With 2023 off to a rocky start for entrepreneurs and startups due to rising interest rates, inflationary pressures and the collapse of highly recognized banks for venture-backed companies – such as Silicon Valley Bank (SVB), Signature Bank and other financial institutions with a greater appetite to do business with these types of riskier companies – the market saw both a pullback by venture capital firms, limiting follow-on equity rounds for the weaker companies in their portfolio as well as a sharp decline in the availability of venture debt. The simultaneous pullback in both the equity and debt markets for these early- and growth-stage companies has left many of these companies in a precarious position, focused on capital preservation and, in some cases, survival, with many ending up in a fire sale or shutdown mode.
There was a great deal of uncertainty as to what the future held in terms of venture debt after the upheaval in the banking market. For the remainder of 2023 and beyond, it initially seemed unlikely that traditional banks, including those remaining banks that targeted the startup world, would be the source of venture debt due to the riskier nature of these loans (which generally would not meet their underwriting criteria) as well as more uncertainty and unpredictability in the growth prospects of many of these companies, given the instability in the financial markets for both debt and equity. However, recent trends suggest that there may be more banks than expected that have jumped in to fill the void, with HSBC and Stifel starting to offer new financing alternatives (both institutions picked up former SVB team members) and CIBC and First Citizens Bank (which acquired SVB) continuing to make and honor existing loans. It will be interesting to see how HSBC targets the market, as it recently launched a venture banking practice, but the growing consensus is that loans will start at $1 million post-Series A.
To understand venture debt as it is today, one must understand its history. Venture debt became prominent in the 1970s and 1980s with the rise of SVB and similar lending institutions willing to accept more risk and do business with high-growth startups. Many of the great companies that we all know of today were, in part, the product of venture debt. Venture debt seemed to peak during what is known as the pre-dot-com era (mid/late 1990s). During this period, venture debt financing topped out at around $5 billion. This was until 2001 when events took place that led to the bursting of the dot-com bubble and the crash of the markets in the early 2000s. This crash led to many venture capital firms exiting the market and others becoming much more conservative and risk averse. Things again started to look up in the mid-2000s, but the market was again crushed by the crash of 2008. Much as in the 2001 crash, lenders became significantly more risk averse or they exited the market completely. Venture debt only works if there is venture capital (equity behind it), and much of the exit of venture debt in these prior financial crises was tied to the lack of new equity investment.
As the market came back with a vengeance in recent years, lenders had again become more flexible in their lending habits, and the venture debt market grew tremendously. However, the rapidly rising interest rates, inflationary pressure, volatile public markets and other macroeconomic factors, including the collapse of SVB and other banks as noted above, that converged in late 2022 and early 2023 led many to speculate that venture debt markets would tighten significantly – and they did, in fact, do so for the first half of 2023. But there does seem to be a light at the end of the tunnel, although likely with more conservative terms and underwriting.
What Is Venture Debt, and How Does It Work?
What is venture debt?
So, what is venture debt? At a high level, venture debt is similar to any other kind of debt. It is a loan from a bank or a nonbank lender to early-stage companies that have previously completed round(s) of venture capital equity funding. Most of the time, these companies have strong growth potential but little to no marketable collateral such as cash, real estate or liquid investments with which the lender can secure its obligations under the loan, making them risky candidates for conventional bank loans. When they lend, venture debt lenders, as opposed to conventional banks, focus more on a company’s growth potential and equity backing than its cash flow and profits. Additionally, venture debt can be attractive to early-stage companies, as it can be used as a complement to equity financing that will not dilute existing equity ownership or change management control in the company.
Who are the lenders?
