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2023 has been a pivotal year for the venture debt markets. Following the collapse of the largest venture debt provider – Silicon Valley Bank (SVB) – and a significant pullback in equity financings, more companies may begin to explore venture debt financing to help extend their runway or boost short-term growth. But, just like the equity capital markets, the venture debt landscape has not been immune from the impacts of market volatility. As private company leaders consider whether to raise venture debt, they’ll want to understand how lender expectations have evolved in the current high-interest environment and the different financing options available in the aftermath of SVB.
A gathering of executives in The Circle offered a closer look at the venture debt markets in 2023, with market insights from two seasoned venture lending experts: Josh Dorsey (Managing Director, Stifel Venture Banking) and Ken Loveless (Partner and Co-founder, Founders Circle Capital).
New Lenders, Different Incentives
Since venture debt is typically raised immediately after an equity round, it’s unsurprising that a decline in equity fundraising in the last twelve months has made it more challenging for companies to secure venture debt. “Generally, if there’s less equity in the market, there’s less debt,” said Josh.
The good news is that many more venture debt lending options exist. Since the sudden collapse of SVB in March 2023, more commercial banks have opened up or expanded their venture debt practice, and a flurry of new fintechs and venture debt funds – many led by former SVB employees – have emerged.
As companies explore new lending partner relationships, they’ll want to consider the incentives of these institutions and how they may evolve with increased regulation on the horizon.
“Banks might use debt facilities to capture deposits or diversify their loan books. Increased regulation might make it more expensive for these institutions to lend or maintain their capital-to-deposit ratios, and that increased risk could lead to more lending scrutiny or higher borrowing costs. It’s important to think about the underlying incentives of the lender you’re considering borrowing from.”
– Josh Dorsey, Managing Director, Stifel Venture Banking
Reflecting on the capital markets and banking landscape in 2023, Ken expects that larger banks may scrutinize lending opportunities more carefully: “With the increased cost of capital, bank balance sheets are shrinking, and they’re focusing on higher-quality companies with a clear path to their next financing,” said Ken. To fill the gap in lending for growth stage companies, he expects we could see a proliferation of private credit funds entering the venture lending space that provide flexibility but potentially higher borrowing costs.
Lenders are going to be assessing each new borrower based on either “venture risk” (i.e., the ability of a borrower to pay back venture debt at the next fundraise) or “business risk” (i.e., with working capital or cash flow). That analysis is typically driven by four key factors:
- Whether a company has enough balance sheet cash or can sacrifice short-term growth to reach the milestones that will drive enterprise value and get them to their next funding round.
- What happens to the company if it runs out of cash? What is it worth?
- An accurate financial forecast of company growth and the reliability of that forecast.
- Whether existing investors will support the company and bridge it to the next funding round (or profitability) if it executes against the financial forecast.
Deciding How Much Debt to Take On
As the cost and availability of venture debt continue to fluctuate, companies will want to think strategically about how much debt they will want to take on. Venture debt deals can be as high as 20-30% of the previous fundraising amount, but once you get into the realm of equity displacement – roughly $12 to $15 million in venture debt – there are added layers of complexity. “There aren’t many banks that offer a product for that level of debt financing,” explained Josh. “Or they won’t lend without structuring in covenants or lending milestones that protect their downside risks.” Venture debt funds can be a viable alternative, but they often lend at a higher right and with added fees and warrants that may not justify the cost.
From the venture investor perspective, Ken advises companies not to take on debt that is more than 15% of operating expenses after modeling for following a significant reduction of force, as that can significantly hinder your ability to raise your next round of capital.
“For late stage companies, right now is a time to think about the maximum level of debt you can borrow against working capital assets. Anything outside of that needs to be on a six-year cashflow term. Otherwise, it’s bridge or venture risk to a scaled company, which is going to hurt your ability to negotiate during a fundraise.”
– Ken Loveless, Partner & Co-Founder, Founders Circle Capital
Josh added that losing leverage on the capital raising front can lead to a “worst case scenario” where the interest-only period ends and the company cannot refinance to a lower interest rate (which lenders typically only allow after a fundraise or change to the capital structure). “Essentially, the company now has to manage this fixed burn without really getting any value other than that original runway extension,” he said.
Negotiating Levers With Lenders
Negotiations around pricing, structure, and interest terms will be primarily driven by the lender’s venture or business risk evaluation. However, successful venture debt relationships are built on aligning incentives of the lender and borrower, and the conversation highlighted a few negotiating levers that companies might have at their disposal:
- Increasing Bank Deposits – In the wake of SVB, banks are paying more for deposits; therefore, larger banks may be willing to offer better debt terms to companies that agree to maintain higher deposits at their institution.
- Investment Banking Relationship – Some large banks see venture debt as a relationship building tool. Investment banks, in particular, can exert a significant level of influence on the lending arm of an institution and if the bank sees an opportunity to underwrite a future IPO or exit event, that could translate into better debt lending terms.
- Higher Fees – Paying higher interest rates or prepayment or origination fees or agreeing to a higher initial line of credit can potentially give a company more flexibility to negotiate things like the term of the loan, warrants or covenants included in the deal. Paying a higher upfront premium to a lender may be more cost-effective in the long run and give the company the flexibility to use or not use the debt (keeping it instead as an insurance policy) and shrink its outstanding liability.
Ultimately, companies must go into venture debt negotiations with a clear sense of what they’re trying to solve and close alignment on those goals with the CEO and board. Companies should also broadly explore the market and compare terms with several lenders.
As market volatility continues, the venture debt landscape will evolve with the equity capital markets. New lenders will likely enter the debt space, while regulation will continue to shape the incentives of lenders and the factors that impact pricing and negotiation terms.
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