Venture debt investors who typically have greater appetite for lending in higher risk cycles remain a viable — if sometimes pricey — source of financing for certain CFOs.
While not the right fit in all cases, venture lenders provide an alternative to CFOs who have seen a number of routes to fresh capital narrow amid global economic turmoil this year. Startups or companies with less predictable cash flows often gravitate toward it.
“The venture fund ecosystem is accustomed to risk, is accustomed to changing markets…and so they’re sort of prepared to continue to lend in markets that are uncertain, where more formulaic lenders can’t find the underwriting criteria,” Jennifer Post, a partner in Thompson Coburn law firm’s corporate and securities practice who has worked closely with venture debt funds, said in an interview.
Indeed, the value of publicly announced debt financing rounds raised by venture-capital-backed startups in the U.S. rose to nearly $15.9 billion in 321 deals this year through July. This is compared to $13.3 billion in 320 deals during the same seven-month period last year, according to an Aug. 3 report from Crunchbase News which tracks the data.
In contrast, mergers and acquisitions (M&A) worldwide slumped 21% during the first half of 2022 compared with the same period last year, according to Refinitiv. Meanwhile, equity volatility and regulatory scrutiny have damped company’s prospects of using special purpose acquisition companies (SPACs) as an exit strategy.
As funding options shrink, tech firms in particular are eyeing debt funds, according to Efraim Chalamish, an adjunct professor of law at NYU, writing in a July 21 piece for Global Finance magazine.
“The decline in startup funding globally and the uncertainty around raising new venture funds have brought attention to new sources of capital for technology companies to address liquidity and operational concerns via venture debt financing,” Chalamish wrote.
Weighing the cost
Finance chiefs considering venture debt should weigh the advantages and disadvantages. Venture debt is typically non-dilutive and funding levels have been rising in recent years, ranging from $2 million up to $50 million and higher, Post said.
The main drawback is that venture debt tends to be more expensive than commercial loans but the terms are generally more flexible in terms of the amount of debt available and how and when it is deployed to the company, she said. But venture lenders tend to be more partnership oriented, typically making the deal based on a company’s projected milestones, capital raising ability and a variety of metrics versus just looking at a company’s balance sheet.
“You certainly pay more for the debt capital but in return you get real partnerships from venture lenders and partners who have funded many scaling companies and understand what the choppy waters look like there and how to structure resolutions,” Post said.
The willingness of venture lenders to work with companies can come in handy if “things get skinny” and a company deviates from a plan because the venture lenders have more leeway than bank lenders have, she said.
Some of the big name venture debt players include Hercules Capital and Trinity Capital. But Post said she would advise firms to do their homework and research lenders that have deep domain expertise in the company’s sector that would be better equipped to understand a certain patent approach or metric, for example.
“You have to find the right lender,” Post said, noting that some will consider pre-revenue companies. “If they really understand the industry they might be able to take the risk.”