Venture debt lenders and equity investors are very different. In a nutshell, equity investors, such as venture capital firms and high net worth individuals, infuse a certain amount of capital into a company in exchange for an equity ownership interest in the company. Equity investors hope to achieve a big return on their investment once the company matures and declares and issues dividends and/or there is a sale event, among other liquidity events. They usually get a preferred return of capital and perhaps an accruing dividend on that capital that is paid when and if there is a liquidity event, but they generally do not have a set timetable or the equivalent of a maturity date nor a guaranteed repayment obligation from the company as to either return of invested capital or a certain return on their investment. To the contrary, when venture debt lenders enter into a credit facility, the lender expects to be repaid every cent that is lent plus interest. This is no different from a residential mortgage company demanding that you repay your entire mortgage plus interest, but the venture debt lender does not have a lien on your residence as security for the loan.
How does venture debt work?
As an initial matter, before a venture debt lender agrees to lend to an early-stage company, the lender generally will assess the company’s business plan, financials and growth potential to determine whether they will proceed with a loan and, if so, how much funding they will provide. Because lenders in this space assume a greater risk when loaning to unproven companies, as compared to traditional loans to established companies, it goes without saying that lenders want to be protected and compensated accordingly. For example, venture debt normally follows a round of venture capital (e.g., equity or subordinated debt) funding as a form of support for the lender’s extension of credit. Instead of securing its obligations through the company’s assets as a traditional bank does, it instead uses the amount of venture capital funding previously supplied as a source of validation. This is in part due to the overall theory behind venture debt; lenders place significant value on their trusted relationships with the venture capitalists behind the companies, which are often clients of the lender.
Not only does the equity funding provide comfort to the lender in the form of support for the borrower from its existing or new investors, but the available loan amount also is set based on the previous round of venture capital funding. Normally, loans are limited to 25% to 35% of the most recent round of equity funding and are relatively short term (one to three years). These venture debt loans typically have an interest rate higher than the traditional loans we would customarily think of, due in large part to the speculative nature of the business that is borrowing the funds and the need to compensate the lender for the additional risk. In addition to higher interest rates to compensate the lender for its risk, venture debt is usually coupled with warrants to purchase the borrower’s equity to provide additional upside for the lender, assuming the company achieves future success. The total value of warrants issued to a venture debt lender is between 5% and 20% of the principal loan amount. These warrants are usually a right to buy the last round of priced equity and generally have a term of one to 15 years.
Finally, venture debt lenders aim to protect themselves with certain operating covenants in the loan agreement by including affirmative and negative covenants that place limits on the borrower’s activities. However, as compared to a more traditional asset-based loan, the number of covenants included may be minimal and limited to just a few financial covenants. These financial covenants normally lay out conditions that the borrower must fulfill or avoid to maintain the relationship with the lender. Financial covenants are normally limited to the borrower promising to maintain a positive growth rate and/or maintain a certain level of liquidity. Venture lenders also historically required that borrowers maintain 100% of their cash balances with the bank acting as a lender. When depositors became aware of SVB’s problems, they quickly tried to withdraw their funds, even if it put their loans in jeopardy. This was, in part, a major issue during the collapse of SVB. Therefore, newer venture debt models appear to be more flexible, with some lenders willing to limit the deposit requirement to a lower percentage of cash or a fixed amount tied to the loan balance to cover debt service for a period of time.
Relevance in 2023
In the first half of 2023, venture debt deals declined a whopping 38% across the board, going from $20.07 billion in 2022 to only $6.34 billion in 2023. This most likely can be attributed to the failure of SVB and the lack of larger banks and venture debt funds stepping up to fill SVB’s void, rising interest rates, and uncertainty in the markets. However, more recently, we have seen alternative lenders and other banks step in to try to fill this void. In the meantime, only time will tell how the venture debt market will react to the current macroeconomic environment.
Meet the Authors
Josh Galante is a member of the firm’s business department and focuses his practice on complex business combinations and investment transactions. He advises public and private companies, investors and entrepreneurs on a range of corporate and securities law matters of strategic importance.
Jeremy M. Miller is a member of the firm’s business department and counsels investors, entrepreneurs and public and private companies in all aspects of their business needs.
Lori Smith is chair of the emerging companies & venture capital practice and is an active participant in the firm’s health law and mergers and acquisitions groups.