Dec 18, 2023

Term loans vs. venture debt - is it all just marketing?

Arc Team

Go-To-Market

When navigating the debt funding landscape as a first-time founder, it can be difficult to tell the differences between the various financing options. Both bank and non-bank lenders seem to overcomplicate just about everything they do, not maliciously of course, but in an attempt to convince you to seek their guidance. One of the common questions we get asked quite often is what the difference is between term loans and venture debt, and which option is better for startups. In this guide, we break down each form of financing, including the pros and cons, so you can make a more informed decision for your startup. Ready? Let’s dive in!

An overview of venture debt

What venture debt is (and isn’t)

Venture debt is a form of debt financing that is specifically designed to meet the needs of high-growth startups and emerging companies. Venture debt is typically characterized by three things: 1) a bullet structure, with principal repayment due at maturity; 2) monthly, interest-only payments; and 3) warrant coverage. Venture debt is not directly dilutive, though, through required warrants in some deals, it can be. Historically, venture debt was reserved for tier-one venture-backed companies, though that has changed in recent years. For more information, check out the founder’s guide to venture debt.

What startups use venture debt for

Startups typically use venture debt to hold them over until their next equity raise (bridge), to continue or accelerate their growth (growth capital), to acquire other startups, or to limit dilution and maintain control of their business. Most of the time startups do not use venture debt to satisfy their day-to-day working capital requirements.

How long it takes to raise venture debt

Venture debt closely resembles equity capital in its extensive due diligence and negotiation process. Startups often engage with multiple venture debt providers, comparing the resulting term sheets to optimize their financing terms. While the entire process, from the initial meeting to funds landing in the bank account, generally spans 8-10 weeks, heading into 2024 we expect the venture debt processes to extend beyond the 12-week mark.

An overview of term loans

What term loans are (and aren’t)

A term loan is a type of loan that has a specified repayment schedule, or term, over its duration. The term can range from a few years to several decades, depending on the purpose and structure of the loan. Term loans may have fixed or variable interest rates, can be either secured or unsecured, and are not dilutive. For more information, check out the founder’s guide to term loans.

What startups use term loans for

Startups use term loans for various purposes to support their growth and operational needs. While startups often rely on equity financing and venture capital, term loans can provide additional funding and financial flexibility. Startups may use term loans to bolster their working capital, ensuring they have sufficient funds to cover day-to-day operational expenses. They may also use a term loan to purchase equipment, technology, or new office spaces.

How long it takes startups to raise a term loan

While some startups may secure term loans relatively quickly, ranging from a few days to a couple of weeks, others may experience a longer timeline, especially if the loan is part of a more complex financial arrangement. Generally speaking, term loans take less time to raise than venture debt.

Venture Debt vs Term Loans

The key similarities and differences between venture debt and term loans

The key similarities between venture debt and term loans

Debt Structure: Both venture debt and term loans represent forms of debt where a specified amount of money is borrowed and must be repaid over a predetermined period.
Repayment Schedule: Both types of loans typically have a fixed repayment schedule, outlining when and how the borrower is required to make payments. This schedule often includes regular, equal payments over the loan term.
Interest Payments: Venture debt and term loans involve paying interest on the borrowed amount. The interest can be either included in the monthly payment, or the lump-sum payment.
Use Cases: Both financing options can be used for a variety of business purposes, including working capital, equipment purchase, technology investments, expansion, and other long-term investments in the business.

The key differences between venture debt and term loans

Equity Components: Venture debt typically includes equity-like features, such as warrants or options to purchase the borrower's equity, whereas term loans typically do not include equity components.
Flexibility and Structure: Venture debt offers more flexibility in terms of repayment structures, including interest-only periods and bullet payments. Term loans on the other hand tend to have more standardized structures, with fixed repayment schedules.
Maturity and Repayment: Venture debt usually has shorter maturity periods, and repayment may align with specific milestones or equity financing events, term loans typically have longer maturity periods, and repayment is spread over the agreed-upon term, with regular payments.

The key pros and cons of venture debt vs term loans

Venture Debt - Pros

Leverage for Equity Financing: Venture debt can be strategically used to enhance a startup's negotiating position in subsequent equity rounds.
Flexibility in Repayment: Startups may negotiate interest-only periods or balloon payments to align with their cash flow dynamics.
Customized Terms: Venture debt agreements can be tailored to meet the specific needs of the startup. Terms, including interest rates, covenants, and maturity dates.

Venture Debt - Cons

Equity Dilution: Although venture debt is considered non-dilutive in the sense that it doesn't involve issuing new shares, the inclusion of warrants or equity kickers can lead to future equity dilution if the lender exercises these options.
Collateral Requirements: Some venture debt agreements may require the startup to provide collateral, such as intellectual property or other assets.
Financial Covenants: Venture debt agreements often include financial covenants that the startup must adhere to. Breaching these covenants can trigger default and may result in penalties, higher interest rates, or other adverse consequences.

Term Loans - Pros

Stable Repayment Structure: Term loans have a fixed repayment schedule, usually consisting of regular, equal payments over the loan term.
Long Maturity Periods: Term loans typically have longer maturity periods compared to other forms of debt, providing businesses with an extended timeframe to repay the borrowed amount.
No Equity Dilution: Term loans do not involve the issuance of new shares, resulting in no dilution of ownership for existing shareholders.
Speed of Access: The application and approval process for term loans can be more streamlined compared to equity fundraising.

Term Loans - Cons

Prepayment Penalties: Some term loans may have prepayment penalties or fees for paying off the loan before the agreed-upon term.
Limited Flexibility: The terms of this form of financing are often more rigid compared to other financing options.

Ideal use cases of venture debt vs term loans

Ideal use cases of venture debt

Bridge Financing: Venture debt can serve as a financial bridge, helping startups maintain operations and achieve milestones while awaiting the next equity funding.
Technology and Life Sciences Companies: Venture debt can support these companies in funding critical technology initiatives without immediate equity dilution.
Flexible Repayment Structures: Venture debt often offers flexible repayment structures, including interest-only periods, balloon payments, and milestone-based payments.

Ideal use cases of term loans

Established Businesses with Stable Cash Flow: Term loans provide a structured and predictable repayment schedule, making them suitable for businesses with stable financials.
Working Capital Needs: Term loans can provide a reliable source of funding to cover day-to-day operational expenses and support business growth.
Long-Term Projects: Term loans with longer maturity periods are suitable for financing projects with extended payback periods, such as expansions or new facilities.

Wrap up - term loans vs. venture debt - it is not just marketing

As you can see, while term loans and venture debt are similar, they’re not the same. Venture debt is moreso suited for high-growth technology startups that have recently raised equity capital, whereas term loans are better suited for mature businesses that need fixed repayment schedules. Venture debt’s bullet structure makes it great for startups that want to invest in their growth but don’t want to be dragged down by monthly repayments, while term loans are great for equipment or new facility purchases. If you’d like to explore these financing options, we’d be happy to help—get in touch.