The loss of SVB will undoubtedly constrain the availability of venture debt in the near term. But, SVB was not the only provider of such debt. Hercules Capital and Square 1 Bank, among others, provide the same or similar sources of capital to the startup ecosystem. It is also important to note that the collapse of SVB was unrelated to its traditional business model and, more specifically, the business of providing capital in the form of venture debt.
As a result, it is still important for us to cover this topic. First, to provide the overview we originally planned, but now, to also give our thoughts on its future.
So, what exactly is venture debt, who is it for, what are its risks—and now, what is its future?
What is Venture Debt?
Venture debt is a type of debt financing tailored to startups’ needs. It is typically provided by specialized lenders who understand the risks and opportunities of the startup ecosystem. These lenders usually focus on a borrower’s ability to raise capital to fund growth and repay debt rather than other measurements for obtaining debt, which focus on historic cash flow or working capital assets. In addition, unlike traditional bank loans, venture debt is often structured as a loan with warrants or equity kickers, giving the lender the right to purchase equity in the startup later. This structure allows the lender to participate in the startup’s upside potential while limiting its downside risk, which in turn assists in its provision of “traditional debt” capital to “non-traditional” borrowers.
Who is it for?
Venture debt can be a good choice for startups that need additional capital to scale their business but do not want to dilute their equity. It is often used to extend the runway between equity rounds, to smooth out cashflows, or to fund specific initiatives, such as product development or marketing. It can also be used as a bridge loan to help a startup reach profitability or to finance an acquisition. Venture debt is most appropriate for startups with a clear path to profitability and positive cash flow. Lenders will typically look for startups with a strong revenue stream, a clear plan for growth and a strong management team. In addition, the typical venture debt lender focuses on the capacity of existing investors to close one or more follow-on rounds in case the company fails to attract new investors. As a result, startups that are pre-revenue or have uncertain revenue streams may have difficulty obtaining venture debt financing.
What are its risks?
While venture debt can be a useful financing tool, startups must understand the risks. One of the most significant risks is the potential for default. Startups that take on too much debt may be unable to make payments, which can lead to bankruptcy or a forced sale of the company. Another risk is the dilution of equity. While less impactful than an equity round, venture debt lenders typically require warrants or equity kickers as part of the financing package, which can dilute the ownership stake of the founders and other equity holders.
Startups should also be aware of the terms and conditions of venture debt financing. Lenders may impose restrictions on the use of the funds, such as limiting the amount that can be used for executive salaries or marketing expenses. They may also require covenants, such as maintaining a certain level of cash reserves or achieving certain revenue targets. Startups should carefully review the financing terms and negotiate where possible to ensure they can meet the lender’s requirements.
What is the future of Venture Debt?
So, in light of the collapse of SVB, is Venture Debt still an available and viable alternative? As noted above, it is still available through various other providers, and even SVB has announced plans to continue providing lending while under FDIC stewardship. But is it viable? Our answer is yes. We are still in an uncertain equity funding market and valuations remain down – Venture Debt can provide a solution to those problems. Of course, it will be harder to obtain in the near term, and now, more than ever, startups must carefully select their lending partners. But that does not diminish its importance as a startup funding tool and valuable capital source in the ecosystem.
Author Jason Acevedo is a partner in the Venture Capital & Emerging Growth practice group in the Corporate and Securities Department at Klehr Harrison.
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