Beyond equity: the new venture debt landscape

July 2024  |  FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

July 2024 Issue

Launching a new business comes with numerous obstacles for budding entrepreneurs. Some cite hiring and recruiting issues, the difficulties of developing a pricing model or the need to build brand awareness. But for the majority of fledgling businesses one issue often takes precedence: how to source adequate funding.

In the start-up world a variety of funding options exist for companies looking to foster growth or scale their enterprise. Among these options is venture debt financing – a form of financing that may not have the same visibility as other funding methods such as equity financing, but nevertheless plays a key role in the evolution of many start-ups.

In summary, venture debt is the process of lending funds to early-stage, high-growth companies that are already supported by venture capital (VC). It serves as an additional source of liquidity for start-up and scale-up businesses during the intervals between equity financing rounds.

Moreover, venture debt is typically an additional source of funds, supplementing VC rather than replacing it. What makes this financing option particularly attractive is that it does not involve surrendering an additional stake in the start-up company, thus reducing the risk of equity dilution.

Despite its popularity, however, tremors across financial markets in 2022 and 2023 resulted in a challenging environment for the VC market, and by extension, venture debt. Analysis by Pitchbook reveals that 665 early-stage venture debt deals were struck in 2022. By the end of 2023, the equivalent figure had dropped to 408 deals, a 39 percent reduction.

“In 2023, the US experienced a regional banking crisis and the collapse of Silicon Valley Bank (SVB),” says David Spreng, founder and chief executive of Runway Growth Capital. “This financial stress, coupled with high inflation, led to cautious bank lending standards, prolonged higher for longer rates, fluctuating equity markets and declining VC valuations.”

Thus, while demand for venture debt has remained strong in recent years, a confluence of macroeconomic factors impacting markets across the globe have contributed to less dealmaking across all stages of the start-up investment lifecycle.

Rebound in 2024

Despite the challenges of recent years and testifying to its resilience and growth, the venture debt market is experiencing something of a rebound in 2024, with an increasing number of companies returning to this source of capital as an alternative funding choice for their enterprise.

“We expect deal activity to increase in the coming quarters,” concurs Mr Spreng. “Companies that completed equity funding rounds in 2021 and 2022 – at historically high valuations which provided 24 to 36 months of runway – will soon need to return to market to raise additional capital. These companies will seek minimally dilutive, non-priced capital in the form of venture debt to extend their runway as the equity markets remain challenged.”

Underlining this contention is Runway Growth Capital’s ‘2023 Venture Debt Review’, which indicates that borrowers and VCs are just as willing to utilise venture debt now as they were before the collapse of SVB, with 88 percent of VC respondents reporting that their portfolio companies still plan to pursue venture debt in the next 12 to 18 months.

The review also found that 33 percent of borrowers feel venture banks have become less

trustworthy since the collapse of SVB, with 19 percent reporting that they were not willing to raise venture debt with a bank at all. Conversely, 67 percent stated that they were willing to raise venture debt with a non-bank or specialty finance lender.

“In recent months, activity in the venture debt market has demonstrated resilience and growth, with an increasing number of companies turning to this alternative source of capital,” says Jeremy Loh, co-founder and managing partner at Genesis Alternative Ventures. “There has been notable traction observed in venture debt financing deals, especially in Southeast Asia, where venture debt is still a relatively underutilised financing instrument.”

Among the factors driving the uptick of venture debt in Southeast Asia is the growing awareness of its benefits, such as providing additional runway while minimising dilution, complementing equity financing and enabling start-ups to execute on their growth strategies with the lower cost of capital.

“As traditional lending institutions tighten their lending criteria and remain cautious during the current economic environment, venture debt has become an attractive option for start-ups seeking capital infusion,” adds Dr Loh. “Venture debt providers have become more sophisticated in tailoring their offerings to meet the unique needs of different start-ups, thereby broadening the appeal of this financing option.”

Starting the journey

Utilised effectively, venture debt can help a company overcome challenges, seize opportunities and scale its business operations without diluting ownership. Securing and optimising such funding can be crucial in a start-up’s growth journey, as can having recourse to a well-aligned venture debt provider.

“A typical venture debt borrower is a high-growth business that has already raised capital through previous equity fundraising rounds,” explains Hannah Rowbotham, a partner at Fieldfisher. “However the proceeds of venture debt can service a number of purposes, consequently influencing the timing of when a company may decide to take on this type of debt.”

As noted by Ms Rowbotham, there are various purposes for which venture debt can be utilised.

First, where a company does not expect its cash runway to carry the company to its next fundraising round, venture debt is one way to fund operations without the need to raise additional capital from investors until the next valuation milestone.

Second, unanticipated investment and growth opportunities may arise between funding rounds – for example asset acquisitions or expansion into a particular market – and venture debt could allow a company that would otherwise lack the available funds to capitalise on such opportunities.

