How the venture debt market has grown and developed recently
September 2023 | SPECIAL REPORT: TECHNOLOGY, MEDIA & TELECOMMUNICATIONS SECTOR
Financier Worldwide Magazine
September 2023 Issue
Venture debt and growth finance are forms of debt finance for early-stage companies and start-ups. Venture debt is complementary to equity investment and has a number of benefits: (i) it helps companies fuel their growth; (ii) it extends the company’s cash runway; (iii) it provides flexibility; and (iv) it enables companies to pursue growth opportunities and milestones – all without diluting ownership or reneging control.
Both traditional banks and specialised debt funds offer venture debt products and structure venture debt facilities to accommodate the specific cash-flow patterns and growth projections of start-ups. Venture debt can be used to fund various business needs, such as expansion, working capital, research and development, marketing initiatives and acquisitions. It is often used in conjunction with equity financing rounds to bridge the gap to profitability.
Recent market developments
The UK venture debt market has witnessed significant growth and development in recent years, and these have reinforced the benefits of venture debt and bolstered it as a beneficial financing option for start-ups and early-stage companies. In the past few years, several noteworthy trends and developments have shaped the UK venture debt landscape.
First, there has been a surge in the number of venture debt providers operating in the UK. Both banks and non-bank lenders have recognised the growing demand for this early-stage non-dilutive finance and have expanded their products accordingly. Traditional banks have specific venture debt teams, and, at the same time, dedicated venture debt funds have emerged, focusing solely on providing debt capital to the start-up ecosystem.
In addition, US venture capital firms are seeing the UK as a market of opportunities with the likes of Sequoia, General Catalyst, Bessemer and Lightspeed, among others, opening UK offices in the last three years. This increase in the number of venture debt providers has resulted in an increase in competition and the availability of venture debt products, which has, in turn, driven innovation in new debt products and led to more favourable terms and conditions for borrowers. Traditional banks sit alongside specialised venture debt providers, each offering debt financing tailored to the needs of high-growth companies and, as a result, start-ups can access capital more easily to support their expansion plans, whether for product development, market expansion or working capital needs.
Second, growth of the UK venture debt market has been boosted by collaborations between venture debt providers and equity investors, with venture debt firms working alongside venture capital funds, angel investors or private equity firms to provide a combination of debt and equity to start-ups. By leveraging both debt and equity, companies can optimise their capital structure and access a broader range of resources to support their growth initiatives.
Third, venture debt providers have become more astute and sophisticated in assessing the creditworthiness of companies in the technology sector: they understand the risks and growth potential associated with start-ups and provide funding based on the prospects of the business, rather than relying on collateral or historical financials. The result of this is that tech and innovation start-ups or companies with limited operating history can access debt financing off the back of strong growth potential and projections.
Alongside these platform lenders and their use of tech, there has also been a shift toward alternative credit assessment, and this has aided the efficiency and accessibility of venture debt. Traditionally, lenders have relied heavily on collateral and credit scores, creating obvious challenges for start-ups with limited assets and sketchy track records. Creditworthiness based on a broader set of criteria (such as growth metrics, customer acquisition and market potential), and utilising technology and machine learning algorithms, has smoothed and enabled access to venture debt financing for many start-ups and has reduced the reliance on traditional financial indicators.
A further key development has been the government initiatives to support start-ups and the venture debt market and encourage its growth. British Business Bank has launched various programmes to facilitate access to finance for start-ups and scale-ups, including the Enterprise Finance Guarantee and the Future Fund. These initiatives provide loan guarantees, co-investment opportunities and matched funding, thereby reducing the risk for lenders and making venture debt more accessible to early-stage companies.
The emergence of lending platforms has brought further dynamism to the venture debt market. Platform lenders utilise technology, data-driven underwriting and data analytics to aid efficiency and streamline the lending process and match companies with appropriate lenders. Through digital platforms, businesses can access venture debt efficiently and transparently, by passing traditional intermediaries and accelerating the funding process.
