The future of Venture Debt

14th May 2019  

by Paolo Vischi, Analyst Intern at U-Start

When we talk about start-up world, it is impossible to ignore Venture Debt. Among the various financing instruments used to raise capital needed to structure companies’ growth, the entrepreneurs’ tendency is always to prefer to sell part of company’s equity but today it increasingly happens that the founders decide to turn on debt financing. This is the reason why we decided to include in our Academy a dedicated speech on Venture Debt, inviting Luca Colciago, General Partner at Kreos Capital.

There are a lot of reasons in using debt financing, which range from the desire of not being diluted (or not giving up control of the board), to runaway extension needs to be met in a short time. When we talk about Venture debt, it is certainly worth noting that there is a growing availability of an ever-increasing number of operators willing to give credit to companies that often have neither positive cash flows nor the availability of significant assets to be charged to guarantee the debt.

A complementary instrument to Venture Capital

First of all, it is important to clarify what venture debt is, and how this type of credit is usually structured. Venture debt is a non-dilutive source of capital utilised to complement equity in high growth companies which typically don’t have full access to traditional bank financing, due to the lack of positive cash flows or significant assets to be offered. This type of debt financing allows companies with a strong growth trajectory to extend the cash runway (in terms of working capital or capital expenditure) maximising the equity value, while at the same time minimizing equity dilution for both founders and investors ahead of a further financing round or exit event.

As complementary instrument to venture capital, Venture debt is structured as a term loan (or series of term loans), with one-to-three-year term, covered by the issue of warrants giving the right to purchase shares of the issuing company at a predetermined price within a certain time. This to compensate the high risk of financing a company for which the risk of default is higher. In terms of performance & returns on the capital granted, the returns are between about 12% and 25%, reached through a combination on interests on the loan and stock revenues.

Venture Debt is typically structured as one of three types:

  1. Invoice financing: loans granted against the assignment of commercial credits (for example outstanding invoices or in any case money due from customers);
  2. Equipment financing: loans for the purchase of equipment such as network infrastructure;
  3. Growth Capital: Typically term loans, used as equity round replacements, for M&A activity, milestone financing or working capital. Compared to the first two options, the last one is the  most flexible one.It generally grants  from a general privilege on assets such as intellectual property. Startups usually see term loan as the best alternative to equity financing.

From equipment leasing to its explosion Venture Debt is born in the 1970s and 1980s, once entrepreneurs and investors sought alternative forms of financing, and looked to the high-tech equipment leasing industry as a form of financing that could help satisfy the needs of startups at a time when substantial capital investment was required. In those years the companies interested in venture debt operated in the  semiconductor sector with a huge amount of military hardware and computer’s production. The venture debt initially was entirely based on warrants and didn’t fully financed the equipments. However, in the mid-1980s, Equitec Financial Group, a firm active in equipment leasing, developed a leasing and loan product that offered 100% financing, developing the idea of ​​using an "equity kicker" to increase yield, to balance the profiles of higher risk and compensate for any losses compared to bankable credit profiles. In these early transactions, "equity kickers" were typically growth-based commissions or warrants. Then the market grew and prospered in the late 80s and 90s. At that time, during the dot-com bubble the equity financing of Venture Capital reached substantial values ​​and the Venture Debt reflected this trend, reaching   a peak of almost 5 billion dollars in total financing in 2000. Then venture debt activity came to an halt in 2001, as venture capitalists and venture debt firms felt the aftershock of the dotcom crash and many venture debt companies like Comdisco closed. TransAmerica and GATX for example decided to leave only this market while others decided to maintain a prudent approach. Some have begun to require full cash collateral and others significantly reduced risk propensity. The rebirth of venture debt in Europe was fueled by the growth in venture capital  invested between 2003 and 2008, when  it had another setback. Now, the economic recovery and low bond yields have caused an enormous flow of resources towards the Venture Capital market, both for debt and, above all, equity transactions.

Advantages & benefits

Venture Debt provides growth capital with less equity dilution, limited costs and offers  quicker processes. However, sometimes if it is improperly used, without the right attention in negotiation of the terms to which is granted it can reduce the flexibility of the company and its capability to raise future equity rounds. For sure if a company has a low cash balance it would be better not to look at the Venture Debt: the weaker the cash position, the worse the terms granted by the lender will be. Similarly, this form of debt is not recommended when debt payments amount to more than 20% of the company's operating expenses: in this case, in fact, the existence of a loan of such proportions risks discouraging future equity investors, becoming (in a medium-long term perspective) more a burden than a benefit. Too much debt can negatively affect profitability and valuation. 

The most significant danger and disadvantage of using debt is that it requires repayment, no matter how well you are doing, or not. Moreover the cash can be recalled when the company needs it most, for example “material adverse change” or “subjective default clauses” can allow a lender to recall their loan due to events beyond the company’s control (e.g., an existing equity Investor deciding not to participate in a future round or the loss a strategic customer).

The future of Venture Debt

Looking ahead, two different trends suggest Venture Debt as new financing option for companies in the next years. First of all, since 1999, the period of time through which a company reaches liquidity thanks an acquisition or an IPO has increased by almost 3 and a half years. This increase has therefore amplified the need for alternative sources of financing, including venture debt. Moreover, the expansion of venture-backed companies promotes the interest towards alternative financing sources that avoid dilution for existing investors or a loss of the board control.

From the start of the Venture Capital lease in the 1980s, to the growth of Venture Capital and growth capital loans in the 1990s, to adjustments to the changed investment environment after the dot-com bubble and the financial crisis, this market continued to evolve and grow. With the progress of the new Venture Capital models in general, over the next few years the Venture Debt will continue to represent an interesting financing instrument for entrepreneurs and investors willing to support the growth of their companies.