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 By now we all know the recession has had (and is still having) a significant impact on venture capital investments. It is also restricting the amount of venture debt assumed by startup companies as this form of capital funding is somewhat tied to the amount of deals funded by VCs.
The global economic slowdown is not the only reason venture debt fundings have slowed. With the recession and the damage that followed came the realization by many in the VC and startup ecosystem that this debt actually needed to be repaid! This sobering reality has caused a material drop in requests for venture debt from companies who raised venture funding.
Before this recent recession, debt was readily available, companies were successfully receiving follow-on financings, and their prospects for success (and eventual debt repayment) were strong.
When the party ended and companies were either shutting down or not receiving additional financings, the venture debt providers reminded these companies and their investors that their debt needed to be repaid. Facing this reality (like those who did so after the Internet bubble burst earlier this decade) many again swore off the drink that caused this hangover, realizing venture debt wasn’t all that they had hoped for. It didn’t provide the “runway extension” they foresaw (even though these companies were fundamentally flawed enough that they were not supporting themselves with additional equity investments).
Unlike equity fundings into startup companies that have the potential for home runs - and lots of strikeouts - the venture debt model requires repayment rates of 95-99% (depending on the risk/return profile of the firm providing the debt). This leaves little tolerance for loans that can’t be repaid. Accordingly, when a venture debt provider does not have clear insight into how their loan will be repaid, they have a right to be concerned.
Nowadays some say venture debt has become “less useful” to entrepreneurs. The venture debt providers would counter that their product was never intended to be a “game changer” for a company, but instead provide a little extra leverage to help get a company where it needed to be before it raised its next round or before it reached cash flow break even. To be fair, many venture debt providers also would admit to their culpability in providing too much debt to companies. They too have realized their mistake in providing too much “additional runway” for companies without making sure they had an adequate repayment source.
All of this aside, the need for venture debt in the startup industry still exits. While less frequent, the request for venture debt these days are done so from a more pragmatic and conservative viewpoint.
Those who ask for venture debt knowing specifically how it will be used (and more importantly how it will be repaid) are finding competitive and appropriately structured proposals. Companies are increasingly looking to use venture debt to fund working capital shortfalls as they work to get to cash flow break even. Or they’re taking on debt to help them get to a milestone that will allow them to raise more equity, knowing their existing investors will fund the next round themselves if they have to. Bridge loans to nowhere or requests for “runway extension” to take the place of equity are rarely met with a debt term sheet.
And while this hangover too shall soon pass, let’s raise a glass and toast to having long enough memories about how venture debt should, and should not, be used in startup companies.
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Debt Companies
simon