The Hidden Traps of Venture Debt

Welcome everyone to another edition of my China Tech Law Newsletter.? This edition is not China-specific per se, but its something I’ve been seeing with startups globally.? Especially in the last year as some clients are trying to make it through a “winter” in startup fundraising.

In recent years, venture debt has become an increasingly popular funding tool for startups looking to extend their runway without immediately diluting equity. It offers a flexible way to access capital, especially for companies either not looking to dilute their equity cap table or trying to grab extra cash in conjunction with an equity financing. But venture debt, despite its allure, comes with serious risks that founders often overlook, particularly in today’s challenging environment where few companies’ next fundraising round is a sure thing.

Despite some of the pullback following the recent Silicon Valley Bank crisis, many startups still look to corporate venture debt. While it usually comes at a higher interest rate as premium for the increased risk presented by a startup, the “cost of capital” to the borrower compared with equity is still significantly lower.?

Most importantly, unlike equity financing, venture debt doesn’t necessarily require giving up a chunk of the company at today’s valuation. For many founders, the prospect of accessing capital without dilution seems almost too good to be true.

However, this type of financing has critical downsides. First, dilution may come later as many lenders require equity sweeteners such as warrants to enjoy upside along with the loan.? More to the point, unlike convertible notes, which can allow founders some flexibility to convert debt into equity later, venture debt is, well, just that—debt. And as with any debt, it comes with obligations that must be met on time.

Corporate venture debt isn’t a bridge loan, nor is it a means of hedging bets until the next round of equity financing comes along. It carries a fundamental obligation: interest and principal payments. This may seem manageable when the business is thriving, but if growth stalls or future funding becomes scarce, those payments can suddenly become more than just a hiccup in the startup’s journey, they can put it on life support.

The reality is that lenders expect repayments on a fixed schedule. They are not shareholders rooting for the company's success from a distance; they are creditors who can and will call in the loan if payments are missed. Again, many founders still have a mindset which thinks of venture debt as akin to convertible notes.? The key difference is that convertible notes have equity upside.? They also typically have less priority over company assets in case of a default than venture debt.? Thus holders of convertible notes with their equity upside are very much aligned with the company becoming a success and so more forgiving.? They don't want to foreclose on the loan, they want the company to IPO!

For many lenders of venture debt, this just isn’t the case especially when you have negotiated the warrant upside out of the picture.? A classic case of winning the battle (no dilution through warrants), but potentially losing the war by creating a situation where all the lender cares about is getting paid back interest and principal and will have no hesitation to call in the debt if milestones aren’t hit or payments aren’t made on time.

In today’s tight funding environment, venture debt can be especially dangerous. Many startups are finding it increasingly difficult to secure equity financing at favorable terms, if at all. For those relying on future rounds to manage their debt load, a sudden scarcity of capital can be disastrous. If the startup cannot meet its debt obligations, lenders may have the right to take control of critical assets, or worse, to initiate liquidation.?

Even if the company can scrounge together a new equity round to cover debt obligations and prevent a default, it will be done in a very distressed situation where the new fund coming in has all the leverage to dictate wiping out a large portion of the existing equity holders’ value.? Because the new investors will still want to have founders properly "incentivized" holding a certain percentage of equity, existing investors may bear the brunt of dilution or be forced into a “pay-to-play” situation where they themselves need to put in more capital just to maintain their current position.

As economic conditions shift and venture debt becomes harder to maintain, founders need to ask themselves if they can truly afford to carry this kind of liability. Can they meet principal and interest payments if growth slows? Are they prepared for the impact on their business if lenders call in their loans?

While venture debt can certainly provide a useful capital boost for the right company at the right time, it requires founders to think more like traditional business managers, balancing income with fixed obligations and keeping a close eye on cash flow. Unlike with equity financing, the stakes are higher because there’s no room for missed payments.

For startups navigating these waters, careful planning and conservative projections are crucial. Rather than taking on venture debt as “free money”, founders might consider other ways to manage cash flow to wait for a better time to raise additional equity funding. In today’s market, a more cautious approach can make the difference between sustainable growth and unmanageable debt.