Rethinking venture debt in leaner times

Venture-backed start-ups are finding it much more difficult to access capital. Not only have venture capital firms pulled back sharply on dealmaking, but the failure of Silicon Valley Bank means fledgling companies have largely been cut off from a longtime source of relatively cheap debt.

This presents an opportune time for lenders, including established players like ORIX USA’s growth capital business and upstarts like Applied Real Intelligence (ARI), which can be picky about who they lend to and can also charge higher rates.

To foster strong relationships with venture firms, SVB reportedly often made loans to VC-backed start-ups at below-market rates, offsetting the cost with revenue from ancillary services provided by the bank. These loans often disregarded company fundamentals that more conservative banks base their lending on but were not viewed as particularly risky and rarely lost money.

So far, there has been no sign that equity investors will step up to provide more capital to their cash-constrained portfolio companies until market conditions improve. To the contrary, global start-up funding in the first quarter was down 53 percent from the same quarter last year, according to dealmaking data compiled by Crunchbase.

The lack of equity financing may be especially painful for tech start-ups, which have been overusing venture debt in recent years, said Frank Rotman, a founding partner and chief investment officer at QED Investors. He made the comment on a recent webinar about the repercussions of the failure of SVB and other regional banks. The webinar was hosted by Allocate, a Palo Alto-based VC firm that invests in early-stage start-ups.

“If the whole goal of using venture debt is to extend your runway to get you farther before you raise more capital, you basically needed to raise more equity [to begin with],” Rotman said. “That means your investors didn’t put enough money on your balance sheet in order for you to get far enough fast enough to raise capital by de-risking your business. So venture debt is something that’s going to come under the spotlight.”

The main reason for the overuse of venture debt is that over time people have forgotten that it’s debt, not equity, and has to be paid back, Allocate co-founder and CEO Samir Kaji said on the webinar.

“Viewing it as a pure insurance policy that’s going to be there no matter what has led people into this false sense of [thinking], ‘Every time we raise a round, we should do some venture debt,’” he said. “It has also been very cheap. If the cost of funds for venture debt changes because banks can no longer operate on the same economic model, they will start to have to approximate potentially what [private venture debt providers such as] the TriplePoints, Herculeses and WTIs [are charging for debt].”

Zack Ellison, founder and managing GP at ARI, which is raising a debut venture debt fund, said market data doesn’t support the view that start-ups have been overusing debt. In 2021, roughly $340 billion in equity capital was deployed versus less than $35 billion in venture debt to US start-ups, he noted.

“I wouldn’t call that an overreliance on debt,” Ellison said. “I think founders have started to realize that venture debt is the cheaper option to equity financing and it’s much less dilutive. All in, most of venture debt is only 25 percent to 50 percent of the cost of equity and it’s also significantly less dilutive, typically one-tenth as dilutive. Founders over the last couple of years have been looking at venture debt as a complement, but there’s no way they were over-relying on it.”

When valuations were inflated and founders were getting substantial amounts of money for the equity they were selling, “they weren’t looking at debt as closely as they should have because it was so easy to raise equity capital,” Ellison continued. “Ironically, the more successful a company becomes, the cheaper debt is relative to equity. Founders that believe they have truly built a winner should be using as much debt as possible.”

Complement, not substitute

Jeff Bede, managing director and head of ORIX USA’s Growth Capital business, sees debt as a complement to equity capital to help extend the runway for early-stage companies rather than a substitute for it.

“Equity [investors] should always be prepared at earlier stages to fund their business based on milestones,” he said. “At later stages, debt becomes more of a standalone product that can be a replacement for equity and for follow-on rounds of capital.” That’s not only because later-stage companies have reached revenue scale but because debt is not serving as a bridge to the next round of fundraising.

Until recently, earlier-stage companies have relied heavily on venture debt because it was cheap and it gives equity investors the option of reserving some equity capital to invest later in portfolio companies that are performing well.

ORIX’s Growth Capital unit has provided more than $2.5 billion to 196 companies since 2001, according to its website. Bede said that 80 percent or more of the business’s venture lending is to later-stage companies at or beyond their Series C round.

Ellison concedes that even before SVB’s failure, equity capital had become very expensive “because valuations had come down, so [founders] were selling more equity in exchange for cash.” He also noted that check sizes were smaller and funding rounds were taking longer to get done.

With about $750 billion invested in US start-ups between 2020 and 2022, most companies expected at the time of funding that they would be able to raise more capital a couple of years in and now that’s not assured, he said.

