Venture debt is a small but growing part of the private debt landscape looking to fund small but high-growth companies to help them reach their next stage of development.
In the equity world, the role of venture capital is well established, providing funding for companies ranging from start-ups to those that are profitable and delivering risky but potentially lucrative returns to investors.
In the debt world, entrepreneurs are still getting to grips with the new array of financing options now being offered by alternative lenders. Despite this, recent research shows that use of debt among early-stage firms is remarkably high.
US venture lender Runway Growth Capital surveyed entrepreneurs on their experiences with venture debt as part of its Venture Debt Review 2020 and found that more than 80 percent have used the product to fund their business. Furthermore, a majority said they feel venture debt has become more attractive in the past 12 months.
The amount of venture debt being issued has grown steadily too, with $25 billion of transactions in the US in 2019 according to data from PitchBook, against $135 billion of venture capital activity in total.
Acceptance gains momentum
David Spreng, chairman, chief executive officer and chief investment officer of Runway, says: “We’re seeing a continuation of a long progression to accepting venture debt and the pandemic has accelerated that process. We increasingly see mainstream business publications taking an interest in venture debt. We’ve also seen institutions such as the European Investment Bank say that debt is an important part of the venture ecosystem.”
However, not everyone in the venture debt market is convinced that its profile is high enough.
Marc Helwani, founder and chief investment officer of specialist venture lender i80 Group, says he is doubtful that a majority of entrepreneurs have used venture debt.
“That said, things are getting better. Four years ago, no one had heard about us. When we speak to the largest VCs in the market, they’re often amazed to hear this kind of product exists and want to know more about how to integrate it into their portfolio companies.”
Helwani says venture debt is well understood by most VCs today, but often looked at as simply a supplement to equity funding rounds, which can prevent the asset class from reaching its full potential within the sector. “Entrepreneurs and VCs aren’t looking at the big idea behind venture debt, which is that you can retain more ownership by raising it.”
i80 specialises in offering venture debt to companies operating in financial services, providing them with debt capital to fund their activities via perpetual credit facilities. For example, it backs Canadian real estate specialist Properly, which buys and sells residential property. Instead of raising expensive equity finance to invest in new properties, Properly’s facility with i80 allows it to borrow capital to fund property purchases more cost-effectively.
Runway’s Spreng agrees that today the entrepreneur and VC community still has a poor understanding of how debt can fit into their business model: “There are still a lot of misunderstandings and misconceptions about debt. A lot of people still think debt is a bad thing to have on their books and others are using it more as a way to feel comfortable with their finances rather than to drive their business forward.”
Ron Daniel, co-founder and chief executive officer of Tel Aviv-based venture lender Liquidity Capital, says entrepreneurs typically take debt with the closing of an equity round from a bank. “Today most venture debt is being issued in round B to round C and is mostly used to make the company feel more secure, using this money to feel better about the state of their capital,” he explains. “But we think venture debt should be used for growth because if you spend $1 million to generate $3 million of revenue then that’s an efficient use of the capital.”
In Runway’s survey of entrepreneurs, it found only a small number believe avoiding the dilution of an equity raise was the major benefit of using venture debt to fund their business. Instead, confirming Daniel’s claim above, most feel venture debt is a way to extend company capital to reach an important milestone, or as a reserve of capital when unable to raise equity.
Runway’s report goes on to add: “While most founders claim to be comfortable using venture debt, they often do not understand when, how and why it should be used. Many see debt as a backup option when equity capital is unavailable, rather than a complement to their capitalisation strategy. Furthermore, there is a perception among entrepreneurs that venture debt is akin to taking a mortgage on your home, unaware it is lending against enterprise value, not assets.”
According to the survey, 81 percent of entrepreneurs expect there will be equity dilution of their business associated with missing milestones over the next 12 months, raising concerns about the cost of equity that could provide impetus for entrepreneurs to seek out cheaper solutions such as venture debt.
For venture debt fund managers, raising awareness of the asset class and how it can be used to benefit high-growth companies is a key priority in taking venture debt to the next level of development.
“Educating the VC funds is the best way to get the message out there,” says Spreng, adding that engaging with the major legal advisers that serve the VC community is also important to raising awareness.
Helwani agrees that improving knowledge of the product among VCs is the best way to raise broader awareness among entrepreneurs. “What we’re trying to do is spend as much time as we can with VC firms, we’re in touch with around 100 VCs each quarter. If the market has a greater awareness of venture debt and what it can do then growth will become more organic.”
Educational outreach is also important to bring more capital into venture debt funds from LPs. “We need to get the LP community to understand what we do. They’re in search of yield and we can show that we can produce higher returns than conventional debt but with relatively low risks,” adds Helwani.
Venture debt has seen huge development of its potential in recent years, rising from a relatively low base to having a value equivalent to almost 20 percent of the venture capital universe as a whole. However, the feeling in the industry is that there is still significant room for growth as both VCs and entrepreneurs like the product but need to develop more experience in using it as an effective way to prevent dilution of equity and help turbocharge a start-up’s growth.