Another noteworthy innovation has been revenue-based financing: a form of debt financing where repayments are tied to the borrower’s future revenue. The debt is repaid (or not) from a share of the borrower’s revenue and it is generally unsecured. Revenue-based financings have gained traction over recent years due to the flexible repayment structure and the fit with companies with recurring revenue models (for example, software as a service (SaaS) and subscription-based businesses).
Things to consider in venture debt financing
Venture debt financings are different from financings to established companies with a history of steady cashflows; there are different drivers in terms of the credit process and this needs to be reflected in the process and legal documentation. Some key areas are outlined below.
Financial covenants. Typical financial covenants looking at leverage and debt and interest cover will not work for early-stage businesses and are not an appropriate measure of performance or financial health. Venture debt lenders often have no financial covenants at all or alternatively look to financial targets around cash-burn, liquidity, capital expenditure, performance against budget, recurring revenue, cash and so on. To the extent there are any, the financial covenants (and timings as to when they bite are tested) need to be reviewed and set carefully in line with the company’s growth plans and strategy. An exit strategy and repayment plan is also key: there should be a clear plan for the repayment of venture debt which is aligned with potential liquidity events, such as an initial public offering (IPO) or acquisition. We have also seen lenders open to accepting equity cures.
Warrants and equity kickers. Given the higher level of risk taken in venture debt financings, it is common for lenders to take a warrant or, where lenders are unable to hold warrants, some equity-based fee, so the lenders can share in the upside where the company is successful.
People are key. Venture debt providers have to assess whether the success of the business rests on a few key individuals. If so, key-person risk needs to be considered and mitigated (slightly) by insurance, service contract terms, change of control provisions (where those individuals, as is usual, hold equity) and replacement mechanics. Where the business is regulated, lenders (and the company) need to ensure that the management team has the expertise and experience to navigate regulatory requirements and manage the business’s operations within a regulated environment. Further, where businesses already have institutional investors, such investors are specifically linked to change of control clauses or replacement covenants should be included to ensure entities of similar or equal reputation step in.
Business as usual. Early-stage companies need to consider what operational permissions they need from lenders to continue to grow and run the business without interruption or seeking consent at each twist and turn, for example permissions around intragroup cash movements and acquisitions. Equally, borrowers will need to be willing to agree to more comprehensive reporting and information sharing obligations: if the lender is expected to be flexible, it will want to retain its ability to keep abreast of changes and decisions in return.
Intangible assets. Technology and innovation companies typically have a limited pool of tangible, physical assets and consequently venture debt financings have a security net which is predominantly or wholly made up of intangible assets (e.g., patents, trademarks and know-how). Credit and enforcement papers need to be accepting of the reliance placed on a pool of intangible assets if any enforcement were ever to happen. Diligence is therefore imperative. Where do the intellectual property rights and intangible assets sit? Are these registered or unregistered rights? What contracts and licences surround them?
Regulation. Where the business is operating in a regulated area, lenders will need to ensure that the business complies with relevant laws, regulations and licensing requirements. This includes verifying the business’s contracts, licences, permits and compliance reports, and assessing any potential risks or liabilities associated with regulatory non-compliance. Furthermore, lending into a regulated entity requires lenders and borrowers to carefully assess the available security package: certain assets (for example regulated bank accounts or restricted cash) may need to be ring-fenced from all-assets security and excluded from liquidity tests.
Lender reputation, alignment and track record. When looking for a venture debt provider, start-ups and early-stage companies should consider which lenders understand the challenges faced by them and can offer strategic insights, introductions and ongoing support. In addition, venture debt lenders that can offer a flexible and customised approach could be better suited to the variability and pace of business in the start-up ecosystem.
Kerry Langton, Ruth Marken and Charles Kerrigan are partners at CMS. Ms Langton can be contacted by email: kerry.langton@cms-cmno.com. Ms Marken can be contacted by email: ruth.marken@cms-cmno.com. Mr Kerrigan can be contacted by email: charles.kerrigan@cms-cmno.com.
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Kerry Langton, Ruth Marken and Charles Kerrigan
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