Venture Debt — No Longer a No-Brainer
Venture debt is a boon for fast growing startups. With annual total costs (fees, interest and a potential equity kicker) rarely exceeding 13–15%[1], it’s a relatively inexpensive way to extend the runway (or in banker lingo: optimize the balance sheet by limiting dilution and lowering the average cost of capital).
Or so everyone thought.
More recently, since the funding drought started to bite, some nasty (and probably so far under-appreciated) side effects of debt funding have been receiving more attention.
The problem
When times are good (as they generally were until about two years ago) it’s all too often pushed aside: debt, unlike equity, has to be repaid, in hard fiat including interest and fees. Why spend much thought on repayment if, for example, the loan can be expected to increase revenues and unlock follow-on funding at attractive terms or if there is a path to break-even?
Yet as the last two years have shown, taking on a loan can backfire if things don’t go as planned, be it because the additional funding does not (sufficiently) extend the runway, be it because it doesn’t help with growth:
The (illustrative) chart shows the cash balance of a (loss-making) startup (initially EUR 10m) without debt (blue line) and if topped up with EUR 5m of venture debt, repayable over four years. Repayments kick in after 12 months and total fees (primarily for the commitment of the loan and coverage of the lender’s cost) due before or at drawdown are 2%. The red line assumes an annual interest rate of 9%, the grey line of 14%. In all scenarios the company’s operating cash profile is assumed to be the same.
As one can see, the additional financial flexibility offered by the loan is significant in the beginning, but once the repayments kick in the extra buffer shrinks quickly. While in the (hypothetical!) example the company without debt would have reached break-even in the third year, the interest and fees of the loan mean it needs additional funding in year four.
Unfortunately, for many borrowers what was once considered hardly more than a theoretical risk has turned into grim reality : the loan needs to be repaid and there is no “easy equity” in sight like in the good old days.
The consequences
If there is no equity available (at acceptable terms), can’t the maturing debt be refinanced by a new loan, or simply rolled over (de facto by stretching out its repayments)? No, at least not at acceptable terms. In the absence of profits, lenders — including existing lenders — as a matter of principle require strong backing by shareholders and significant cash reserves/runway before committing. The old joke that you can only get money from a bank when you don’t need it definitely holds a grain of truth : ).
For a short while after valuations started coming down in early 2022 many founders and lenders thought venture debt might be able to take the place of what previously would have been equity in many startups. Yet as the market dip turned into a lasting correction lending volumes quickly followed the decline in equity markets, a trend that was probably exacerbated by the failure of Silicon Valley Bank in March 2023 (although that had nothing to do with its venture lending business).
The squeeze faced today by many early-stage borrowers rarely means they are pushed into insolvency, at least not where the business as such is doing well enough, because the value of a startup consists mostly of its potential and much less of an asset base that can be monetised in a liquidation. For this reason, and being mindful of their reputation, lenders generally seek to work with the company, offering covenant relief (e.g. a waiver of minimum financial performance thresholds — more on that below) and payment deferment in return for operational changes (esp. cost savings), the adjustment of loan terms (e.g. higher interest rates) and, most importantly, the raising of additional capital, no matter the cost. This may force the startup to issue equity at an extremely discounted valuation and/or onerous terms such as a multiple liquidation preference.
So was it all a mistake?
With hindsight, taking on the amount of leverage that many startups did two or three years ago looks imprudent, especially if, as was the case for many borrowers, raising (more) equity would have been a viable alternative. But that’s the benefit of hindsight, which easily overlooks the prevailing optimism back then and the abruptness and severity of the downturn.
Still, a lesson from the relative “debt binge” might be that the risks of debt should get more consideration — on both the lenders’ and borrowers’ side. As the current market shows, simply comparing the cost of the loan with the (ex ante) cost of equity doesn’t do the trick. The potential additional cost of later capital raisings at unattractive terms triggered solely to avoid a default needs to be factored in as well. At the risk of committing “hindsight bias”, this seems especially true in a bull market dominated by great optimism.
So it wasn’t all wrong, but as often in life, the dosage makes the difference: What causes headaches today might have been okay at a somewhat smaller size. Today’s troubles of some startups clearly show: the refinancing risk grows disproportionately to the size of the loan.
When negotiating debt today…
Even if the venture loan market has declined, new loans are still being granted in significant volumes. For instance, the biggest market, the US, still saw USD 6.3bn of loans in H1 2023, despite the demise of SVB at the end of Q1 2023. The main difference to the heydays is that lenders have become a lot more conservative when assessing the “bankability” of a potential borrower. At the same time loan costs have increased significantly (more on this below), making borrowers more hesitant too, even if they tick all the boxes. Based on our experience the following trends seem worthwhile noting (disclaimer: this is a highly subjective view based on incomplete data, so do not feel discouraged to prove us wrong!! : )):
It’s all about the runway: While in 2021 a venture loan might have been granted if the company still had a runway of 18–24 months (in some cases even less), lenders today generally require at least 24, better 30–36 months. We would add to that: be realistic when doing your numbers, there’s nothing to be gained from an overly optimistic plan that derails at the first occasion. If based on conservative assumptions you cannot easily model a runway of at least 30 months, you should be extra careful and consider reducing the loan size, even if the lender would be more forgiving.