“What’s going to happen when a start-up can’t refinance its debt facility and they’re short months of runway?” Ellison asked. “They’re going to be in a bind and the VCs that backed them are going to have to step up to the plate and put more capital to work to fund them in later rounds.”

Lending terms haven’t changed dramatically, but leverage has come down a bit with heightened focus on credit quality, Bede said. Given the state of the economy and the market, and with equity capital harder to raise, “lenders are focused on business model scale and the quality of companies.”

More important than the amount of leverage “is the fact that we’re looking for fundamentally sound businesses that are sustainable and a good fit for debt rather than ones that need emergency financing and try to use debt as a last resort,” he said.

ARI doesn’t rely on equity sponsors, “but we do look at the quality of the VCs that have invested in the company already,” said Ellison. “If the company is backed by really smart investors that have a lot of dry powder, that really like the sector and the company, that helps give us some confidence that the company will have access to equity capital in the future.”

Co-investment opportunities

Rapid deleveraging is allowing ORIX USA-Growth Capital to continue to increase the size of its loans to its better performing companies. The larger loans are a good fit for co-investments by limited partners, which are showing strong interest in those opportunities, Bede said.

ARI has also seen a lot more interest in venture debt over the past year or two by certain LPs such as family offices, including through co-investments, Ellison said. For a debt deal as large as $30 million, ARI intends to deploy some of that from its debt fund and then share the remainder with its fund LPs at a significantly reduced fee, he said.

“One thing we can do that helps portfolio companies quite a bit is we can make introductions to a huge number of family offices and institutional investors that are not in the traditional VC ecosystem,” Ellison added. “Oftentimes, founders don’t know how to connect with family offices or with the right institutions. We will provide them with venture loans, but we can also provide them with valuable access for free to our large network of family offices and institutional investors who might invest on the equity side as well.”

Patrick Turns, a principal at Selego Capital who manages alternative investments for family offices, said they prefer to come in as lenders, with the backstop that if something goes wrong and they don’t get paid back, their loan converts to equity.

“That puts [the family offices] a little higher up the pecking order should things end up in bankruptcy or liquidation,” said Turns.

That’s especially attractive to a family office with extensive experience in the same industry as the company it is investing in. One of Turns’ clients has generational experience with hotels. If it were approached for equity capital by an individual hotel company that wanted to expand, his client would prefer to lend the company $5 million or $10 million at a favorable interest rate, he said.

“If the company can’t repay the loan, the family office has the hotel as collateral and “the comfort that, ‘If I end up having to take this hotel back, I’ve been running hotels for three generations; I know what this hotel is, I know I can turn this hotel around and run it,’” he said.

Although First Citizens Bank recently bought SVB’s $72 billion loan book out of FDIC receivership, Ellison said he expects the size of the business to shrink from its current size. “SVB had a unique model where they were integrated into the start-up and VC ecosystem like no other bank.” First Citizens doesn’t “have any history in venture debt, and their location and the DNA of their workforce will make it virtually impossible for them to be close to the force that SVB was.”

Help wanted

With lending capacity sharply reduced for the present, Bede said he is seeing VCs step up to support their existing portfolio companies. But the bar for equity capital is higher now for new investments.

Fortunately, debt capital has historically been a small percentage of the enterprise value of these companies – in the range of 10 to 20 percent, Ellison pointed out. Equity investors can fill some of that gap but may not be willing to for companies they don’t regard as top performers.

The top companies will receive the lion’s share of funding, “but it’s going to be expensive, it’s going to be hard to get, it’s going to take a long time,” Ellison added. “It’s not going to be on terms on the equity side that they probably consider founder friendly.”

There’s a big opportunity for venture lenders right now because there aren’t very many of them to fill the funding gap and it takes years to build a venture lender.

ORIX USA’s growth capital team is also increasing its support for its portfolio companies, said Bede. Over the past 12 months, in addition to upsizing its loans, ORIX has had a number of delay draws, or additional capacity commitments that are available as companies continue to perform well.

“It’s a good way for companies to not take on all the debt at close but have access to capital over time as they grow,” Bede explained.

Without access to more equity capital, Bede expects companies that have revenue scale but are underperforming to continue to cut costs to extend their runway or drive profitability. He also expects private equity players to continue to do roll-ups of cash-strapped companies, as well as some strategic sales. Earlier stage companies that have not reached revenue scale yet will have more challenges to raise capital and need to find more efficient ways to drive growth, he said.