In the first seven months of the year, venture capital (VC)-backed businesses in the United States raised close to $15.9 billion in debt through 321 deals, according to Crunchbase
data. Startups disclosed over $13.3 billion in debt in 320 acquisitions by the same time in 2021.
Debt experts claim that the growth is definitely real
Even though it's crucial to note that those figures are not all-inclusive and that some entrepreneurs in industries like fintech frequently raise loans for working capital, the rise in debt coincides with many venture capital firms cutting back on funding.
The following are some of this year's highest-announced debt financing:
- Financial services company Freepoint Commodities, based in Connecticut, disclosed a $2.6 billion debt financing.
- EdgeConneX, a Virginia-based provider of edge infrastructure, completed a $1.7 billion loan transaction.
- Liquidity Capital, a newcomer to alternative financing in New York, announced a $725 million loan raise.
Why is debt financing gaining momentum?
Venture debt financing offers a business a loan that can be utilised for specific goals; such as capital expenses, liquidity for the next equity round, or acquisitions, as opposed to traditional stock investment, which dilutes existing owners. Lenders evaluate
the loan's risk profile based on upcoming equity rounds and the company's capacity to raise further capital based on its strong performance and growing momentum, so it does not entirely replace equity investment.
Since the debt is not guaranteed by ongoing, positive cash flow or company assets, which can be taken care of by regular loans or bank credit lines, the financing model is ideal for growing businesses. To make it simple for businesses to manage their capital
structure, interest is paid over the first few months of the loan, and the conditions of the loan are modified in accordance with the company's maturity profile.
Suppose you consider debt and credit facilities as becoming more appealing alternatives for startups looking for capital, particularly during a downturn like the one we are currently experiencing. In that case, you will see that the number of businesses
obtaining debt capital seems to be increasing. There may be a variety of causes for this. While some founders can find it challenging to seek venture capital, others might not want to because they would rather avoid diluting ownership.
Clara, a startup in spending management situated in Mexico City, stated on August 8 this year that Goldman Sachs had authorised it for financing worth up to $150 million. According to the statement, the facility would enable Clara to expand its corporate
card, accounts payables, and short-term financing products for companies in LATAM. The business claims it is presently collaborating with over 5,000 enterprises in Mexico, Brazil, and Colombia, and it hopes to double that figure by the end of the year. Notably,
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 headed by Coatue and became unicorn.
On August 2022, Yieldstreet disclosed that it had acquired a $400 million warehouse facility from Monroe Capital LLC in the United States. According to a representative from the upstart alternative investing company, Yieldstreet, this financing is the highest
of its kind to date. Since its launch in 2015, the firm claims to have attracted more than 400,000 customers and received over $3 billion in funding for various investment products. This isn't any typical corporate debt; it employs a warehousing facility,
which means it's intended to expand the pool of investments available to users of Yieldstreet's platform rather than pay general operations or expenses.
This is a short reminder that debt financings differ from warehouse facilities because debt is lending money for operating purposes. A line of credit is essentially what warehouse facilities are.
What to keep in mind before opting for debt financing
For venture debt, you need to make advance plans to be implemented shortly after an equity fundraising. Everyone at the table—founders, venture capitalists, and lenders—is satisfied, and there is no adverse selection for the lenders. You won't be able to
acquire debt if you try to put something in motion with less than six months worth of cash. It can be drawn down far into the future if implemented after equity financing; this is known as a forward commitment/drawdown, and offers the startup a great deal
of flexibility.
It's crucial to comprehend every single term. The existence of things like funding MACs, or investor abandonment clauses, is frequently unknown to entrepreneurs. The lender may use these clauses to prevent the startup from receiving funds or causing a default
once funds have been received. In either case, the business is in jeopardy and cannot rely on the funding. You should therefore be aware of your lender, have your venture capitalists be aware of your lender, and pay close attention to your terms.
Don't take out personal loans. Lenders frequently include numerous covenants in a deal's structure, such as minimum capital requirements. For instance, if you continually keep $2 million in the bank, they will lend you $4 million. In that instance, the actual
amount of new capital you receive is a mere $2 million. Additionally, the potential for investor desertion or MAC clause may prevent you from actually using the funds.
Lenders are becoming increasingly cautious even if startup interest in venture debt is on the rise. Startups are contacting venture financing more frequently than ever before. Lenders are also decreasing the dollar amounts of fresh commitments, shortening
interest-only periods, requesting more warrants, and becoming much pickier about which firms they choose to fund.
Conclusion
Although debt financing seems to be becoming more prevalent in the headlines, it is too early to declare the end of venture capital raises as the industry appears to be undergoing an adjustment.
Ramp, a startup company for business cards and expense management, reported a $750 million fundraising at $8.1 billion, of which $550 million was debt funding supported by Citi and Goldman Sachs. Following other fintech peers like Brex into the loan offering
space, banking service provider Mercury has announced it will start 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 yet another thing that should be kept under consideration.
Most business owners would only use debt financing if the price were the only factor, avoiding ownership dilution. Due to the first rule of venture debt, this strategy is ineffective for high-growth companies. You can bootstrap your company by forgoing venture
funding, but venture debt is probably out of the question for your business. More conventional debt may be an option, but those call for positive cash flow, such as term loans based on cash flow or asset-based credit lines.
Since venture financing is intended for businesses that put growth before profitability, the venture lender would instead follow reputable investors' footsteps than take a chance on a loan to an unbacked business.
Venture debt is typically not accessible to seed-stage businesses. Regardless of their natural entry point, most VCs (unlike most angel investors) often invest in many equity rounds and keep money reserves for this purpose. Taking a sizable amount of debt
at the seed stage is definitely not ideal if additional equity money is needed to fund the company, even if you can find a loan with an angel-backed profile. Typically, institutional VC investors don't want to see a sizable amount of their new equity pay off
previous debt.
Remember the major debt rule as well. You have to pay it back at some point, be it in total or through debt consolidation, and you cannot predict how inconvenient that day will be in advance.