Your equity backers matter more than ever: The reputation and track record of a startup’s investors have always been important, for lenders even more than for later equity investors. In today’s market most lenders have become even more selective. If there’s uncertainty about a major investor’s long-term commitment, venture debt may well be available only in connection with a proper funding round. More than ever, you should be highly selective when choosing your equity backers. Focusing mostly on price is rarely a good idea.
Interest rates: Venture loans have clearly become costlier. Interest rates are up significantly, especially in the US, but also in Europe, driven by the increase of the underlying base rates (in the US the benchmark Prime Rate is up from about 4% before the pandemic to currently 8.5%; in Europe Euribor is up from less than zero to about 3.5%). In contrast, the premiums charged on top haven’t moved much based on our experience, although three trends seem worth pointing out: First, the particular situation of the startup (geography, growth, burn, equity backers, etc.) has become ever more important, making generalizations difficult. Second, lenders are more reluctant to price a loan below their assessment of the risk. Third, lending rates of traditional banks remain lower than those offered by specialised funds.
Interest rates are still negotiable though. In contrast to the good old days you may no longer be able to demand a fixed rate (lenders have learnt their lesson from the unprecedented interest rate hike in 2022), but especially if you have several offers on the table a reduction beyond a few basis points may well be possible.
Even at 14 or 15% p.a. taking on some debt may not be reckless. As you can see from the chart above, a higher interest does push down cash flow, but relative to operating costs and repayments the impact is small, and it shrinks ever further if one includes the interest tax shield. The relevant tax loss carry-forwards may not be worth much if break-even is still far out, but as soon as there are taxable profits the tax shield earns its name.
Warrants have become more important: In the good old days the warrants requested by lenders rarely caused a headache: at 10% or less of the loan amount and with an exercise price around the level of the last (high) funding round, the resulting dilution generally was below 1%, even in case of a large loan. Today the picture is different. Warrants of 12–15% are no longer unheard of and the lower valuations mean much greater dilution when the warrant is exercised. For example, while the dilution of a EUR 500k warrant is 0.5% at a EUR 100m valuation, it’s 1.7% at EUR 30m. But keep in mind: Because of the exercise price, the dilution will only really hurt if by the time of exercise the startup’s valuation has increased significantly.[2] In this case, however, the total pie will be much larger for everyone, making the warrant slice almost a “nice to have” problem.
Covenants: As the above shows, taking on a venture loan hasn’t exactly gotten easier. Yet in one area where one could have expected a significant tightening this hasn’t happened: financial covenants.[3] These establish hurdles which if breached allow the lender to trigger an event of default. This is not what the lender wants of course. Instead he hopes to steer the company in a certain “lender friendly” direction including greater frugality and conservative decision making. Typical examples are maintaining a minimum cash or working capital balance, or requiring a certain financial performance relative to the business plan.
Financial covenants have traditionally been requested by bank lenders whereas the specialised debt funds have not included them in their terms. As far as we can see, even as troubled loans and write-downs have increased, neither have bank lenders materially tightened the covenants they request, nor have funds changed their preference for flexibility over rigidity. So as a founder you are well advised to push back if a lender seeks to impose (onerous) covenants. If you cannot avoid them altogether (e.g. because the lender is a bank), make sure the hurdles are set sufficiently low to not unduly limit your operational flexibility.
When thinking about venture debt…
Make sure your business and financial performance have a solid footing. Significant revenues and runway are a must, as are solid and committed equity investors. Considering a debt top-up in connection with a Series B round (or later) often is a good idea, whereas before it could be unduly risky and a waste of time. Beyond that, from a more operational perspective (looking esp. at growth and burn) we see in very broad terms three different groups of suitability for venture debt:
So as was to be expected, venture debt may be a no brainer for the outperformers whereas struggling players should only try their luck if there’s no other way. For everyone in between it’s even more important than usual to be extra diligent and careful.
If there is a case for (some) debt, try to get at least three competitive offers. When you have them, don’t be shy to play your hand — there aren’t as many attractive borrowers as there used to be. And even if lenders insist on a (relatively) high interest rate, taking on the loan may still be justifiable if adequately sized. Yes, debt has become more expensive, but so has equity.
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[1] For example, if one assumes a 10% interest rate, 2% initial one-off costs (esp. for coverage of lender’s legal costs and a closing fee) annualized over four years and 2.5% annual costs of the warrant (based on a 10% warrant coverage and assuming a return of 25% p.a. as for other equity, i.e. 25% x 10% in relation to the entire loan), one gets to (approximate) annual costs of 10% + 0.5% + 2.5% = 13% (pre any tax savings). For some rough indications of return expectations of various funding forms see here.
[2] If there hasn’t been a (material) increase the exercise of the warrant will be like a normal capital increase (at fair market value or not far away from it). In case the warrant is exercised in connection with an exit the payout to the holder will be zero or close to zero.
[3] The term “covenant” (at times also called “undertaking”) refers to a broad range of obligations imposed on a borrower, which cover — besides the financial covenants — information duties, positive (“do”, e.g. maintain proper asset insurance) and negative (“don’t”, e.g. make payments to shareholders) covenants.
