Enterprise Explains: Venture debt
Enterprise Explains: Venture debt. Venture capital — where investors provide funding to small businesses with long-term growth potential, in exchange for equity — has become a core component of startup financing. VC is actually a subset of private equity, although the two types of investment differ substantially. And it’s booming, with global VC investment exceeding USD 675 bn in 2021. But venture debt — or, as Bloomberg puts it, VC’s lesser-known “baby cousin” — is also seeing soaring growth.
So what is venture debt, exactly? It’s a kind of loan offered by banks and nonbank lenders that typically combines the traditional features of a loan with some aspects of VC financing. It’s designed specifically for early-stage, high-growth companies that may not yet be in the black, but are performing well and generating strong revenues. It’s not generally available to seed-stage companies, but is “designed for companies that prioritize growth over profitability,” a Silicon Valley Bank explainer notes.
It’s important to understand that venture debt doesn’t replace VC investment. It complements it: “Venture debt really piggybacks on venture capital,” says Alex Baluta, CEO of alternative asset investor Flow Capital. It’s debt that supports the equity and serves as a bridge for high-growth, venture funded companies — to their next funding round, IPO or sale, he adds. Companies without VC investors face significant difficulties in attracting any venture debt, says SVB. “The venture lender wants to follow in the shoes of investors they know and trust, rather than risk lending to a company without venture backing,” it adds.
What’s the big advantage of this kind of financing? It’s non-dilutive: For business founders, venture debt provides growth capital with minimal equity dilution. Founders get relatively fast access to a predetermined amount of capital, without having to give up another big chunk of equity. This can fuel growth, so borrowing companies could achieve a higher valuation before their next VC funding round. Venture debt investors usually have a hands-off approach as well, and generally don’t require board seats, says VC firm Emergence Capital.
Plus, venture debt is more flexible than traditional bank debt. And it’s becoming more and more creative in the types of loans offered, says Baluta. “Some [investors] will do it based on your ad spend; some offer short-term loans, or perpetual loans.” Recurring revenue loans might be provided to companies with a regular, expected income; product-based loans often center around particular technology, which the borrowing company has developed and is trying to sell; and equipment financing is secured by the equipment owned by borrowers, Bloomberg notes.
The size of loans can vary considerably: Industry leader Silicon Valley Bank issues venture debt loans as big as USD 30-40 mn, while Flow Capital — a smaller operation — tends to stick within the USD 1-5 mn range, says Baluta. Loan types and sizes vary significantly based on the scale of the borrowing business, the quality and quantity of equity it’s already raised, and its objective for raising venture debt, notes SVB. The principal amount of debt is often around 30% of the total funds raised in the last round of equity financing, according to an explainer by online platform Corporate Finance Institute.
How are they structured? Venture debt usually incorporates three elements, notes UK-based asset manager BOOST&Co. These are a fee of 1-2% of the approved loan amount, an annual interest rate of 10-12%, and an equity kicker worth 10-20% of the loan. The equity kicker is usually structured as a warrant, giving the lender the right — but no commitment — to purchase a relatively small amount of equity within the borrowing company at a fixed price within a specific period of time. The debt should usually be repaid within three-four years, CFI notes.
The global venture debt market is booming: The market for potential venture debt investments based on VC investments stood at some USD 47 bn, as of March 2021, according to Bloomberg. Total venture debt activity grew to roughly USD 25 bn in 2019 from USD 5 bn in 2010, and the boom in special-purpose acquisition vehicles (SPACs) could speed its growth still further, it added. The largest proportion of venture debt is funneled into tech companies, which borrowed some USD 18 bn in 2020, according to data company Pitchbook.
And in MENA, appetite for the funding mechanism also appears high: Some 80% of investors and startups surveyed by Magnitt and Shuaa for their recently released MENA Venture Debt Sentiment Report (pdf) plan to use venture debt as a funding tool in the near future. 74% of investors had at least one portfolio company that had previously raised venture debt. And some 31% of the startup founders surveyed had raised venture debt to finance their startups. 40 investors were interviewed for the survey — 30% of whom were from the UAE, 20% from KSA, 23% from the rest of MENA, and 27% from other parts of the world. 70 startups were surveyed — 52% in the UAE, 19% from KSA, 9% from Egypt, and 26% from the rest of MENA.