Venture Debt: Why Startups Borrow Instead of Raising Equity

Startups often raise capital by selling equity, but issuing new shares is not the only way to fund growth. Some venture-backed companies also use venture debt to access capital without immediately giving up more ownership.

For private investors, debt can change both a startup’s financing strategy and its risk profile. In this week’s blog, learn why startups may choose venture debt over additional equity and what investors may want to consider when evaluating it.

What Is Venture Debt?

Venture debt is a form of financing generally provided to venture-backed companies that may not yet have the profitability, cash flow, or assets required for traditional bank loans. Specialized lenders and banks may instead consider factors such as the company’s investors, growth, cash runway, and ability to raise future capital.

Unlike equity financing, where investors receive ownership in exchange for capital, venture debt typically requires the company to repay the principal along with interest. Loans may also include warrants that give the lender the right to purchase equity under specified terms.

For example, assume a startup recently raised a $20 million Series B at an $80 million pre-money valuation and needs another $5 million to expand its sales team and continue product development. Rather than raise more equity, the company could borrow the $5 million through venture debt.

Why Would a Startup Choose Debt Over Equity?

Startups may use venture debt for several reasons, but the decision often comes down to balancing access to capital with dilution. Three common reasons include:

1. Extending Runway – giving the company more time to reach revenue, product, or operational milestones before its next equity round
2. Reducing Dilution – accessing capital without immediately issuing additional shares
3. Funding Specific Needs – financing equipment, acquisitions, working capital, or other initiatives without a larger equity raise

In the example above, management may believe another year of growth could support a higher valuation in its next financing. The $5 million loan could provide additional time to reach those targets before raising more equity. The tradeoff is that the debt generally must be repaid, regardless of the company’s performance.

How Can Venture Debt Reduce Dilution?

Every time a company raises equity, existing shareholders own a smaller percentage of the business after new shares are issued. In the example above, the startup was valued at $80 million before its Series B and $100 million on a post-money basis following the $20 million financing.

If the company then raised the additional $5 million through equity at the same $100 million valuation, new investors would receive approximately 4.8% of the company. Borrowing the $5 million instead would avoid immediately issuing those additional shares.

However, venture debt is not necessarily non-dilutive, as warrants can create dilution if exercised. For example, if the lender required 10% warrant coverage, it would receive warrants to purchase $500,000 of stock. Assuming an exercise price based on the $100 million valuation, that would equal roughly 0.5% of the company on a fully diluted basis, compared with about 4.8% for an equivalent equity raise.

What Does Venture Debt Cost?

Venture debt typically carries interest and may also include origination fees, closing costs, prepayment penalties, or end-of-term fees. Depending on the loan, the company may make regular principal payments or have an initial interest-only period before principal repayment begins.

Continuing the example above, suppose the startup borrowed $5 million at a 10% annual interest rate. If the full balance remained outstanding for one year, the company would pay approximately $500,000 in interest. A 1% origination fee would add another $50,000.

Venture debt may also include warrants that give the lender the right to purchase shares, as well as covenants that require the company to meet certain financial conditions or obtain lender approval for certain actions. As a result, the cost of venture debt can include potential dilution and limits on the company’s flexibility in addition to interest and fees.

When Can Venture Debt Be Useful?

Venture debt may make more sense when a company has a specific use for the capital and a plan for repaying it. In the example above, the startup could use its $5 million loan to fund additional development before launching a product or reaching an important revenue milestone.

Venture debt can also be arranged alongside an equity financing to provide additional capital between major fundraising rounds. This can give a company more time to reach milestones before raising additional equity, although repayment obligations begin regardless of whether those milestones are achieved.

Venture debt can also broaden a company’s sources of capital by adding relationships with lenders alongside its existing equity investors. Some venture lenders invest in both debt and equity, which could also provide another potential source of funding in a future equity round.

What Happens if the Startup Cannot Repay the Debt?

Venture debt creates a contractual obligation to repay the lender. Loan agreements may also include security interests in company assets, financial or operational covenants, and provisions that give lenders certain rights if the company defaults.

If a startup runs short of cash, debt payments leave less capital available for hiring, product development, marketing, and other operations. The company may need to raise additional equity, renegotiate its debt, reduce spending, or pursue other alternatives. If the company misses payments or breaches its covenants, it may be in default, which could allow the lender to charge a higher interest rate, demand immediate repayment of the outstanding balance, or take control of pledged assets. In more severe cases, a default could force the company to restructure, sell itself on unfavorable terms, or shut down.

In a sale or shutdown, creditors generally have priority over all shareholders. This means outstanding debt can reduce or even eliminate the proceeds available to equity holders, particularly if the company is sold for less than expected.

What Can Venture Debt Mean for Private Investors?

For private investors, the amount of debt relative to a startup’s cash balance and ongoing expenses can help put its financial position into perspective. A company with substantial liquidity may have more flexibility than one with limited cash and significant monthly payments.

The repayment schedule matters as well. If payments come due before the company expects to generate sufficient cash flow or complete another financing, it may depend on raising additional capital. Investors can look at the amount borrowed, available liquidity, repayment terms, and maturity date when evaluating the debt.

Final Thoughts

Venture debt can give startups access to capital without immediately issuing more equity, but it also adds interest expense and repayment obligations. Its impact depends on how the capital is used and the company’s ability to repay it. For investors, the key is understanding why the company borrowed the money, when it needs to repay it, and whether it has the resources to do so.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Convertible Debt (aka Convertible Notes)
• From Equity to Alternatives: Understanding Dilutive vs. Non-Dilutive Funding
• Investor Insights: Understanding Down Rounds
• Venture Debt in 2025
• How Subsequent Funding Rounds Affect Your Investment