Venture capital loans are used by companies to secure capital for a start-up or growth. This type of capital is risk capital in that there is substantial risk related to the possible future creation of profit in return for the investment capital. Venture capital loans are high risk for the investor, so they normally have a higher interest rate than bank loans. Start-up companies are more likely to secure a loan from a venture capital firm than from a bank due to the risks involved. Since it is a loan, it must be paid back with interest to the venture capital firm regardless of the success or failure of the start-up company.
Many venture capital loans require an equity injection of 15 to 20 percent of the outstanding equity in the company, and the loans are frequently secured by company securities. A loan may be convertible into equity shares in the company. Some venture capital loans must also be approved by appropriate government entities. Not all venture capital firms provide venture capital loans, and some banking institutions that do not make venture capital investments will make venture capital loans.
Historically, entrepreneurs would search for wealthy individuals to fund projects on a case by case basis. Over time, venture capital firms or funds developed. These firms are usually groups of private investors who have come together to make some of these riskier investments. By working together, these investors hope to reduce the individual risk associated with each of the investments.
A venture capital loan is a contractual agreement under which the start-up company is required to repay its loan with interest; however, it is still a high-risk proposition for the investor. If the start-up company does not make any profits, the company may not be able to repay its loan. If the loan was secured by company securities, the investor may rank ahead of other creditors to the company’s assets. If not, then the investor may lose its entire loan amount and any unpaid interest to date.
Each venture capital firm and individual investor has different due-diligence requirements before it decides to grant a loan. These requirements usually include a detailed financial feasibility study and a technical assessment to determine if the company is a good risk. Depending upon the investor, an independent accountant or consultant is used to make this assessment. If it is a larger venture capital firm, an employee of the firm usually makes the assessment.