Venture debt: Flexibility is the key to gaining traction

Connection Capital's Claire Madden looks at how venture debt could plug vital funding lines as markets become choppier.

Guest comment by Claire Madden, Connection Capital

In our experience, many private investors are flexible about the types of investment strategies they will consider. They are alive to the fact that different market environments create opportunities for different strategies to perform. In the current climate, venture debt (a segment of the private debt market) may appeal to those who wish to take an ‘opportunistic’ investment approach to a sector where market dislocation has created a sudden spike in demand.

Venture debt allows early-stage, high-growth technology companies to bridge the gap between primary equity funding rounds (for example, between Series B and Series C venture capital investment).

The drivers used to be business specific. For example, if shareholders wanted to delay the next round of fundraising until a major milestone had been reached, which would push up the valuation, such as a big contract landing, the company would seek venture debt funds to tide them over in the meantime.

Now the reasoning is more general and market related. Whereas the benign conditions of the past five years made fundraising relatively easy, shareholders are no longer convinced that valuations will continue to climb in the present environment. Therefore, they may choose to delay the next round of fundraising until the market has recovered and equity investors are more bullish, in order to raise funding at a premium to its previous round. As a result, many are prepared to pay for interim funding in the form of venture debt, while they wait for the optimal timing to raise its next round of capital.

This is where specialist providers can step in: this is not the territory of traditional mainstream banks. Interest rates on venture debt are higher than senior bank debt, but the risk is greater too. Interest is typically rolled-up and the debt is non-amortising. Providers will often want some sort of equity warrant included in the deal, so that they can participate in any upside as the business increases in value.

Good relationships vital

For all these reasons, when considering the merits of any deal, venture debt providers will be making an assessment not just of the business itself but of the shareholder base, too. Since the debt will only be repaid when the next funding round takes place or on exit, providers need to be confident that shareholders will stump up the capital, bringing on board third-party VCs if required. Likewise, the existing shareholders will be looking for reliability and deliverability on the part of any venture debt provider, to avoid the risk of being let down at the last minute and seeing liquidity – and therefore value – go up in smoke. Good relationships between the two are therefore vital.

For investors who are happy with the mechanism for getting the debt repaid in the next fundraising round or who can see a near-term exit, and who are comfortable with the credit risk involved, the returns are enticing. It’s a sphere that, unless you are an experienced pure-play VC investor, you are unlikely to be able to gain exposure to any other way.

There are several long-established players in the venture debt market such as Kreos Capital, but the positive market dynamics are attracting new entrants into the arena too who are increasingly making a mark, such as Shard Credit Partners. If the market remains this buoyant, more will follow.

Seeking venture debt solutions to bridge the gap in between funding rounds looks set to remain a prevalent feature of the marketplace for some time yet for ambitious tech businesses and their shareholders. For investors, that bodes well for the opportunity set, and, as with any strategy, if the market dynamics and the returns are right, more capital is likely to flow in.

Claire Madden is a managing director at Connection Capital, a UK-based firm offering access to alternative investments for family office and high-net-worth investors