The Reorg Primary View: Venture Debt Firms Predict Growing Demand as Equity Turmoil Continues

Dealmaking in the venture debt space has so far proved more resilient than the leveraged finance market, with volumes on pace to decline 7% year over year to total $22.4 billion through the first nine months of 2022, compared with a 28% decline in corporate bond issuance.

Despite sitting on large cash balances from record equity raises in recent years, the amount of runway startups have, on average, started to decline since the beginning of this year. As revenue multiples continue to compress, driven in part by the rising rate environment, equity is becoming increasingly expensive for tech startups that are valued on projected future cash flows. This has led to an increase in demand for venture debt and alternative financing products such as revenue-based financing, Don Muir, CEO of ARC Technologies said.

“We afford these [startups] less [equity] dilution and the chance to avoid a down round,” Jeff Bede, Managing Director and Group Head of ORIX Corporation USA’s Growth Capital Business, said recently at SuperReturn’s 2022 Private Credit conference in New York.

The chart below from Kruze Consulting, a startup accounting and advisory firm, shows the need for additional financing in the startup market. Months of runway - the amount of time a company can continue at current levels of cash burn - peaked in the fourth quarter of 2021 at about 26 months for the average startup, but declined to 23 months by the second quarter of 2022.
 
“There’s probably not enough capital to go around at embedded valuations, providing a pretty interesting gap in capital,” said Ed Testerman, a partner at King Street Capital. “The opportunity set over the next 12 [to] 18 months is as good as it’s been for a while.”

Venture debt is typically sought subsequent to venture capital raises and represents 20% to 50% of the value of a company’s equity raise. Data from Pitchbook shows VC-backed companies received $33.1 billion in debt financing in 2021, compared with $341.5 billion in venture capital raised in its record year in 2021.

These companies are often cash flow negative as they are prioritizing growth, dissuading some financiers, said Tim Gravely, co-head of credit at Aquiline Capital Partners noting that they focus on companies with the ability to flip the switch to profitability. Venture lenders have their own preferred metrics to assess opportunity. The metrics often used to gauge a company’s ability to become profitable include retention rates, how embedded the software of a company is with clients, annual recurring revenue, churn, net retention and gross margins for SaaS-based companies, Gravely said. Additionally, by looking at a company's sales and marketing spend, lenders can determine, in part, the ability of the company to de-emphasize growth and prioritize profitability.

The growth in debt financing for startups tracks the growth of the startup industry at large. During the last sustained major downturn, the global financial crisis, the amount of venture capital raised was less than a tenth of what it was in 2021, according to Statista data. However, this has now changed.

Two decades ago, Raoul Stein’s firm, Kreos Capital, was raising $100 million-sized funds. Today, his funds measure $1 billion to $1.5 billion. Stein expects fund sizes to grow even more and approach $5 billion to $10 billion as startups remain private longer, creating more mature companies and thus increasing the check sizes debt providers can write, he said.

In 2000, the tail end of a similarly buoyant period for tech valuations, the median age of the 380 venture capital-backed IPOs was six years, while in 2021 the median age of the 311 VC-backed IPOs was 11 years, according to data from Jay Ritter, professor at the University of Florida and an expert in the IPO field.

Attractive fundamentals have enticed new market participants. For the financiers, they represent opportunities to participate in deals promising mid-to-high-teen equity-like returns, with senior secured positions in the capital structure.

However, Lisa Conmy, partner at Foley & Lardner LLP, points out total returns only reach the mid-teens if warrants are included. One investor with experience lending to smaller companies sees growth lending as akin to investing preferred equity, but priced cheaper, and warns that a reset is coming for the market, which has been riding a frothy economy over the past 10 to 15 years. Additionally, the source believes the lack of collateral backing growth-lending deals negates the senior secured position many in the industry tout.

Other problems persist for the industry. Lenders may be able to extend runways for companies coming off record equity rounds in the past two years, but a longer period of subdued VC activity could hamper future lending conditions. Equity rounds provide benchmarks for lenders, and debt lenders will also need a resumption in equity flows to pay back their lending deals, Scott Orn, COO of Kruze Consulting points out.

Market participants are nonetheless optimistic. Whatever the true risk of the market, institutional finance players are continuing to dive in despite the downturn. Blackstone is planning to invest $2 billion or more into debt deals with companies across startup stages. KKR is reported to be looking to acquire a venture debt lender. Other recent entrants include Bain Capital, Vista Equity Partners and BlackRock.

The investors interviewed highlighted a key growth driver as larger financing packages for later-stage growth companies, rather than a larger amount of smaller deals. Growth will not occur at the earlier stages of the market, but rather an increasing number of higher-quality companies will raise debt in an underlevered market, Bede said.

More bespoke deal structures will also come to the market, or new models of nondilutive finance targeting subscription services will expand financing options for the startup market. As larger companies emerge in the startup environment, the swath of opportunities lenders think they can target makes them confident of sustained growth. As Bede put it, those thousands of mature, proven businesses are the core of the growth lending market.

--Geoff Burrows