Minh Le has been extremely busy. He assists entrepreneurs in obtaining various lines of credit as a market manager for Silicon Valley Bank’s Washington and Western Canada region. And, as venture capitalists reduced their spending in response to the slowing economy, he received a flood of new clients last year.
“We’re seeing the most velocity I’ve seen in a decade,” Le said.
As traditional venture capital becomes increasingly difficult to raise, many startup advisors advise founders to look into alternative financing tools such as venture debt or revolver loans to secure cash while avoiding equity.
Bonfire Ventures Principal Tyler Churchill stated at a Perkins Coie event in Seattle in October that his firm advises almost all of its portfolio companies to consider what a venture debt facility would look like.
Several advantages of debt, according to startup advisors, include extending cash runways without dilution, maintaining ownership control, and avoiding a potential down-round, in which companies raise cash at a lower valuation than previous rounds.
Debt, on the other hand, comes with its own set of constraints: increased financial scrutiny, strict limits on growth and spending, and obligations to repay the loan principal. [Venture Capital Market Nigeria]
Still, when the equity markets were hot a year ago, many startups didn’t even consider debt, according to Zachary Hoene, a J.P. Morgan commercial banker specialising in technology companies.
According to PitchBook data, the second largest quarter in terms of total venture debt value over the last decade was last year’s Q2. According to PitchBook’s Venture-Monitor report, debt deal value for tech had surpassed 2021 numbers by the end of the year, with more than $29 billion raised across 2,188 deals.
According to CEO Melissa Widner, Lighter Capital, a Seattle lending firm that provides revenue-based debt instruments to early-stage startups, doubled its book size in 2022, marking its best year in history. She mentioned that Lighter is funding more companies that were previously on a traditional venture capital path but don’t want to risk a flat or down round.
The increase in venture debt raised coincides with the cooling of VC markets. According to Ernst & Young’s funding analysis, venture-backed companies raised a total of $209 billion last year, a 36% decrease from the previous year.
Analysts at PitchBook predict that the upward trend will continue in 2023. They predicted that equity markets would remain difficult, prompting many startups to “consider venture debt as a way to supplement their need for equity financings.”
Poor performance of public tech stocks may also be a factor in the renewed interest in debt, according to SVB’s Le.
Many startups raised their most recent equity round during a period when revenue multiples were high in comparison to the market, inflating their valuations. Because of the current downturn, startups are likely to be valued at the same level or lower, resulting in a potential flat or down round.
Startups are frequently advised to avoid these scenarios because they may result in more dilution for the founders and their employees, according to Le. It also forces their financial backers to downgrade the company in their portfolio, which they must report to their limited partners, he adds.
In down markets, it can be “helpful” for startups to raise enough debt to keep their businesses running, avoiding any potential down round, according to Le.
“In particular, growth stage rounds,” he added. “It’s just really difficult to get them right now. As a result, pursuing debt is a viable option.”
In 2022, several Seattle startups took on debt, including Convoy ($100 million), Coding Dojo ($10 million), and Icertis ($150 million).
JT Garwood, founder and CEO of medical supply marketplace Bttn, announced that Silicon Valley Bank has granted his company a revolving credit facility. According to him, the debt instrument helps to cover inventory expenses and uses the company’s accounts receivable as collateral.
“We needed to make sure we weren’t using venture dollars, which are typically used to grow the business, to buy inventory,” he explained. In June, Bttn received $20 million from equity investors Tiger Global and others.
Taking on debt pushed Bttn to be more fiscally responsible, according to Garwood. Due to the lender’s requirement for quarterly audits, the startup must know when its customers will pay for their purchases. According to him, this has changed the checkout and sales flow of the business in some ways.
“It’s not a disadvantage,” he said of the new financial safeguards. “However, it does compel you to invest in resources capable of providing that level of monthly quarterly reporting.”
Another potential disadvantage of taking on debt, according to Hoene, is the legal covenants that come with bank loans. He stated that these could include annual growth, maximum burn, or a minimum cash balance.
These conditions may also force founders to change their mindset, forcing them to take a more conservative approach to growing their businesses.
Debt instruments are typically available only to companies that have previously raised equity funding and have some measure of success, according to Hoene, making it difficult for newer or less established startups to access this type of financing.
According to PitchBook, growth stage startups will receive more than 40% of all debt dollars invested in venture-backed companies by 2022.
Venture debt deals are typically 20-to-30% of the amount raised in a startup’s most recent equity round. They are similar to insurance in that they provide a rainy day fund in the event that raising funds elsewhere becomes difficult or impossible, according to Hoene.
“It’s a lot more difficult for a bank to come in with any kind of venture debt facility if you’re under four months of runway,” Hoene said, adding that the legal process to reach an agreement could take months.
Venture debt lenders profit by charging interest, origination fees, or prepayment penalties. It typically has a higher interest rate than a traditional loan and has shorter repayment terms (12 to 24 months).