Third, since prudent financial management is important for ensuring the viability of the company and achieving favourable valuations, adding debt to the capital structure can demonstrate a management team’s reliability and ability to scale efficiently.

Lastly, the unpredictability of early-stage businesses can lead to product delays or revenue falling short of assumptions or performance targets, so the availability of venture debt provides a company with protection against unpredictable cash flows by funding operations until revenues improve or stabilise.

“Once funding is obtained, founders should be looking for capital repayment holidays to ensure that it is structured optimally for their business,” advises Ms Rowbotham. “Working with a lender that really understands the venture and growth market and, ideally, the particular sector in which they operate, can be invaluable in terms of industry guidance, partnership and networking opportunities.”

Echoing the need for borrowers to carefully scrutinise their venture debt partner is Dr Loh. “Many focus their venture debt conversations on price and loan quantum,” he attests. “They should also consider choosing a venture lender that can be a long-term funding partner.

“Navigating the maze of start-up financing might appear intricate, yet at its heart lies a simple truth: not all financial resources are equivalent,” he continues. “Each start-up possesses its distinct ambition, business model and market dynamics. As a result, the blend of financing a start-up pursues should be meticulously customised to align with its growth trajectory and overarching strategic vision.”

Through the lender’s lens

When lending to start-ups, several factors are evaluated to determine a company’s suitability for venture debt. These include the company’s business model, market potential, operational scalability, the management team’s experience and track record, and current market dynamics.

“Lenders will also examine the company’s financial health, including revenue growth, cash flow management and the clarity of its path to profitability,” says Mr Spreng. “Some lenders focus on early-stage companies while others focus on later-stage borrowers. It is important borrowers approach lenders with matching stage and industry interest.”

According to Dr Loh, there are key aspects which lenders need to consider when assessing a company’s suitability for venture debt financing, as outlined below.

First, financial metrics. Financial health is analysed using key financial metrics such as revenue growth, cash flow projections, profitability, customer acquisition cost and burn rate. These metrics provide insights into the company’s ability to generate sufficient cash flow to meet debt obligations and sustain operations.

Second, management team. The experience, expertise and track record of the company’s management team will be evaluated. Strong leadership and a capable management team inspire confidence in the company’s ability to execute its business plan and navigate challenges effectively.

Third, market opportunity. The market opportunity and competitive landscape in which the start-up operates is examined. Lenders assess factors such as market size, growth potential, barriers to entry and the company’s unique value proposition.

Fourth, business model and strategy. The start-up’s business model, revenue streams, customer acquisition strategy and go-to-market approach will be scrutinised. Lenders seek clarity on how the company plans to monetise its products or services, acquire customers and achieve sustainable growth.

Fifth, risk assessment. A risk assessment will identify potential risks and challenges that could impact the company’s ability to repay the debt. This includes evaluating factors such as market risk, technology risk, regulatory risk, competition and operational challenges.

Sixth, collateral and security. Depending on the lender’s risk appetite and the company’s financial profile, collateral or security may be required to mitigate risk. Lenders may seek collateral in the form of tangible assets, intellectual property or personal guarantees to secure the debt.

Seventh, use of proceeds. This involves assessing how the company intends to use the proceeds from venture debt financing. Lenders look for a clear and strategic use of funds that aligns with the company’s growth objectives and enhances its long-term value proposition.

Lastly, exit strategy. The company’s potential exit strategy, such as initial public offering, acquisition or other liquidity events, should be taken into account. A well-defined exit strategy provides assurance that the lender will be able to recoup its investment and interest payments within a reasonable timeframe.

Reset and stable

As equity capital remains scarce and expensive, an increasing number of fast-growing companies are poised to explore venture debt in the years to come. Across the board, valuations have been reset, innovation is expected and the pipeline of prospective deals is stable.

“Venture debt is expected to continue playing a key funding role globally for start-ups, as they turn from relying on equity to sustain their business into profitable, lean companies that can leverage debt to grow without raising further equity,” says Dr Loh. “This is one key trend observed over the last 18 months, and venture lenders have taken favourably to such companies which may now become an attractive lending target for traditional lending institutions.”

Among the sectors set to take advantage of the venture debt pocket of the financing market are climate tech and FinTech, while nascent companies that develop artificial intelligence and machine learning applications are also poised to garner significant venture debt investment.

“Climate tech is currently a sweet spot for VC investment, so we should expect to see increased lending to these emerging technology businesses,” notes Ms Rowbotham. “On the FinTech side, while 2024 may be too early for a bounce back to 2020-21 record levels, expense management and cross-border money transfers remain attractive propositions for lenders.”

As indicated by signs of positivity and recovery in the market, venture debt is a viable way for borrowers to raise capital in the current market. Offering a unique blend of flexibility and equity preservation, for many, venture debt is an attractive, and increasingly familiar, form of start-up financing.

© Financier Worldwide

BY

Fraser Tennant