Venture debt can be a powerful lifeline for startups – extending runway, funding growth, and bridging the gap to the next milestone. But it’s far from a risk-free solution. When misused or poorly structured, venture debt can threaten your company’s future. Here’s what every founder needs to know about the dangers of venture debt and how to navigate this complex financing tool strategically.
Over-Leveraging: When Too Much Debt Backfires
It’s tempting to take as much venture debt as the lender will offer, but that can put your startup in a precarious position. Taking on more than three to six months of runway in debt is usually excessive (and remember, most lenders will want you to have 12 months of organic runway in addition to your venture debt). If the next equity round is delayed, stalled, or only available at unfavorable terms, you may face a scenario where new investor funds go straight to paying off lenders instead of fueling growth. This can make your company unattractive to future investors and limit your options for scaling.
Default Risk and Aggressive Terms
Venture debt often comes with strict covenants and triggers. Two clauses that require extra caution are:
- Material Adverse Change (“MAC”) Clauses. These clauses allow the lender to call a default based on their perception of negative business developments, even before actual financial failure.
- Investor Abandonment Clauses. If your lender includes an investor abandonment clause, a default can be triggered if your existing investors indicate they won’t continue supporting the company – sometimes regardless of your cash position.
Defaulting can have severe consequences, including forfeiting company assets, forced sale, or even liquidation. Lenders typically have senior claims, so equity holders get paid last.
Cost and Dilution: The Hidden Price Tag
Venture debt may appear less dilutive than equity, but it comes with costs that add up:
- High interest rates and fees. Interest rates for venture debt are often higher than traditional loans, sometimes up to 15–20%, with origination and end-of-term fees.
- Warrants. Lenders who hold warrants have the option to purchase shares at a set price, leading to future dilution if your company grows rapidly.
Repayment Pressure and Cash Flow Drain
Unlike equity, debt must be repaid on schedule – no matter how your business is performing. Regular interest payments and eventual principal repayment can drain cash from core activities such as R&D or hiring, increasing financial strain if the business isn’t scaling as planned.
How to Use Venture Debt Wisely
- Stay conservative. Only borrow as much as your company’s burn rate times three to six months.
- Scrutinize term sheets. Watch out for aggressive clauses such as MAC or investor abandonment, and negotiate to limit their impact. We’ve got more information on venture debt term sheets (and a free downloadable sample).
- Have a repayment plan. Don’t assume the next round will arrive – model scenarios where growth slows or fundraising takes longer.
- Align with investors. Make sure your board and investors are on board with your debt strategy and understand the associated risks.
Strategic Capital or Structural Trap?
Venture debt can help startups achieve vital milestones and optimize capital structure, but only if approached with discipline and a full understanding of the risks. If you’re considering venture debt, work closely with experienced advisors. Kruze Consulting can help you evaluate options and model scenarios, so any venture debt you take on will help your progress, not undermine it.
