In the current surging rates environment, raising capital from VCs or angels has become increasingly expensive for companies, leading many founders to delay raising new rounds or to look for alternative sources of capital as the end of their runways loom.
Venture debt is one source of alternative financing that founders are increasingly turning to. Our Managing Partner Carlos Espinal chatted with Craig Netterfield from European venture debt specialist Columbia Lake Partners about:
– What exactly venture debt is?
– What type of companies venture debt is suitable for?
– How they “operate like a VC, but give loans rather than take equity”.
Carlos: How is venture debt different from traditional banking debt?
Craig: Traditional banks and venture lenders differ in three key areas:
- View of collateral.
Most traditional banks will only consider assets (real estate, accounts receivable, re-sellable inventory, or machinery) as collateral for a loan. Less traditional banks will also view positive cash flow, even from asset-light companies, as collateral. Most banks will typically not loan to any loss-making companies.
Venture lenders typically lend to a much larger range of companies. This includes companies that are making losses if the cause of the losses is to increase enterprise value, for example, by growing revenues, creating intellectual property, or both.
- Lender protections.
Banks typically require loanees to keep cash deposits in an account at the lending firm. They also commonly use financial covenants as tools to help them manage the risk of their loans.
Venture lenders won’t use financial covenants to protect their loans. Companies that are considering venture debt need the flexibility to adjust their operations quickly in response to market conditions. In my experience, financial covenants can often incorrectly signal a company is underperforming. These “false positives” cause loan defaults and angst for management and VC shareholders.
Venture lenders also do not require portfolio companies to deposit cash in specific institutions. Firms are free to bank with whomever they choose. The importance of this flexibility was seen most recently with the failure of Silicon Valley Bank, which resulted in many companies’ cash being trapped days before payroll was due.
- Pricing and structure.
The traditional credit culture inside banks – which is unlikely to change quickly as it has served them well for hundreds of years – is to price loans within a tight band and control for losses by declining loans they view as risky.
Venture lenders use a wider set of tools in order to control losses and manage risk. These include adjusting the size or duration (repayment profile) of a loan (both upfront and during the loan) and pricing in the risk. This means that venture lenders are willing to provide loans to a wider range of companies than traditional banks, but they do so at a higher cost.
Carlos: What has changed in the last year due to rising interest rates?
Craig: The cost of equity has increased.
The simple “finance math” reason for this is that in a time when interest rates are near zero, the value of $1 today is similar to the value of $1 in one year or even several years. The present value of tomorrow’s dollar is very close to a dollar. But each interest rate increase causes that present value of tomorrow’s dollar to fall.
This means that the value a VC gets from a future company sale (which might happen in 5-10 years) is much lower in our current period of higher interest rates than it was when rates were closer to zero. This reduction in exit value means VCs have to pay less today in order to get a similar return at exit, making “today’s” venture raise more expensive for a company than “tomorrow’s” venture raise.
The operational implication for startups has been a switch from VCs funding today’s growth (which is now more expensive) to preferring to fund growth at some future “tomorrow” date when it is less expensive. This means that high-burn, high-growth companies are out of favour, and also means that high-burn, not-high-growth companies will really struggle to raise new equity rounds from new lead investors.
Venture lenders will often look more closely at growth efficiency within companies and lean more heavily into companies with a strong underlying business that will benefit from delaying fundraising through this current period of uncertainty.
Carlos: How does increasing interest rates alter the relative cost of venture capital vs venture debt?
Craig: Despite the increase in interest rates, venture debt is still a cheaper alternative to venture capital. Venture debt is typically half the cost of venture capital when looking for funding. Even with interest rates on the rise, this is still the case because the pricing impact of reduced present value of that 5-10 year company sale is far greater than the increase of the interest rate charged on a loan.
Carlos: How do the investment priorities differ between venture capital and venture debt funds?
Craig: Even with interest rates rising and the value of rounds dropping, I believe that the investment priorities are the same for both venture debt and venture capital, which is to fund good companies.
At Columbia Lake Partners, we are currently seeing many companies who raised equity in 2021 and 2022 testing the market for additional capital. These companies are now considering debt to help fund them through this difficult equity market and then look to raise a new equity round in late 2024. We are actively deploying capital into those companies with strong underlying metrics (discussed below).
Carlos: What makes a company a good candidate for venture debt today?
Craig: In the current environment, good candidate companies for venture debt often have:
- A 9-18 month cash runway, where a loan could extend this by an additional six or so months. Companies with shorter runways may combine a smaller equity round with venture debt;
- A low-burn rate, although higher-burn companies can be a fit where metrics are improving and the company is becoming more efficient over time;
- A supportive investor syndicate. Being in a turbulent funding environment makes the investor syndicate and board dynamics ever more important. Our experience has taught us that strong boards can best help companies through a period such as this.
Carlos: From the founder’s perspective, in what scenarios should I be considering venture debt?
Craig: If you believe in your growth story and don’t want to raise a priced equity round in the current environment, venture debt offers a less dilutive way to achieve this growth and provides you with more optionality beyond 2023, when the funding environment has potentially improved.
There are several use cases for debt in this environment, which can help prevent (or reduce the size of) a bridge round or save the use of your VCs’ funding reserves as “just in case” money.
Some companies will also use this environment to buy direct or adjacent competitors or advance R&D through acquisition. A loan can help fund the cash portion of these deals.
You can read more about use cases for debt financing in Columbia Lake Partners’ Knowledge Centre: Knowledge Centre — Columbia Lake Partners | Financing European Growth (clpgrowth.com)
Carlos: How are venture lenders different from other types of debt providers like revenue-based financiers?
Craig: Venture lenders differ in the type of products that they offer and in how the lenders themselves are financed.
At Columbia Lake Partners, specifically, we see ourselves as long-term partners for a company. Our typical loan is for 3-4 years; we have numerous examples of companies who borrowed a small amount from us initially and then grew that loan by as much as 5-10x over time. Our approach is a mix of looking “at the numbers” and qualitative assessment of the management team and the opportunities each company has; One of our portfolio companies referred to our team as being like “VCs who happen to lend” as opposed to “bankers who work with tech companies”.
The last few years have seen a growth in quant-oriented firms offering loans, often based on a percentage of annual recurring revenues. These loans will have a much shorter duration and a higher IRR, albeit with no warrants. A fixed-fee loan repaid over a short period can be expensive on an IRR-basis but helpful for smoothing out working capital fluctuations. Some specialty finance companies also use a quantitative approach while offering longer-duration loans, using leverage so they can offer these loans with no warrant and still generate the returns their VC backers need.
This piece has been edited by our visiting analyst Daniel Inge.
The content of this blog post is solely for informational purposes and may not be construed as legal, tax, investment, financial, or other advice.