How do venture debt overhangs affect equity funding?

Venture debt overhangs are an issue we are seeing more often, and they are frequently blocking the next equity funding round for startups.

What is venture debt overhang?

Debt overhang is a common term in business, and it refers to companies that have taken on so much debt that the amount of debt affects the company’s ability to fund future projects. In other words, the company has borrowed so much money that banks don’t want to give them more. Venture debt overhang works the same way, but instead of banks refusing to lend more money, it can cause venture capital firms to shy away from investing in a startup.

So how does this happen? When capital is plentiful, startups can easily raise funding. However, a lot of them will also raise venture debt. Once the startup has funding, banks are more willing to loan the company money. Startups take the loans because it’s a way they can pay for additional operations or hedge against unforeseen funding shortfalls. 

These venture debt deals are often pegged at a ratio of the last equity round. For example, if a company raised $20 million they will probably get around $5 million in debt fairly easily. Typically startups use venture debt to get capital to fuel business growth, or as a “safety net” to extend their cash runway to reach milestones or funding rounds.

Large amounts of venture debt make investors nervous

In recent times, the dollar amounts of VC funding went up quite a bit, but as the market has cooled, equity funding is a lot harder to get. But startups still have venture loans they took out earlier. This means there is now a pretty large overhang and that debt is looking risky to investors. Investors don’t really want to put a significant amount of new money into paying that debt off, and that is how the overhang blocks future equity fundraisers.

So now we are seeing new investors looking at the debt and saying “I love the company, I love where you’re going, but if I put in $5-10 million, that’s just going to pay the debt off and is not a good deal for me as the investor.” So venture debt overhang is slowing down or even stopping some of the additional funding rounds.

How can you deal with venture debt overhang?

There’s no easy answer to venture debt overhang. It’s impossible to go back in time and avoid taking out a venture loan, but we can learn from our mistakes:

  • The first lesson is to not take on as much venture debt. Don’t be too aggressive in that area.
  • Secondly, when you do raise venture debt, make sure you have a plan for paying it back – or at least for getting a cash flow break. That way you don’t have to depend on investors to help pay it back for you.

Most importantly, just be aware that venture debt overhangs are now more and more frequently having an effect on the many startups out there that are trying to fundraise equity. This issue is popping up a lot more and it can be a real headache.

If you have any other questions on venture debt overhangs, valuations, startup investing, startup accounting, or taxes please contact us.

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