Amid the economic downturn, many VC-backed companies are turning to lenders for capital, but some investors are concerned that the risks of venture debt are being overlooked.
This year has seen $26.5 billion invested across 2,419 venture debt deals in the US, according to PitchBook data, with Q2 2022 being the second largest quarter in terms of total debt value in the last decade.
Rising interest rates and market volatility have caused equity funding to become less readily available than in previous years. For startups looking to extend their runways without risking their valuations, venture debt seems to be a natural choice, especially because it is cheaper than equity.
But it is not without risks to startups or their investors—which are heightened in an economic downcycle.
“A lot of people don’t recognize that the economics of the venture lender are very different than those of a venture investor,” said Nate Lentz, a Philadelphia-based managing director at Osage Venture Partners. “For them to lend a startup $2 million and lose it is a much bigger loss than for a venture investor. When things go wrong, the venture lender will very quickly go from being your partner to wanting their money back.”
Stricter covenants
Unlike equity, venture debt needs to be repaid. If a startup defaults on repayment terms or covenants—loan conditions that set minimum financial and performance requirements—then the results can be disastrous.
When in default, the loan is due and payable immediately. And if the lender is unwilling to negotiate, then interest rates can be increased or access to additional credit may be revoked. Although a rare occurrence, lenders do have the right to force a company to liquidate or be sold if they default.
According to Lentz, the downturn has caused many venture lenders to include more or stricter covenants. Achieving required growth rates or other performance-related metrics is more challenging, given current market conditions, therefore increasing the risk of default for companies.
This is particularly of concern for companies that are raising debt to avoid a down round, said Jai Das, president and co-founder of Sapphire Ventures.
“What I’m concerned about is the scenario where a company takes venture debt in order to keep an artificially high valuation,” he said. “If the company deteriorates, there’s the possibility that the debt holders will own a lot of the company. When sold, the lenders get most of the value. I typically would deter my portfolio companies from taking venture debt.”
Impact on exits
Debt is higher up the capital stack than equity, so when it comes to exiting, venture lenders get their money back first. If a company takes on a lot of debt and the proceeds from the exit doesn’t cover it all, then founders, employees and other investors may end up with nothing.
Too much debt can also impact a company’s exit prospects, Das said. A possible acquirer could balk at the cost of repaying a loan or public investors may hesitate if a company has a high level of debt on its balance sheet in the case of an IPO. Das said he believes that companies need to think through the long-term consequences of venture debt rather than just focusing on the short-term benefits.
For some startups, raising venture debt is a means to tide them over until the next equity round. However, it can cause problems down the line when trying to raise, said Lainy Painter, a New York-based partner at Craft Ventures.
"[VCs] prefer to invest in growth rather than repaying debt,” she said. “There’s an assumption that the responsibility to pay off the venture debt falls to the next investors in an equity round. If a startup has a clear plan on how to pay off the debt, then it shouldn’t be an issue, but if they don’t it could make it harder to raise new funding.”
A place for debt
For VC investors, a startup’s potential growth is still key when deciding to invest. If capital raised is simply going toward repaying existing debt rather than funding new initiatives or expansion, then there’s limited upside for the investor as their capital is not contributing to helping the startup evolve.
This is potentially a bigger consideration now as VC dealmaking slows. In Q3, US VC deal count was down nearly 20% from the first quarter of the year, according to the PitchBook-NVCA Venture Monitor.
Although venture debt has its risks, it still has a place in the startup community, Painter said.
“If a startup is cash-flow positive or has collateral, they might consider taking on debt,” she said. “It can be a great instrument to optimize capital structure and lower the cost of capital since debt is cheaper than equity. But if a company is just using debt to extend runway without a path to profitability, it creates a lot of problems. Debt needs to be repaid. If a startup is using debt to delay difficult decisions, it’s a setup for disaster.”
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