Venture debt has become a mainstream financing tool for startups, providing a way to access capital with less dilution compared to traditional equity rounds. But if you’ve negotiated a venture loan, you may notice lenders sometimes ask for more than just repayment – they want the right to purchase equity in your next round. Here’s why, and what founders should watch out for.
Why Venture Lenders Want Equity Rights
Venture lenders are sophisticated players in the startup ecosystem. When they back a promising company, they’re not just looking for loan repayments and warrant coverage (the standard equity kicker that comes with venture debt). They also want the option to invest additional capital alongside other investors in your next equity round, often requesting the right to put in a meaningful sum – sometimes $1 million or more.
Their logic is straightforward: If the company is successful, they want to increase their upside with an ownership stake in the company. By getting in on the next round, they can convert their insider knowledge and early support into equity gains, just like your existing VCs.
The Hidden Challenge: Pro Rata Rights and Cap Table Complexity
On the surface, having your lender eager to invest more might sound positive. However, this can create real headaches during your next fundraising. Here’s why:
- Crowded cap table. Most venture-backed companies expect the next lead investor to take a significant chunk of equity – often 20% or more.
- Pro rata rights tension. Existing investors typically have pro rata rights, which enable them to maintain their ownership by investing more in new rounds. When a lender demands a large allocation, it squeezes the available room for everyone else, leading to difficult negotiations.
- Ownership dilution. The more parties vying for a slice of the new round, the harder it is to keep everyone happy. This can result in a “scrum” among investors, with founders caught in the middle trying to balance relationships and preserve their own stakes.
Best Practices for Founders
To avoid future complications, founders should:
- Limit lender equity rights. Negotiate to keep the lender’s equity investment rights modest – think $50K to $200K, rather than a million-dollar allocation. This keeps the lender aligned with your success without disrupting the delicate balance of your cap table.
- Communicate with existing investors. Be transparent with your current investors about any new rights granted to lenders, and ensure everyone understands the impact on pro rata allocations.
- Plan ahead. As the number of stakeholders grows, managing pro rata rights and cap table allocations becomes more complex. Use robust tools and clear documentation to track ownership and rights.
Lenders Are Impressed with Your Startup
Venture lenders want equity rights because they see the upside in your success, not just the safety of their loan. While their participation can be a vote of confidence, granting them too large a stake in your next round can create friction and dilute existing investors’ rights. Thoughtful negotiation and careful cap table management will keep your fundraising on track and your investors aligned.
