hand, involves investors providing capital in exchange for ownership stakes in the company. Investors in private equity usually actively manage the company and may gain control or significant influence over decision-making.
Are warrants considered debt?
No, warrants are not considered debt. They are options that provide lenders with the right to purchase equity in the company at a predetermined price at a later date. Warrants are considered a form of equity participation, not a debt obligation.
How do warrants affect the startup’s equity?
Warrants don’t immediately dilute a startup's equity. However, if exercised, they can lead to dilution because they result in the issuance of additional shares. The extent of dilution depends on the number of warrants exercised and the overall increase in shares outstanding.
Do all startup loans require warrants?
No, not all startup loans require warrants. Some lenders, particularly those who assume less risk across their portfolios, may offer startup debt financing without warrants. Startups need to evaluate the loan terms and understand whether warrants are part of the deal.
Who offers venture debt financing?
Venture debt financing is typically offered by two main types of providers: banks and non-bank specialty finance companies or funds.
What is the biggest mistake founders make when taking on venture debt?
A common mistake founders make is focusing primarily on the price and loan size when selecting a loan. Instead, they should place more emphasis on evaluating the lender. Choosing a lender with the experience and capability to navigate the challenges VC-backed companies face is crucial. A lender who understands the startup ecosystem and the natural cycles of the innovation economy can be a valuable partner, especially when unforeseen challenges arise.
Conclusion
Key takeaways on venture debt and warrants
Venture debt provides startups with capital without immediate equity dilution, while warrants allow lenders to share in the company’s success. The combination of venture debt and warrants offers a flexible financing option that benefits both startups and investors.
Final thoughts for startups considering venture debt
Startups should carefully consider venture debt as a financing option to extend runway or finance growth without giving up equity. Understanding how warrants fit into the deal can help entrepreneurs make informed decisions about the best business financing options.
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