Business Financing 101: Venture Debt vs Traditional Bank Loans

Raising funds for a small to medium-sized business is challenging. Traditional banks show little interest in servicing newer companies. Their interest rates and loan approval criteria are dependent on unrealistic revenue requirements. Venture capital firms don’t charge interest, but they want equity that cuts into other shareholders’ profits. Neither option is all that appealing.

Thankfully, there’s another choice. Venture debt financing offers the same levels of funding banks provide, without the same criteria for approval. It can also be acquired without surrendering an equity stake in the company. In this article, we’ll define what venture debt funding is and how it compares to bank loans or venture capital.

What is Venture Debt Financing?

Early-stage companies find it difficult to secure traditional bank financing because they don’t have a track record of consistent revenue to show. Venture debt funding is great for young companies seeking capital because it comes from specialized lenders that don’t have the same requirements that banks do. Interest rates and repayment terms are set by the lender based on the borrower’s company analysis.

Venture debt should not be confused with venture capital. The latter is a term that is usually used to describe funds exchanged for equity, which we’ll cover in more detail below. Venture debt financing is taking out a loan without surrendering an equity stake. That’s an important distinction, particularly during the first few years a company is in business.    

The terms of venture debt financing can be more flexible than what a bank will offer. Smaller payments, delayed payments, and early repayment incentives could be included in the contract. Venture funding companies are also not FDIC-insured, so they’re able to do business with companies in sectors that don’t have access to federally backed banks.

Types and Uses for Venture Financing

There are several types of venture debt. Funding companies in this space usually offer different options that are structured for specific purposes. This is necessary because there’s a significant difference between a start-up looking to get off the ground and an established company wanting to grow and scale its operations. Here are some examples:

• Working Capital Venture Funding: An infusion of working capital can help a company get through a challenging period or fund an expansion that will generate new revenue. Neither of these happens without cash flow.
• Equipment Financing and Leasing Loans: New equipment is expensive, even when it’s leased. Venture finance lenders can provide the funds to purchase or lease the equipment a company needs to maintain its operations.
• Commercial Real Estate Loans: Traditional banks and credit unions are reluctant to underwrite loans on commercial real estate, particularly for applicants with less-than-perfect credit. Venture funding companies can be more flexible with approvals.
• Venture Funded Line of Credit (LOC): A line of credit allows the borrower to take only what they need when they need it. An LOC can also be reused, unlike a loan which is a one-time solution. Seasonal businesses are a good fit for this option.  
• Hybrid Loans: A hybrid loan is a combination of two or more of the loan products above. For example, the business could combine working capital funding with an equipment financing loan, bundling repayment for both into a single monthly payment.

Venture Debt versus Traditional Bank Financing

A common mistake that many business owners make is looking at venture debt financing as a second choice. Founders all too often go to the bank first, get refused, and then choose to look at other options. Even then, the tendency is to consider giving up equity for venture capital before paying potentially higher interest rates for venture debt funding.

This reasoning is flawed. Banks and credit unions set interest rates based on the current prime rate and a risk analysis of the borrower. SMBs in their first few years of operation are always considered high-risk. They’re also subject to sector analysis that can categorize their business based on their competitors. The bank uses that analysis to justify higher rates and fees.

Venture debt lenders do their risk analysis based on the company’s financial reports, bank account balances, billables, and owner profiles. They’re also focused specifically on business loans. Venture funding companies don’t give out personal loans. They’re able to see the true value of an SMB, not simply a data analysis created by an algorithm.  

The same rules apply to a business line of credit, with one exception. Banks traditionally have variable rates on LOCs that are based on the lending prime rate at the time of withdrawal. Venture funding companies have the flexibility to offer fixed rates if they choose. Banks and credit unions won’t do that. Repayment terms at venture lenders are also more flexible.

Venture Debt Funding versus Venture Capital

The value of individual shares in a corporation is determined by the overall valuation of the company. That valuation will be lower when a business is in startup mode, so shares will be worth less. Venture capital firms ask for some of those shares in return for funding. They won’t issue a loan that needs to be repaid. They’re looking for a piece of the company.

Putting up existing shares surrenders ownership and voting rights, depending on how the deal is structured. Issuing new shares dilutes the value of what existing shareholders already own. As the company grows and increases its valuation, the venture capital firm increases its profits while the amount lost by the original shareholders grows.

Venture debt doesn’t have the same drawbacks. The company borrowing the funds will need to pay an interest rate on them, but ownership of the company remains unchanged. On top of that, interest on business loans can be tax deductible. Stock losses are too, but only if the owner of those shares sells them when the company goes public. That’s a topic for another article.

Choosing the Right Funding for Your Company

Despite the drawbacks, there might be times when either a traditional bank loan or venture capital funding could be the right choice for your company. We encourage you to do more research on both. Chances are you’ll decide venture debt funding is a better option. Contact us today to learn more about how Wise Venture can help you with this.