The collapse of Silicon Valley Bank in March 2023 profoundly changed the market for venture debt - and start-up funding more broadly. Whilst many had dire predictions about how the bank's demise might affect funding options, the impact has in fact been that a wider group of funds and institutions have stepped up to offer venture debt. This proliferation means that founders need to understand their options in order to choose the most appropriate deal for them.
Here we look at what venture debt actually is and why it can be a valuable tool in the financing toolbox.
Why seek venture debt funding?
The continuing turbulence in venture capital funding provides an important and timely reminder to founders and investors in earlier stage, high growth, venture backed businesses (particularly tech start-ups), to consider venture debt as an option in their journey to IPO/sale and as a valuable supplemental or alternative way of accessing funding between equity raises. Whilst more traditional commercial loans are usually out of reach for businesses at this stage, who can be categorised as high risk for debt solutions, venture debt is unique because it specifically targets businesses in this space. Venture debt providers will assess the enterprise value of a business to calculate their risk and mitigate their higher stakes by taking a small equity tranche, usually in the form of a warrant, alongside the loan. Venture debt should be seen as a contender for capital raising alongside traditional equity financings to support additional financial runway, economic and productivity milestones, R&D targets, product development, staff increase and marketing/brand expansion.
Rather than seeing equity raises and venture debt as separate and distinct financing options, they can and should also be viewed collaboratively as complimentary means of fundraising.
In fact, the two are co-dependent in many ways. Venture debt won't ordinarily be available to a business unless there has already been institutional venture capital investment; existing venture capital investors can boost their exit value if the business is subject to less dilution, allowing it to focus on revenue growth via venture debt funds.
Venture debt can also, at certain stages in the lifecycle of a business, make for a more stable alternative to equity funding with a clear repayment plan and framework in which to develop and scale up the business.
How to access it
Venture debt is provided by some, but not all, commercial banks and specialist venture debt funds. The commercial terms offered, amount and types of funding available and the flexibility on negotiation significantly varies between different providers.
Venture debt providers traditionally, though not always, target early stage, high growth businesses, particularly in the tech space, which have completed at least one sizeable equity funding round with institutional investors.
Even where venture debt funding does not immediately follow an institutional funding round, it is worth considering, if you can demonstrate to the lenders a clear intention/plan to raise further equity in the near future. A term sheet might then be tailored to include this as a milestone against future drawdowns of the loan.
Lenders will also want to see sufficient runway capital (capital available to enable the business to operate at a loss for a certain period) to run the business for at least another 9-12 months (typically).
Businesses working on an equity term sheet and moving towards a funding round are in a great place to approach venture debt lenders for funding and take advantage of a preferential bargaining/negotiating position for competitive terms with them.
It may seem odd to be raising debt when a business is cash rich (or about to be) from an equity raise, but bear in mind that the loan may not need to be drawn down immediately, with committed funds then available when needed to provide a valuable capital source for future up-scaling.
With more venture debt providers on the horizon, it is an opportune time for founders to consider their funding options, think about venture debt and research the bank of providers out there. Some offer more innovative and flexible debt packages tailored to the projected landscape of the business, in addition to the more familiar and traditional options.
Choosing between banks or funds
It is important to avoid shortlisting venture debt providers on the basis of the most competitive pricing and fees, or on the largest loan offered. It is also essential to evaluate venture debt providers holistically, in terms of the industry sectors they target, their reputation and how long they have been doing this for.
Other factors to consider are their regulatory framework, their underlying primary funding sources, their level of experience and how flexible they can be for your business, as well as their take on scenarios like down rounds (a point where the value of a business is lower than at a previous financing round).
Venture debt via commercial banks:
- Typically offer more flexible, blended credit packages tailored to the business such as working capital, invoice discounting and trade finance options, alongside traditional term loan structures.
- Key terms can be more rigid, with less scope to negotiate due to internal credit requirements and limitations and more standardised documentation.
- Interest rates and fees may be more competitive than venture debt funds.
Venture debt via venture debt funds:
- May be more flexible on traditional lending terms with potentially wider scope for commercial negotiation.
- Borrowing costs and risks to a fund can be higher than for a commercial bank, which sometimes results in less competitive interest rates and fees.
- Will not usually be able to provide multiple financing options and will usually favour a term loan approach in structure.
Venture debt terms and expectations
A typical term for a venture debt loan is between 36-48 months. There is usually scope for extended availability periods from closing to actual draw down of loan, as well as multiple tranche and drawdown options and interest only periods. The amount of any warrant may also be given in tranches to tie in with the total amount actually drawn down rather than the total commitment. The size of the loan available will vary depending on the total amount of existing equity, the stage of the business, industry and investor credibility.
The venture debt loan will be senior ranking. This means that it must be repaid first, with a full security package. Any existing or future loans (including convertible loan notes/shareholder loans) will be required to be fully subordinated to the venture debt loan.
The lender will require:
- an ongoing and comprehensive performance, information and negative covenant package (usually without financial covenants);
- first ranking security over the entire business and undertaking and assets, including intellectual property, and also including subsidiaries where applicable;
- usually a board observer seat and, less commonly, a board seat:
- arrangement and end of loan fees;
- an equity kicker, usually in the form of a warrant giving the lender future share acquisition options (at a much less dilutive level than an equity round) or an alternative pre-calculated return payable on termination.
Considerations before you approach a lender
- Timing – tie discussions with lenders into timing of funding rounds and get in early.
- Consider your investor profile - you will need credible institutional backing.
- It is essential that you can demonstrate runway capital pre-loan - venture debt is not a rescue/distressed debt option.
- Ensure data for your business in terms of credentials and financials and any assets (particularly intellectual property) is current and accessible to lenders for their due diligence process,
- Investor/shareholder and board consent will be required for the venture debt round and any related warrant/equity kicker.
- Venture debt rounds can be speedier to put in place than an equity raise although, it can typically take between 2-3 months to close a venture debt round, so it's essential to think ahead and open discussions with lenders in advance of funding needs.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.