Capital idea: the rise of venture debt

March 2021  |  FEATURE  |  BANKING & FINANCE

Financier Worldwide Magazine

March 2021 Issue

Amid the ongoing economic uncertainty emanating from the coronavirus (COVID-19) pandemic, an increasing number of capital-hungry companies are turning to venture debt as a relatively speedy way of accessing new funding.

Venture debt, as defined by the Corporate Finance Institute (CFI), is a type of debt financing obtained by both early and late-stage companies. It is typically used as a complementary method to venture equity financing and can be provided by both banks specialising in venture lending and non-bank lenders.

An attractive route for investors, venture debt involves moderate risk yet provides superior returns, whereas venture capital follows a high-risk, high-reward risk-return profile. Furthermore, the venture debt asset class can also help companies to quickly adapt to new market conditions, an important consideration during uncertain times.

According to Pitchbook, venture debt is rapidly increasing in use and popularity. Indeed, the venture debt market increased by a factor of five from 2010 to $25bn in 2019, with the asset class accounting for approximately 15 percent of the estimated total aggregate venture funding activity.

“Although not a new concept, the venture debt asset class is still in its infancy relative to traditional venture capital,” notes Runway Growth Capital’s’ ‘2020 Runway Venture Debt Review’. “Lack of education and awareness has led many entrepreneurs to have misguided notions about venture debt – how it should be used, and why it can be a valuable option for those looking to finance their business while retaining equity.

“Substantial growth in the venture debt market has occurred over the past 10 years,” continues the report. “However, we have only begun to scratch the surface of what is possible for this asset class.”

Yet recent events have done much to disrupt the growth journey of venture debt. “As a result of COVID-19, investors have favoured certain sectors and abandoned others,” observes David Spreng, chief executive of Runway Growth Capital. “This has left many companies without the equity support they expected, leading to increased usage of venture debt among entrepreneurs.

“For these companies, venture debt provides a lower cost of capital from both an economic and governance standpoint,” he continues. “Founders can then minimise dilution without sacrificing the ability to invest capital when and where it is needed, to grow their business and extend the time needed to become cash flow positive.”

In the view of Steven J. Keeler, a partner at McGuire Woods LLP, there can be some dilution if the lender asks for a stock warrant in addition to the note. “But the dilution will be significantly less than it would be with convertible debt or straight equity,” he notes.

That said, venture debt is not a replacement for venture capital. “It can be an effective capital supplement or bridge between equity rounds to extend a company’s growth and financing ‘runway’,” says Mr Keeler. “And for It is also well-suited for strong companies able to weather periods of economic uncertainty and time their capital raises to avoid valuation and other issues, venture debt can be the answer. 

“Venture debt terms and varieties are constantly evolving,” he continues. “Venture capital has become more flexible and tailored to individual situations. For example, some companies are well-suited to offer revenue sharing deals in which the investor’s stake automatically converts to debt, convertible debt or straight equity upon a failure to hit revenue milestones.”

Pros and cons

Drilling down, COVID-19 is having a specific impact on how companies interact with potential venture debt lenders – highlighting the pros and cons of utilising the asset class as a means of acquiring capital.

“The pandemic has had a surprising impact on the entrepreneurial journey, resulting in increased importance of alignment between founders and capital providers,” observes Mr Spreng. “When times are tough, it is not just economics. Now more than ever, it is about vision, ethics and outcomes.

“Founders and management teams do not want the source of capital to dictate the direction, mission or ethos of their business,” he continues. “Venture debt enables founders to grow their business without giving up voting shares, board seats or equity – giving them a stronger voice in how they run their company.” For Mr Keeler, the main objective of venture debt is to avoid owner dilution, especially during a period where a company’s valuation may be artificially low due to external factors.

Mr Spreng agrees, and expects to see companies that were more exposed to the effects of COVID-19 seek incremental, non-dilutive financing – meaning venture debt or revenue sharing deals – to repair their balance sheets and capitalise on a recovery and potential pent-up demand in spending.

“Companies are operating in a very uncertain environment and businesses with solid fundamentals want to have an extra layer of cash buffer to be able to steamroll ahead of their competition,” says Dr Jeremy Loh, co-founder and managing partner at Genesis Ventures. “Raising equity in this environment could mean a lower valuation that could hurt their next financing round ambition. An added advantage of venture debt comes in the form of bringing lenders that are sophisticated about innovative and disruptive new economy businesses into the capital stack and capitalisation table.”

