What are the risks of venture debt?
Takeaway: Venture debt is a powerful but unforgiving tool; a failure to raise your next equity round can trigger a default on the loan, giving the lender the right to seize your assets, including your intellectual property.
While venture debt can be a smart, less-dilutive way to fund specific capital needs, it is crucial for founders to understand that it is not "easy money". It is real debt, and it carries a different, and in some ways more severe, set of risks than an equity investment. Unlike your VCs, who are partners in the upside and downside, a venture debt lender is a creditor. Their primary goal is to get their money back with interest, and the loan agreements they put in place are designed to ensure this happens.
The Existential Risk: Default and Foreclosure
This is the single greatest risk of venture debt. If your company defaults on the loan—by failing to make an interest payment or failing to repay the principal at the maturity date—the lender has the right to foreclose on its collateral.
The Blanket Lien: A venture debt loan is almost always secured by a "blanket lien," which is a security interest on all of the company's assets. This includes your cash, your equipment, your accounts receivable, and most importantly, your intellectual property.
The Foreclosure Scenario: In a default, the lender can legally seize your company's assets, including your patents and source code, and sell them to get their money back. This is an existential, company-killing event.
Restrictive Covenants
Venture debt agreements contain a series of "covenants," or rules, that your company must abide by. A breach of any of these covenants can also trigger a default.
Negative Covenants: These are the most common. They prohibit your company from taking certain actions without the lender's prior consent. This often includes selling major assets, taking on additional debt, or paying dividends to stockholders. These covenants can limit your operational flexibility.
Financial Covenants: While less common for very early-stage companies, some debt agreements may include financial covenants, such as a requirement to maintain a minimum amount of cash in the bank at all times.
The "Material Adverse Change" (MAC) Clause
Most loan agreements contain a broad, catch-all "MAC" clause. This gives the lender the right to call a default if they believe there has been a "material adverse change" in the company's business or financial condition. This is a vague and subjective term that can give the lender significant leverage if your company hits a rough patch.
Venture debt is best used when you have a high degree of confidence in your ability to raise your next round of equity financing. It is a powerful tool for bridging a known funding gap, but it is a dangerous instrument to use if the company's future is highly uncertain.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.