Venture debt is a specialized loan type designed to meet the needs of venture-backed businesses. Entrepreneurs find this financing method appealing as it allows them to extend their cash runway while reducing equity dilution. Despite a 2023 disruption, in part due to the collapse of Silicon Valley Bank (“SVB”), interest in venture debt remains strong, as evidenced by Deloitte projecting a 25% rise by the end of 2024. SVB’s collapse opened new opportunities for lenders, with venture debt continuing to provide funding access to companies that often have negative cash flows and limited collateral or personal guarantees, but retain an underlying business model that investors believe to be successful.
Unlike traditional commercial lending, venture debt requires lenders to understand startup dynamics and the underlying business. When researching potential companies, lenders often prioritize research and development, marketing, and talent acquisition over cash flow. The company assets are typically intangible, like intellectual property or patents, making standard foreclosure processes difficult. As a result, lenders must be confident in both the company’s long-term prospects and its investors to underwrite and structure deals effectively.
Risk Assessment and Structuring a Venture Debt Transaction
The structure of a venture debt transaction can be directly correlated to its pricing. Lenders may offer better terms for deals that include broader lien rights or provisions for equity conversion, which provide extra protections in case of default. Covenants can also restrict the borrower’s actions during economic downturns, while some lenders may require collateral as an added safeguard.
In lieu of conventional repayment criteria, lenders assess key factors such as:
The quality of the company’s investor base
Recent fundraising rounds
Projected cash burn rates
The level of committed capital from investors
For lenders, belief in the company’s underlying business and the likelihood of continued investor support is critical. This belief drives decisions on pricing and terms. Entrepreneurs benefit from extending their cash runway, but venture debt’s higher interest rates and added equity warrants reflect the heightened risk involved. Companies backed by experienced investors with a strong history of follow-on funding often secure more favorable terms.
An Opportunity for Private Lenders
While attention in 2023 focused on the stock market performance of large tech companies, smaller startups faced different challenges. The combination of a weak IPO market, subdued M&A activity, and a 60% drop in venture capital funding since 2021’s peak has made venture debt an increasingly attractive option. The venture debt market also saw a contraction in 2023, dropping from over $30 billion to roughly $12 billion, which included the collapse of SVB, historically a major provider.
The collapse of SVB intensified demand, creating opportunities for private credit funds to step in. These funds are drawn to venture debt due to its attractive yields—typically between 10% and 14%, with leveraged funds achieving gross returns up to 20%. Venture loans often include equity kickers, offering additional returns from high-growth companies. Additionally, the market’s high barriers to entry limit competition, presenting unique investment opportunities.
Venture Debt Versus Venture Capital
Venture debt transactions require a thorough understanding of both the company’s business model and its prospects. For borrowers, the benefits include flexibility and reduced dilution, but covenants and warrants tied to these loans can affect future equity rounds. For lenders, belief in the business’s ability to secure further venture capital is essential for ensuring repayment. This requires due diligence similar to that of venture capitalists, focusing on growth potential, financial health, and management quality.
If you have any questions about venture debt, please contact Paul Marino (pmarino@sadis.com) or Jonathan Bernstein (jbernstein@sadis.com).
