In the first seven months of the year, venture capital (VC)-backed companies in the United States borrowed nearly $15.9 billion through 321 deals, according to Crunchbase data. As of the same date in 2021, startups have disclosed over $13.3 billion in debt across 320 acquisitions.
Debt experts claim the growth is definitely real
While it’s important to note that these numbers aren’t all-inclusive, and that some entrepreneurs in industries like fintech often borrow for working capital, the rise in debt coincides with many venture capital firms cutting funding.
Below are some of this year’s most announced debt financings:
- Connecticut-based financial services firm Freepoint Commodities announced a $2.6 billion debt financing.
- EdgeConneX, a Virginia-based edge infrastructure provider, has closed a $1.7 billion lending transaction.
- Liquidity Capital, a New York alternative finance newcomer, announced a $725 million loan.
Why is debt financing gaining momentum?
Venture debt financing provides a company with a loan that can be used for specific goals; such as capital expenditures, liquidity for the next round of capital or acquisitions, as opposed to traditional equity investments that dilute existing owners. The lenders are assessing the risk profile of the loan based on upcoming equity rounds and the company’s ability to raise additional capital based on its strong performance and growing momentum, so it does not fully replace an equity investment.
Because the debt is not backed by ongoing, positive cash flows or company assets that can be supported by regular loans or bank lines of credit, the financing model is ideal for growing businesses. To help companies manage their capital structure, interest is paid in the first few months of the loan and the loan terms are adjusted according to the company’s maturity profile.
Suppose you view loans and credit facilities as more attractive alternatives for startups looking for capital, especially during a downturn like the one we’re currently experiencing. If so, you’ll notice that the number of companies raising debt seems to be increasing. This can have different causes. While some founders find it difficult to seek venture capital, others may not want to, preferring to avoid ownership dilution.
Clara, an expense management startup based in Mexico City, announced on Aug. 8 this year that Goldman Sachs had authorized it for up to $150 million in funding. According to the statement, the facility would enable Clara to expand its corporate card, accounts payable and short-term corporate finance products in LATAM. The company claims it is currently working with over 5,000 companies in Mexico, Brazil and Colombia and hopes to double that number by the end of the year. At the time of a $30 million financing in May 2021, Clara’s estimated valuation was $130 million. Eight months later, it had received a $70 million Series B under Coatue’s management and became the Unicorn.
In August 2022, Yieldstreet announced that it had acquired a US$400 million warehouse from Monroe Capital LLC in the United States. According to a representative of emerging alternative investment firm Yieldstreet, this funding is the largest of its kind to date. Since its inception in 2015, the company says it has attracted more than 400,000 clients and raised over $3 billion in funding across a variety of investment products. This is not typical corporate debt; It uses a warehousing facility, which means it intends to expand the pool of investments available to users of the Yieldstreet platform rather than pay for general operating costs or expenses.
This is a quick reminder that debt financing is different from storage facilities as debt lends money for operational purposes. A line of credit is essentially what storage facilities are.
What you should consider before you decide on external financing
Venture debt requires you to create plans in advance that will be implemented shortly after a fundraising. Everyone at the table – founders, venture capitalists and lenders – is happy, and there are no adverse choices for lenders. You won’t be able to get into debt trying to start something with less than six months of cash. It can be stretched far into the future if implemented after equity funding; this is known as forward commitment/drawdown and gives the startup a lot of flexibility.
It is crucial to understand each and every term. Entrepreneurs are often unaware of the existence of things like MAC funding or investor exit clauses. The lender can use these clauses to prevent the startup from receiving funds or causing a default once the funds are received. In either case, the company is at risk and cannot rely on funding. You should therefore know your lender, make your venture capitalists aware of your lender, and pay close attention to your terms.
Do not take out personal loans. Lenders often include numerous agreements in the structure of a deal, such as: B. Minimum Capital Requirements. For example, if you keep $2 million in the bank all the time, they will loan you $4 million. In this case, the actual amount of new capital you receive is only $2 million. Additionally, the risk of investor flight or MAC clause can prevent you from actually using the funds.
Lenders are becoming increasingly cautious, even as startups become more interested in venture debt. Startups are turning to venture finance more often than ever. Lenders are also lowering the dollar amounts for new commitments, shortening interest periods, requesting more warrants, and becoming much more selective in choosing companies to finance.
Conclusion
Although debt financing seems to be becoming more common in the headlines, it’s still too early to call the end of venture capital raising as the industry appears to be adjusting.
Ramp, a business card and expense management startup, reported a $750 million fundraising of $8.1 billion, of which $550 million was debt financing backed by Citi and Goldman Sachs. Following other fintech competitors like Brex into the credit offering space, banking services provider Mercury has announced that it will launch its own venture debt offering. Mercury hopes to lend over $200 million this year and around $1 billion over the next two years.
There is one other thing that should be kept in mind.
Most business owners would only take out debt financing if price was the only factor in avoiding ownership dilution. Because of the first rule of venture debt, this strategy is ineffective for high-growth companies. You can build your business without venture capital, but venture capital is probably not an option for your business. More traditional debt may be an option, but these require positive cash flow, such as B. term loans based on cash flow or asset-based lines of credit.
Because venture finance is designed for companies that prioritize growth over profitability, the risk taker would instead be following in the footsteps of reputable investors rather than risking a loan to an unsecured company.
Venture debt is usually not accessible to companies in the seed phase. Regardless of their natural entry point, most VCs (unlike most angel investors) often invest in many equity rounds and hold cash reserves for this purpose. Significant debt at seed stage is definitely not ideal when additional equity is needed to fund the business, even if you can find a loan with an angel-backed profile. Typically, institutional VC investors do not want a significant amount of their new equity to pay down previous debt.
Also remember the principal debt rule. At some point you will have to pay it back, either in full or through debt consolidation, and you cannot predict how unfortunate that day will be.