Tech startups are turning to venture debt to survive bear market
Tech startups are relying on debt to get them through a tumultuous period as equity valuations slump and the era of venture capital largesse draws to a close.
Credit, rather than equity, is helping tech companies keep their operations going while avoiding a damaging “down round”, investors and tech startup heads said at the Web Summit conference in Lisbon this week.
The rising frequency of down rounds — whereby companies raise equity funding at reduced valuations — has increased tech firms’ appetite for debt, both conventional and convertible. High-profile revaluations of Swedish fintech Klarna Bank AB, which saw its value plummet by close to $40 billion, and payments giant Stripe, down 27%, have fueled the trend.
“Startups want to avoid a down round and it’s the same for us as investors,” said Cynthia Nadal, founding partner and head of fintech at capital firm Reaction. “We want to limit the mark downs in our portfolios, so we’re also the first to encourage our own portfolio companies to consider debt as a valid option, much more than we used to.”
Venture debt, which refers to bonds and loans given to startups still short of profitability, has increased significantly over the past several years, according to data from PitchBook Data, Inc. Volumes in the US hit $17.1 billion in the first six months of 2022, up 7.5% from the same period in 2021. Meanwhile, venture capital funding is down 8% over the same period to $147.7 billion.
But debt financing comes at a cost. While deals are typically private, Kreos Capital told Bloomberg earlier this year that the coupon rate is 9%-10%, compared with conventional corporate bond markets with lower yields. Such arrangements weigh on the companies’ balance sheets, and could also impact their ability to reach profitability and obtain future funding rounds.
Mood Music
Market leader Silicon Valley Bank is in the process of closing a $2 billion venture debt fund while big financial firms such as Blackstone Inc. and KKR & Co. are also entering the space.
“Last year it was difficult competing with the amount of available equity capital,” Rosh Wijayarathna, head of corporate finance for EMEA at Silicon Valley Bank, told Bloomberg. “This year the mood music has changed with pressure on valuations, and debt capital is now a lot more attractive.”
He said that SVB Capital’s funding has been across various structures including straight debt and convertible debt, a type of bonds that can be converted into shares after a given period of time, usually at a pre-agreed price.
One startup that has made use of debt is Laka, a UK tech firm operating in the insurance space. Co-founder and chief executive Tobia Taupitz told Bloomberg that the company had issued convertible debt to its existing backers and also taken on venture debt from Silicon Valley Bank.
“We did a Series A funding round in January, but I don’t know what the market is going to look like in the next six months,” he said. “This debt gives us optionality.”
Convertible Debt
Convertible debt has been something of a favorite for large tech companies in recent years, with the likes of Peloton Interactive Inc., Just Eat Takeaway.com NV and Affirm Holdings Inc. all issuing “zero coupon” convertible bonds during the pandemic era to a hungry investor base anticipating big gains in the underlying stock.
In the current environment, however, it has become much more of a defensive deal, allowing investors to support their portfolio companies through the next few years until valuations recover, in theory.
“As a company, you have a ticking clock of two, two-and-a-half-years before you need to do a funding round — and you don’t want that to be a down round,” said Brian Smiga, managing partner at Alpha Partners. “So what you do is you take on debt — and if you’re a cash generative company, you can even use it tactically to gain market share.”
