On Definitions and Language
The Oxford English Dictionary defines the term Venture debt as… just kidding. I promise to never write an introduction like that. The Oxford English Dictionary doesn’t actually have a definition for “Venture Debt” so my gripping introduction would have been ruined anyway. I do want to talk about the Oxford English Dictionary though because definitions and language have an impact on this post and for answering the question “What is Venture Debt?”.
A fascinating aspect of language is that the words and terms we use change and evolve as we use them and new ones are created. Between 400-1250 terms are added each quarter by Lexigraphers (dictionary editors). In 2020, some of the term additions to the dictionary included Zoom, GOAT and Cookie Monster. “Arr” was also added to the dictionary in 2020, but it has been clearly defined as a pirates figure of speech and not ARR (Annual Recurring Revenue). I’m not kidding. 1
I remember when the word “Skype” was frequently used as a verb for a video call, so it will be interesting to see if the addition of the word “Zoom” can stand the test of time. Fortunately for Skype, words are actually rarely removed from the dictionary. They are just re-indexed with a label added that says “archaic” or “obsolete”. I doubt Microsoft wants to hear Skype referred to in either of those ways. Luckily for them, their word is still active without this official label, even if it has been replaced in most conversations.
Knowing that definitions change and words evolve helps to understand some of the confusion that exists today around the definition of “Venture Debt”.
What is Venture Debt?
In this post, I will look into answering the questions “What is Venture Debt?” and “What it is for?”. (I’ll go into the specifics of various terms, warrants, and pricing in a follow-up post).
Venture Debt is a term that is thrown around quite a bit, but actually causes a lot of confusion in technology finance, since it is not properly defined. Since the meaning of a word can evolve into however it is most commonly used, it’s also possible that we just haven’t finished deciding what exactly it means.
Venture Debt is sometimes used to describe any type of lending to a tech company (or “venture”), and other times it is used to describe a specific type of lending to a startup that is backed by Venture Capital. A company that has Venture Capital backing is sometimes referred to as being “sponsored”. With the term Venture Debt gaining popularity internationally, the same issue of it having different meanings is showing up in international announcements and marketing.
These are two commonly used definitions of Venture Debt:
- Venture Debt: as a specific financial instrument created for financing Venture Capital backed companies only. This type of venture debt is marketed as a complement to a recent or ongoing equity raise.
- Venture Debt: as any form of lending to a technology startup. This method is often presented as an alternative to funding with Venture Capital. This type of debt will typically be marketed as looking at both VC and non-VC backed companies. It can also be marketed along the lines of “Consider raising Venture
CapitalDebt as an alternative financing option!”
Let’s look at each of the two definitions:
Venture Debt – The Financial Instrument for VC backed Companies:
Venture Debt has traditionally been a specific type of lending product for Venture Capital backed companies within the broader category of Technology Lending. There are many other types of lending to tech companies too other than just Venture Debt. Other examples of products include Merchant Cash Advances (MCA), Factoring, Term Loans, Recurring Revenue Lending, and many more.
The most common and traditional use of Venture Debt to a Venture Capital-backed company is to increase a company’s runway until its next capital raise. By adding venture debt and extending a company’s runway, the company has a longer timeframe to increase its valuation before the next raise. While this is not the only use for venture debt (equipment, servers, acquisitions are other examples) it is the most commonly thought of when lending to Venture Capital-backed ventures.
Runway is the companies time, usually represented in months, before the cash available to pay monthly expenses will run out. The calculation is very simple: cash in the bank (plus any available credit facility) divided by monthly net loss (which is described as burn) equals runway. So if the company has 2MM in the bank and a 1MM Venture debt loan and is burning 300K a month, they have 10 months of runway. By adding Venture Debt, the amount of cash available is increased and this runway is extended. This is shown in the diagram below.
This Diagram from Silicon Valley Bank shows an extension of a companies runway by taking on Venture debt shortly after an equity raise (can also be done at the same time as an equity raise). The additional capital added runway extension so that a larger valuation milestone could be reached at the next raise.
So what do Venture Capital firms think about this kind of debt being used?
Airbnb and Venture Debt
Something interesting to note in the rise of venture debt’s popularity is that it has not always been looked upon favorably (and still has its doubters). Paul Graham tweeted this about it:
For anyone unfamiliar with Paul Graham, he is an icon in the tech industry and one of the founding members of Y combinator, an incubator that has launched over 2,000 companies. So when Paul Graham shares his opinion on this, many founders will listen.2
There are pros and cons to using both debt and equity as a startup that should be considered by founders for each method of financing. Taking on debt is referred to as leveraging, and simply put, leverage is an amplifier. Both the returns and risks of an investment are amplified with debt. Since startups are already generally considered extremely risky (which is why Venture Capital and Angels are funding them), it’s an extremely relevant question to ask whether or not there needs to be even more risk added on to the business.
I understand where Paul Graham is coming from here. This is especially relevant for companies and investors that are based in Silicon Valley where there is a ton of equity and capital available in the market. Adding an amplifier of leverage can seem like an unnecessary addition.
Another argument against venture debt is that founders often don’t understand it or know how to use it (especially for earlier stage founders that don’t have a CFO in place yet). Although this could be a valid concern, I find it underestimates founders’ abilities to learn about financing tools and apply this knowledge. When we consider that founders have learned how to use financing instruments like SAFE’s, Equity raises, and many more complicated tools than loans, this concern seems less relevant.