In the view of Mr Keeler, the attractiveness of venture debt, as with many market cycles and investment trends, will depend on a company’s industry and business model. “In general, the COVID-19 pandemic has been different from prior downturns in that many companies continue to have good fundamentals and prospects,” he contends. “As a result, access to short-term debt financing that is not dependent on the borrower’s receivables or assets but, rather, is more dependent on its venture capital investor relationships and burn rate, is particularly attractive now as a way of bridging a company through to a future equity round during more certain times. And revenue sharing arrangements should always be considered when venture debt is on the table.”

Venture debt’s biggest con is that it is not readily available to startups that have not done an institutional venture capital round, which depends on a company’s attractiveness to equity investors.

“Many venture debt borrowers tend to be software as a service (SaaS), with dependable revenue streams or life science companies with significant venture capital backing and access to non-dilutive capital, such as grants or licence royalties,” adds Mr Keeler.

Venture debt vs. venture capital

A common question among investors is how venture debt stacks up against venture capital as a means of raising funds. The general consensus is that venture debt cannot be considered a direct replacement for venture capital-backed equity. “The rare exception may be a company accessing capital in close proximity to a company sale,” notes Mr Keeler. “The amount of venture debt is usually between one third to half of the most recent venture capital raise, so it is really just a means to extend the date of a company’s next venture capital financing round.”

Broadly speaking, however, when venture debt is available, it is an effective way to avoid a lower equity valuation, especially in an uncertain environment, and to preserve the company’s current ownership until it can raise more equity capital at a higher valuation.

“Venture debt should not just be compared to equity financing,” adds Mr Keeler. “It should also be compared to the increasingly popular revenue-based or royalty financing alternative, which is also non-dilutive, and convertible notes which, while a popular means of delaying a valuation or priced round, can be extremely dilutive due to the discounts and valuation caps that now commonly apply to convertible debt.”

Furthermore, in order for venture debt to be as effective as possible, it should not be viewed as a back-up when equity capital is unavailable, but rather as a complementary fundraising strategy. “If equity is available, but too expensive, debt should be considered as an alternative or complement to equity,” suggests Mr Spreng. “If equity is not available at any cost, debt probably is not the solution.”

Certainly, in the case of early-stage or emerging growth companies, venture debt coexists with venture equity to provide the right level of funding mix. “Companies should try to avoid overleveraging on debt which could compromise their ability to repay the debt,” says Dr Loh. “Having said that, different jurisdictions have seen different levels of venture debt maturity. For example, in the US, where venture lenders have a long track record, different forms of venture debt have evolved. Growth companies, for example, are able to raise venture growth debt that could be a direct replacement of equity.”

New formations

In the overall scheme of things, companies continue to face numerous challenges securing sufficient levels of funding. Perversely though, the economic uncertainty stemming from COVID-19 has served to boost fundraising volume via venture debt.

“We tend to see significant new business formations in the aftermath of permanent business closures, leading to a robust fundraising environment,” says Mr Spreng. “The capital is out there, and with low interest rates and more certainty coming from vaccines, companies should see more opportunities to grow their business through venture debt.”

To help achieve new formations, the key is for companies to think strategically and change their posture from defence to offence, perhaps utilising M&A as a way of augmenting and repositioning their businesses for a digitalised future.

“Pandemic or otherwise, it is advisable for companies to always raise more funding than what is typically needed,” advises Dr Loh. “Young companies deal with a lot of uncertainty and rarely meet the forecasted budget growth that they often envisage. Having extra cash, when you do not need it, means that you are able to deal with the onset of uncertainty when it arrives at your doorstep.”

As an extra inducement, although venture debt is required to be repaid within five years, it is often paid back promptly via a new equity round. “Getting it is the difficult part, and a strong venture capital investor relationship may help,” suggests Mr Keeler. “Today, the investor may be a family office as opposed to a venture capital fund, but, ironically, the easier it is for a company to raise equity capital, the easier it will be to get non-dilutive venture debt.”

Traction in 2021

Within the world of aspiring unicorns, entrepreneurs are optimistic about the use of venture debt, with many expecting the impact of COVID-19 on venture markets to lead to a permanent increase in the use of venture debt.

“Venture debt and some evolving alternatives will continue to grow in use as venture capital and private equity in general continue to become the most popular alternative asset class for all profiles of investor,” foresees Mr Keeler. “Venture debt relies on venture capital, and venture capital looks strong going into 2021. And to be sure, venture debt will be even more attractive during economic uncertainty, at least for companies that are in a strong position for growth.”

Likewise, Dr Loh expects to see tremendous venture debt growth in the years ahead. “Companies now are seeking profitability versus growth at all cost, hoping that the next round of equity will happen,” he concludes. “As entrepreneurs become more sophisticated and experienced running their companies, venture debt can become a part of mainstream financing for the next wave of unicorns.”

© Financier Worldwide

BY

Fraser Tennant