Understanding and managing the risks of venture debt

Venture debt can serve many purposes for a growing business. It could help you cover capital expenses or to extend your cash runway, to name just two.

If you're considering venture debt for the first time, you probably have some questions about how it all works.

You might be wondering if it's right for your business, what lenders look for and how to find the right provider.

Another important aspect of venture debt to understand is risk. This article examines some of the common risks linked to venture debt funding, and what you can do to manage them.

Cash flow constraints

Like any other loan, venture debt needs to be repaid, typically over the course of 36-48 months. This might start with an interest-only period of between six and 18 months.

A clear repayment structure and known costs can be a big help when it comes to managing cash flow.

But when you're an early-stage business focused on growth, cash flow constraints are often an issue. One late payment from a customer or an unexpected cost could mean a cash shortage.

If this happens regularly, you might find yourself defaulting on loan repayments. This can have repercussions including damage to your credit score and potential seizure of assets used to secure the loan.

Missed milestones: Understanding execution risks

Venture debt funding is provided on certain conditions. Crucially, it typically comes after equity and complements your venture capital support.

Lenders will want to know that you can access venture capital to make repayments and fund your growth plans.

But what happens when the plans to meet your company's growth targets don't pan out? This is where execution risk comes into play.

Execution risk is the danger of the business failing to carry out its strategy and reach key milestones. This can have many consequences, including damage to investor and customer confidence, which could lead to financial losses.

There are many reasons why execution risk might arise for your company. Some of them might be outside your control - economic trends and market conditions, for instance.

Nevertheless, failing to execute your plans could affect both your ability to make loan repayments and your future borrowing prospects.

Milestone compliance

Business loans often involve a covenant between the lender and the borrower. This is essentially an agreement that both parties will keep to the terms of the deal.

However, venture debt typically doesn't involve financial covenants. What you might see instead are milestones. These are landmark points on your growth journey, which could involve meeting product development or financial targets by a certain date.

Your debt provider may use these moments to make decisions about any future lending. Falling short of a milestone could also be a warning sign to a lender that the business is underperforming.

So how do you manage the risks?

The good news is there are many ways to manage risk.

Here are some recommended practices:

• Think carefully about your capital structure - the combination of debt and equity funding for growth. Debt-to-equity (D/E) ratio is a measure of financial leverage calculated by dividing the company's total liabilities by shareholder equity. A high D/E ratio could be a sign of risky borrowing.
• Use data on projected income and outgoings in a given period to create a cash flow forecast. This helps you understand your cash position so you can keep up with loan repayments and other liabilities.
• Explore how the business can diversify revenue, possibly through activities such as entering new markets or expanding your product offering. This could reduce the risk of relying too much on a narrow range of income sources.
• Speak to potential venture debt lenders about loan terms that align with your growth trajectory.
• Be transparent in your communications and share any concerns you have with your provider early.

Final takeaway: Risk is a given, so explore threats to your business and how to manage them

It's impossible to eliminate risk in business, especially if you're an ambitious start-up hoping to use a combination of equity and venture debt funding to fuel your growth.

While you can’t plan for every eventuality, you can study your biggest risks and come up with a plan to tackle them.

Read our venture debt FAQs if you're interested in learning more about the way these loans can empower you to grow your business.