An interesting progression in this story is that a few months after this tweet, Airbnb, a company that Y Combinator invested in, used venture debt to extend its runway during Covid which led up to an extremely successful IPO. I can’t help but wonder if someone has asked Paul Graham about this and if he has circled back to this tweet.
Something fascinating about the AirBnB Venture debt is that the founder revealed that the venture debt underwriting had valued the shares at $30 each at the time of the debt offering. They IPO’d months later at $68 per share, and actually opened on the first day at $146.3
I can’t help but wonder if the lesson here is that the founders hold the final decision making power or that there is a time and a place for both debt and equity financing.
Impact on Valuation
Airbnb’s use of Venture debt is a textbook example for the following diagram. By extending their runway with debt they were able to delay the timing of their valuation which led to a much higher valuation.
This diagram from Kaufman Fellows shows very simply and clearly why founders chose to use venture debt. With a combination of debt and equity, you have a longer runway and the ability to achieve a higher valuation. This translates into less dilution or a larger amount of funds for the next raise.
The blue line shows the company extending their runway to continue for a longer time before their next raise and achieving a higher valuation compared to the black line which is an equity-only model.
Another benefit to this is that outside of Silicon Valley, raising capital can take a long time to close (sometimes months) and VC/Angel capital can be much harder to access, so additional runway could make a huge difference to a scaling startup.
The Rise in Popularity of Venture Debt
The graph below shows a clear trend in the increasing popularity of venture debt as a financing tool with 3,066 deals completed in 2019 for almost $30B in funding. Conveniently the timing of this graphs publishing also matches up very closely with Paul Graham’s tweet.
Many top companies have taken on venture debt too. Here is a short list of some top companies that have used Venture debt:
- Facebook (used for Servers)
- Justin.tv (now called Twitch)
- Airbnb (during Covid)
- Brex – 300MM
- Eventbrite- 225MM
- Robinhood – Currently raising $1 Billion 4
Venture Debt – The “Alternative”
It’s becoming more and more common to see private lenders use and market around the term Venture Debt as simply meaning an alternative to venture capital rather than just a complement to it. Since most founders are familiar with the concept of raising Venture Capital, marketing the term “Venture Debt” as a debt alternative to raising venture capital may continue.
Here are some examples of Venture Debt being referred to in a context of not requiring Venture Capital backing:
- Flow Capital: ” Venture Debt: Complement or alternative to equity financing”
- Firepower Capital: “Venture debt is a type of debt financing provided to businesses by non-bank lenders to fund growth, i.e. working capital or capital expenses. Venture debt typically complements a VC investment, but in some cases, can also be deployed without a VC sponsor”
- Tech Crunch: “Venture debt, in various forms, is a type of capital provided to startups that may or may not have raised equity-based funds, like venture capital”
- FindVentureDebt.com: “We continue to use “venture debt” as an umbrella term for a broad range of non-dilutive and minimally-dilutive funding since it’s more commonly recognized”
The argument for this definition is that the term Venture Debt is actually relating to the fact that a company is a “venture” that is taking debt. If capital is provided by equity it’s Venture Capital, so if debt is provided to the venture then it can be called “Venture Debt”.
The spin-off may have also started as more and more companies have decided not to raise Venture Capital. Many of these companies are still strong candidates for lending. A great example of this would be companies with very strong recurring revenues. Many lenders feel a strong level of comfort lending to a more mature tech startup with >2MM ARR. The Tangible Addressable Market may not have fit Venture Capital standards with unicorn potential, but it was still a strong business with impressive growth metrics.
Who is Right?
So who is right? And who gets to decide? Some people may say that Silicon Valley Bank gets to make this call since they made this type of lending and the term Venture Debt popular. Other sources suggest that Venture Debt (or Venture Leasing) was first created in the 1970s while SVB was founded in 19835.
The answer to this question is actually that it will completely depend on how the terms are used by the majority. For now, there are two definitions that exist simultaneously, and knowing this can elevate a lot of confusion.
Going forward, I believe that one of two things will happen:
The ambiguity and confusion around the term Venture Debt may cause it to start being used less and less. There are numerous tech lending options available to both venture firms and non-venture backed companies now, and most of them don’t market as Venture Debt. There may be some pressure from other terms as banks start to create “Technology Industry”, “Tech Finance” or “Knowledge-Based Industry” groups. There are also many different structures available to Venture-backed companies other than just runway extension, which is the classic use. Although I doubt the term will be labelled “archaic” or “obsolete” (if it ever makes it into the dictionary), however, the use of the term could slow down.
Another option is that the meaning of the term will continue to morph and we may actually see more and more lenders start to embrace the term Venture Debt to simply refer to lending to technology startups. With this type of lending growing in popularity in the UK, India and Australia, the way the terms are used in international contexts will have a strong impact too. The simplicity of thinking that Venture Capital is equity for startups and Venture debt is debt for startups is tempting to use.
I’m looking forward to coming back to this post in few years to see how the term is being used or if a new term has emerged to replace it, but for now, knowing both uses of the term can hopefully alleviate some of the confusion when you see or hear it used.
(2) Paul Graham Essays Link – Paul Graham has an excellent set of Essays. Reading them was a partial inspiration for starting my own blog and using footnotes in a similar way.
(4) Robinhood article about raising 1 Billion in debt
(5) History of Venture Debt by Espresso Capital